Hennessy Japan Small-Cap Fund 2nd-Quarter Commentary: Earnings Growth Driving Japan's Market Higher
Hennessy Japan Small Cap Fund (Trades, Portfolio) Portfolio Manager Tadahiro Fujimura describes how corporate earnings growth is driving Japan's stock market higher and why mergers and acquisitions activity is on the rise. He also shares his thoughts on small-cap valuations and why his portfolio has shifted toward purely domestic Japanese companies.
While the Japanese economy has been growing steadily, inflation is still well below the central bank's 2% target. Given these conditions, what is your outlook for the Japanese market?
We believe Japan is slowly emerging from its long period of deflation. There is no doubt that an inflation rate of 2% will be hard to reach in the short term, but we believe keeping the consumer price index (CPI) rising at a rate of about 1% is much more achievable and will help change expectations regarding inflation. In its latest reading, inflation edged up to 1.1% in March 2018.
In our opinion, corporate earnings growth is the main factor driving the Japanese stock market higher. During the country's tough deflationary years, Japanese companies were forced to restructure, close plants and reduce employment to survive. These moves increased the efficiency of Japan's corporate sector. As a result, Japanese companies today are highly profitable, internationally competitive and are generating strong corporate earnings growth. We believe earnings growth will continue to be robust, supporting further advances in the equity market.
Mergers and acquisitions (M&A) have had a major influence on the U.S. market. Would you please comment on how M&A trends might be affecting equities in Japan?
Ten or twenty years ago, Japanese management teams thought about M&A very conservatively and were reluctant to pursue deals. However, M&A activity is much more popular now, for two main reasons:
Japanese companies have ample cash on their balance sheets. Returns on these cash balances are low and so there is a significant incentive to raise returns by buying assets through M&A transactions.
Many companies in Japan were established following the end of World War II. Founders of these companies are now near or past retirement age and are looking at M&A to provide them with their succession plan.
Last year was a record for M&A activity in Japan, and we believe activity in 2018 will be just as robust. Small-cap companies, especially, are likely to be acquisition targets.
How much of the Fund's portfolio is exposed to Japan's domestic market and how much to overseas markets?
The Fund's investments are diversified geographically, with exposure to many overseas markets as well as to Japan's domestic market. The Fund's holdings can be divided into three categories with current weightings as follows:
Purely domestic companies - 40%
Companies with partial overseas exposure - 35%
Companies with predominant overseas exposure - 25%
In comparison, a year ago, the Fund's investments were spread evenly among each category. The shift is the result of our belief that domestic companies currently offer slightly greater opportunities for excess return compared to companies with higher foreign exposure.
Would you please discuss valuation levels for Japanese small- and large-cap stocks? How does the Fund's valuation level compare with small-cap stocks generally?
In 2013, the TOPIX Small Index traded on very low valuations, with an average price-to-earnings ratio (P/E) of approximately 10x. Since then, small-cap stocks in Japan have outperformed large-caps and they trade on an average trailing P/E of 17.4x versus 14.2x for the Tokyo Stock Price Index as of March 31, 2018. However, we believe small-cap stocks merit higher P/Es because they are growing faster. Operating profits growth for small-cap stocks has averaged 15% annually over the last five years while operating profits growth for large-caps has averaged only 6% annually.
The Fund's median trailing P/E is 17x, a slight discount to the market, and we estimate that our companies are growing their earnings faster than small-caps overall.
Why should U.S. investors consider investing in Japanese equities?
We believe that tighter monetary policy--or higher interest rates--presents the biggest risk to equity markets around the world in 2018. We believe Japan has one of the lowest exposures to this risk since Japan's central bank is still pursuing an easy monetary policy. In addition, Japan was mired in deflationary recessions when the rest of the world began its economic recovery in 2010. Therefore, while much of the rest of the world has already seen eight years of growth, Japan's expansion is still in its early stages.
Finally, factory automation, such as the use of robots, sensors, motion controllers and other labor-saving technology, is transforming manufacturing everywhere. Japan is the undisputed leader in the fast-growing factory automation market, and many public companies are benefiting from burgeoning growth in demand. Robotics and automation is a major theme of the Japan Small Cap Fund's portfolio.
This article first appeared on GuruFocus.
