Taking stock of Japan’s equity market

Nicholas Price, portfolio manager of Fidelity Japan Trust PLC, takes stock of what has been a very challenging period for investors. He discusses how the market environment is likely to evolve over the coming months and outlines the key areas of opportunity he sees among small and medium-sized companies with sustainable growth prospects.

Key points

• Against a backdrop of rising rates and slowing growth, we have been focusing on defensive/sustainable growth names and services companies that can grow their earnings in a more testing environment.
• We are also finding opportunities in the mid/small-cap space, where valuations have come down significantly and made it a bargain sale for mid-term investors.
• While new listings, both in Japan and globally, are coming under pressure amid heightened geopolitical and inflationary risks, new growth companies are still coming through, which will create future opportunities in the pre-initial public offering market.

 
The first half of the year has been difficult for investors. Aggressive action by global central banks to rein in inflation, supply chain disruptions due to Covid-19 and the war in Ukraine have all resulted in prices declining across regions and asset classes.

While the Japanese market has fallen only modestly in yen terms, style trends have been extreme. Growth stocks underperformed their value counterparts by more than 20% in the first six months of the year, which created performance headwinds for the Trust. As a result, the Trust’s net asset value (NAV) underperformed the index. The 6% fall in the value of the yen against the pound since the end of last year also weighed on the sterling-based returns of the Trust’s NAV.
 

Sustainable companies

 
We turned slightly more cautious towards the end of last year (inventories were on the rise in the manufacturing sector and there were signs of a post-Covid-19 shift from goods to services) and started to look towards companies that can grow sustainably through the second half of 2022 and into 2023.

Against this backdrop, we have been focusing on defensive/sustainable growth names and services companies that can grow their earnings in a more testing environment, as well as those that can positively surprise the market on mid-term growth. Key active positions such as NOF, Olympus and Oriental Land are prime examples.

We are also looking at oversold growth names that are globally competitive and trading on compelling valuations. Gas water heater maker Rinnai is a recent example. Some small-cap growth names have become value stocks, so there is a good opportunity for multiple expansion in the future.

At the same time, we have been keeping a close eye on commodity prices, especially oil, as this will exert a further squeeze on manufacturing margins. On the flip side, there are opportunities in companies that supply equipment to the energy sector (beneficiaries of energy diversification in Europe) and are at the bottom of their respective cycles. Plant engineering company JGC Holdings is an example of a stock that we added to the portfolio. Efforts to secure alternative energy sources globally are driving new liquefied natural gas plant orders for the company.
 

Unlisted positions

 
Following the increase in the Trust’s unlisted limit to 20%, we remain highly active in this domain. From a bottom-up perspective, we continue to see significant entrepreneurial activity in Japan, more so compared with five to ten years ago.

While new listings, both in Japan and globally, are coming under pressure amid heightened geopolitical and inflationary risks, new growth companies are still coming through, which will create future opportunities in the pre-IPO market.

Being on the ground in Japan, and seeing many different companies, means that we are well placed to help entrepreneurs in the latter stages of their pre-IPO journey. We now hold seven unlisted names, representing around 8% of the portfolio, including a new position in a company that operates Japan’s leading learning management platform for high school students and associated services for educational institutions. We continue to evaluate new opportunities, while maintaining a disciplined approach towards valuations.
 

Outlook

 
We believe markets will remain susceptible to a high level of macroeconomic uncertainty, centred on global inflation and interest rates, and attendant concerns about the risk of recession. While we are closely monitoring the impact that imported costs are having on companies and consumers in Japan, inflation is much lower than in other regions and the country is starting to get back to normal as the pandemic recedes.

In this environment, we are focusing on domestic reopening names and oversold, consistent growers. There are also opportunities in the mid/small-cap space, where valuations have come down significantly and made it a bargain sale for mid-term investors.

Japan continues to offer a wealth of under-researched mid/small-cap growth companies. Active managers such as Fidelity, based here on the ground, have the opportunity not only to invest in established global leaders, but also to unearth less well-known companies (including pre-IPO), where lower levels of analyst coverage can often create some great mispriced opportunities.

In an uncertain environment, our in-depth research and on-the-ground knowledge is invaluable when looking at the micro level and speaking to company management to fully understand the prevailing dynamics.
 
More information on Fidelity Japan Trust PLC here >
 

 
Important information
 
This information is for investment professionals only and should not be relied upon by private investors. The value of investments can go down as well as up and you may get back the amount you invested. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Fidelity Japan Trust PLC can use financial derivative instruments for investment purposes, which may expose it to a higher degree of risk and can cause investments to experience larger than average price fluctuations. The shares in the investment trusts are listed on the London Stock Exchange and their price is affected by supply and demand. The investment trusts can gain additional exposure to the market, known as gearing, potentially increasing volatility. Investments in smaller companies can carry a higher risk because their share prices may be more volatile than those of larger companies. Changes in currency exchange rates may affect the value of an investment in overseas markets. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only.