Why emerging markets now?
Many of Japan’s strengths both contributed to and resulted from that prolonged period of dynamic growth from the 1950s to the 1980s.
The national political scene is almost boringly stable, while politicians are supported and guided by an army of famously competent and dedicated bureaucrats. Prime ministerial approval ratings rise and fall and, occasionally, voices of (usually very specific) protest are politely (although loudly) raised in the streets, but nothing threatens to upset the applecart. Market moves resulting from political events are usually short-lived and soon reversed, and investors can, for the most part, regard politics as a sideshow.
‘Japan retains formidable strengths. But where are they being most effectively applied, and what should our notional SWOT analysis for the nation look like today?’
Mobility and discretionary-related themes will likely take time to recover such as EM travel and tourism. However, many secular growth opportunities remain attractive in emerging and frontier markets. Technology disruption continues to be a key area of focus due to structural growth advantages such as lower penetration in fields such as smartphones, payments and food delivery. Moreover, we continue to see opportunities in the cloud and 5G spaces, mainly in North Asia. The recovery in commodity prices and the persistent electrification of the economy should be positive for holdings in our copper, sustainable energy and new auto technology themes.
While the outlook for emerging markets remains encouraging, there are various risks to our thesis. We have been monitoring Covid-19 closely and despite significant progress made in various emerging markets, the threat of a second wave and actions taken to prevent a further spread of the disease could affect the timing of a global economic recovery. The secular growth in the themes we outline is exciting. However, companies and sectors constantly evolve and there is a risk to our forecasted earnings if technology changes are rapid. Lastly, trade tensions and the upcoming United States Presidential Elections have the potential to disrupt investor sentiment towards emerging markets.
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Amidst the psychological turmoil which investors in Japan and elsewhere are suffering as a result of Covid-19’s exacerbation of an already complex environment, it is perhaps timely to reflect on where, on the longer-term arc of dynamism and decline, Japan now sits, and perhaps to offer a tentative SWOT analysis, looking at where the best medium and longer-term investment opportunities in Japanese equities may be found.
In the early years of Japan’s 70-year arc of dynamic growth, maturity and relative decline, corporate managers were obliged by circumstances to be bold. While those leading now-famous companies were often quite young, boldness was not a preserve of the young, and many elderly, grey managers with bottle-bottom spectacles made eye-watering, strategic bets which could make or break their companies. The result was the nation’s now almost forgotten “economic miracle”, in which Japanese companies cut swathes through large, international product markets including steel, shipbuilding, motorcycles, cars, cameras, and industrial and consumer electronics.
The maturing of many of these markets, together with the rise of powerful international competitors (often the beneficiaries of exported Japanese technology) put an end to that phase in economic/corporate history, and observers could perhaps be forgiven for viewing today’s Japan as a nation of comfortable geriatrics, living off the fruits of former glories.
The truth, of course, is much more complicated. Japan retains formidable strengths; but where are they being most effectively applied, and what should our notional SWOT analysis for the nation look like today?
In the context of the 70-year arc of growth, maturity and relative decline, this is the major weakness. The implications of the burden on a relatively shrinking workforce of a growing elderly population have been well aired elsewhere, but the effects of this on national economic and corporate efficiency should not be underestimated and warrant some attention here.
Simply stated, the elderly in Japan have most of the money and retain
much of the political and corporate power. This effects national policy
(for a similar observation about the UK, see the recent Economist article
“Why Boris Johnson’s Grey Army is Bad for Growth”) and there are innumerable cases of geriatric founder/chairmen impeding much needed change in Japanese corporations.
For a country famous for its high-tech prowess, Japan has retained many surprisingly inefficient practices which could long since have been smartened up using modern technology. Perhaps the best-known example has been the continued use of official and personal hanko, the physical seals required to be affixed to many documents, invoices etc. The advent of Covid-19 made the use of these even more difficult, as staff were denied access to their offices, accelerating an already existing trend towards their replacement by electronic systems. The broader trend of which this is a part is referred to in Japan as “DX” (for “digitalisation”) a movement which is providing exciting opportunities for some companies.
Broadly speaking, the major threats to Japanese companies have either always been present, such as vulnerability to natural disasters, or have developed over time in the increasingly competitive environment which has resulted from a combination of economic maturity and globalisation.
The emergence of China as a global economic colossus in recent years has undoubtedly taken its toll on the market shares of some Japanese companies and the pressure from that source is unlikely to abate anytime soon. However, some Japanese companies have benefited from Chinese growth in surprising areas through specialist excellence. It is astonishing that the aforementioned Shimano has not been obliterated by local competitors in a market which has direct access to hundreds of millions of cyclists and that, before Covid-19, stores in Tokyo’s Akihabara “electric town” were thronged with Chinese tourists buying Zojirishi rice cookers. Some Japanese retailers have thriving Chinese operations, as do many manufacturers. China, then offers both threats and opportunities and much the same could be said for Korea.
In this connection, intellectual property theft – wherever it may originate – ,
or, indeed the legal acquisition of key technologies, is a potential threat to any company with specialist knowledge and skills, whether it is Yakult’s famous yoghurt enzyme, Shimano’s cold forging, Asahi Intecc’s high torsional strength surgical guidewires or the optics patents of any of a multitude of Japanese mid-cap companies. Fortunately, most have so far proved to be able to protect themselves through patents and through their grip on the focused commercial networks through which they trade.
Protectionism is an ever-present systemic threat, which has often impacted large Japanese companies and, wherever strong market penetration and political resistance combine, will probably continue to do so. However, as it is a potential threat to any company operating internationally, it perhaps does not merit specific mention in a Japanese context.
Strengths, weaknesses, opportunities and threats
So – where is the dynamism?
A tendency to institutional rigidity
The Old Guard is moving on
the services sector
The covid-19 factor
‘There are still many Japanese companies which enjoy dominant, and apparently robust, market shares in more niche areas’
The names shown above are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or advice. No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment.
The names shown above are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or advice.
Japanese society is famously disciplined and consensual and, while it would be a mistake to ignore real potential sources of tension, here again, stability can largely be taken for granted.
Japanese people are, generally, highly educated and skilled, and this is reflected in a deep reservoir of corporate knowledge which extends into the international arena, reflecting a genuine internationalism, both in the government/bureaucracy and in corporations.
Anyone with experience of dealing with Japanese bureaucracy in the public sector will have encountered the many, almost comical, inefficiencies which persist because the system is deemed to be broadly effective and, provided that those on the receiving end do not take to the streets in protest at its peccadilloes, nobody is inclined to tinker with it.
Such attitudes can also be seen in the corporate world but there the problems tend to be more strategic in their scope and the reasons for their persistence are different.
Meaningless operational diversification, prestige projects, inflated balance sheets and opaque corporate governance structures are well-known and, to the investor’s eye, obvious flaws in the management of Japanese companies which have proved resistant to change over the years. While the winds of change are strengthening, the drag of what might be described as gerontocratic hubris is still all too visible in many companies. This is particularly common where the influence of the company founders or the managers of the “miracle” years persists. It was not so long ago that the world was in thrall to the efficiency of Japanese management (think Ezra Vogel’s famous 1979 publication: “Japan as No.1”) and it is easy to see how this may have resulted in hubris among the old guard.
The fact is that, although Japanese companies were then, and generally remain, very efficient in their physical operations, their bureaucracy and their management as corporate entities have often been very weak, with severe implications for enterprise and shareholder value. Critics of old-fashioned management thinking often, for example, refer to kechikechi kanri – a simplistic “management by stinginess”.
The tectonic foundations of the Japanese archipelago are famously shaky and, although such incidents are seldom widely reported outside Japan, earthquakes and volcanic eruptions occasionally cause significant disruption, as do tsunamis, flash floods and landslides, the latter more common as the global climate changes.
Arguably the big opportunity. If, in total, Japan has been losing market share in many of the broad product markets which it used to dominate and enjoyed technology-driven ascendency in such advanced areas as integrated circuit fabrication for only a short time, there are still many Japanese companies which enjoy dominant, and apparently robust, market shares in more niche areas. Some of these, such as Shimano’s dominance of the market for bicycle gears (based, allegedly, on an ancient tradition of metal-forging skills in its Sakai home base) are surprising, insofar as they operate in ostensibly simple product markets. In many other cases, companies enjoy large, global market shares in esoteric industrial products which most people will never have
Which brings us to what might be argued to be the real sweet spot in the Japanese equity market: the 中堅企業, chuken kigyo, the medium and small companies which represent the strategic backbone of Japanese industry - the mittelstand as they are referred to in German-speaking countries. These are often so good at what they do in their niche markets that larger companies do not attempt to compete with them, and they have therefore weathered the storm of globalisation better than many of the big-name companies operating in broader arenas. Some of them are new, providing newly invented niche products and services, while others have been around for decades.
While environmental issues have only come to the fore relatively recently in the Western world, a series of early environmental disasters (Minamata etc.) together with the pressures of a large and tightly-packed population, have meant that the environment has been taken very seriously in Japan for much longer. This concern has spawned many related technologies, which have
been developed by companies large and small. As such, heightened environmental concerns abroad provide something of a following wind
for many Japanese companies.
In the past, employment in Japan was heavily weighted towards secondary industry, with comparatively few engaged in service activities in the private sector. As the economy has matured, employment in services has grown and now approaches the levels seen in the “Anglo” economies: Canada, the UK and the US. A gap of 8-9% remains, nonetheless and demographic shifts and changes in corporate attitudes to outsourced services mean that the convergence is likely to continue, and so investors should be alert to the growing scope for investment in the services sector.
As the heroes of the “miracle” period ride off into the sunset, however, corporate attitudes are changing. Much has been made of the changes in corporate governance and stewardship of the Abenomics period, and there can be no doubt that these have been seminal.
The implicit assumption now is that “suitable” governance structures
should be in place and that shareholders and managers should cooperate in the promotion of good corporate stewardship. However, in Japan as elsewhere, such changes mean little unless corporate managers are genuinely committed to adherence to their principles. Whilst the most active proponents of change rail at what they perceive to be the glacial pace of real progress, the direction of travel is clear and the waning influence of the forces of resistance can be seen in, for example, the weakened position of Keidanren – the Japan Business Federation. Investors who have direct dealings with Japanese companies now observe more positive attitudes in “young” companies, but also in older companies where a generation change in management has resulted in rejuvenation.
In all, although it might be an exaggeration to describe what is happening
as a revolution in Japanese management, there can be no doubt that
improved governance and stewardship attitudes (and not just structures and guidelines) are emerging in a manager class which is better equipped for future businesses.
Large shares in markets with high barriers to entry
Deep specialist knowledge
Competent and forward-looking management
Relative simplicity of structure with no conglomerate discount
Strong brands (where relevant) or high repute among B-to-B customers
And, maybe, first mover advantage
Whilst world-beating excellence can still be found in large Japanese companies serving mature markets, it is the maturity or saturation of those markets which blunts the commercial value of this internal excellence. Most of Japan’s erstwhile champions either face growing competition from foreign operators which have followed in their wake or have already been overtaken by them. Famous names have even become potential takeover targets and it is clear that excellence, in itself, is not enough. So, what are the characteristics which point to the dynamic sweet spots of Japanese industry?
A reasonable list might be as follows:
• Financial stability
• Competent and forward-looking management
• Deep specialist knowledge
• Large shares in markets with high barriers to entry
• Relative simplicity of structure with no conglomerate discount
• Strong brands (where relevant) or high repute among B-to-B customers
• And, maybe, first mover advantage
It is also preferable to find companies where a new management
dynamism is emerging, either in a new company or in a company where management is being transformed by the elevation of a new, more dynamic, generation. This is particularly valuable when the rejuvenated management can be persuaded to improve the efficiency of the corporate entity,
as well as the physical operations.
Many Japanese companies have all or most of these advantages but, clearly, most do not. Investors can no longer, as they once did, just bet on the overall dynamism of “Japan Inc.” The nation has many abiding strengths but the days when such a broad-brush approach to investing in Japan was warranted are long over.
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