Structural underweight to Japan 'a thing of the past'

The impact of Abenomics and a domestic drive to improve corporate earnings and return on equity will lead institutional investors worldwide to lower their structural underweight on Japanese equities, forecast Chris Sunderland of Eaton Vance.

Speaking at AsianInvestor’s fourth annual Institutional Investment Forum in Tokyo earlier this month, portfolio manager Sunderland said: “It is interesting that pension funds [in Japan] are now playing what is the activist role we see a lot in the US.”

Japan’s Financial Services Agency (FSA) – which oversees banking, securities and exchange, and insurance – recently published final details of the corporate governance code, set to come into effect this June, with a six-month grace period for compliance.

It sets out principles for companies in Japan to follow on issues such as shareholder rights and dialogue, disclosure and responsibilities of the board of directors. While not legally binding, it requires companies not in compliance to explain why not.

It works in tandem with rules being introduced this June by the Tokyo Stock Exchange, setting governance standards that firms need to meet or risk being de-listed.

Japan also published a stewardship code last year aimed at investors to promote the sustainable growth of companies through investment and dialogue. Some 184 institutions in Japan have committed to the code, including 19 local pension funds.

That number includes Japan’s $1.3 trillion Government Pension Investment Fund, which late last year overhauled its equity portfolio with the addition of three benchmark indices for passive investment, including the JPX-Nikkei Index 400, comprising firms selected for higher return on equity and profits.

Sunderland said large pension plans benchmarking to the ROE-enhanced index was good news for shareholders, along with corporate cash finally being used for buybacks and dividends and more independent directors on company boards.

“In general Japanese companies will become less risk-averse and similar to what we have seen in the US,” he said, pointing out that the gap in average ROE between Japan and the rest of the world had shrunk from nine points to five.

“What is really good about this is it is just going to attract more investors and foreign flows into Japanese equities,” said Sunderland. “I think it will lead to a lower structural underweight from long-term investors, so we are pretty excited about it.”

He noted that Hexavest, one of Eaton Vance’s equity investment strategies, had been overweight Japan for two years, sparked by Abenomics and Bank of Japan action.

At the same time he cautioned its call on Japanese valuations was also relative, more a reflection of what he called “Tina”, standing for “there is no alternative”.

Looking at 10-year forward price-earnings, he noted there were few opportunities worldwide, with Japan one of the few options at 14 times earnings, versus 17 times for the US. Emerging markets were even cheaper at 12 times.

“One of the major challenges is there is very little valuation dispersion between countries, which leaves very few interesting opportunities,” he explained.

Sunderland also noted a 96% correlation between a weakening yen and a positive performance for Japan’s equity market. “So long as we believe the yen will continue to depreciate, it is a prudent move to stay overweight Japanese equities,” he added.

However, globally he said Hexavest – a contrarian investor – was positioned defensively, being overweight consumer staples, telecoms and utilities, and underweight cyclical sectors such as energy and industrial/materials. It has raised its cash holdings to 9.5%, against a hard cap of 10%.

Sunderland highlighted fears over investor sentiment, with the Ned Davis Crowd Sentiment Poll – widely followed in the US – having remained in the extreme optimism zone for the past two years.

He added the number of bearish retail financial advisers had not been this low since 1987. “There are too few bears out there. This indicates a high level of complacency among financial advisers and is another troubling sign to consider,” said Sunderland.