On the surface, Japan presents few opportunities for the growth investor. In real terms, the economy has grown just 3% over the past 10 years and it has contracted by 7% in nominal terms. On its current course, Japan’s growth potential is likely to continue to fall as labour participation declines (the workforce peaked as long ago as 1998) and labour productivity gains remain low.
But over the past 10 years, Japan’s listed company sales have far exceeded the growth of nominal GDP. Three areas of growth stand out: the opportunity to expand overseas, especially in Asia; growth through innovation; and growth through disruptive business models.
Japan’s outlook is increasingly harnessed to its Asian neighbours’. China is now Japan’s largest trading partner, with Japan normally operating a small trade surplus. Japan’s foreign direct investment into Asia in 2009 was four times that of the US. One survey of non-financial companies showed that 36% of operating income in the last reported year came from developing markets. Investing in Japan need no longer be about labouring over market share gains in a contracting domestic market. In 2010, 84% of Yamaha Motor’s operating profit came from Indonesia alone. Many Japanese companies have managed to establish high market shares and first-mover advantages in various Asian markets. SMC in pneumatic equipment and Shimadzu in analytical equipment are two examples (see Chart 1 below).
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Many Japanese companies have grown significantly through technological or process innovation. In the past 10 years, Japan has produced 10 Nobel laureates, six in chemistry and four in physics. All but three conducted their research in Japan. Its expertise in material processing is unparalleled. Companies like Keyence and Yaskawa have leading edge technology in a number of fields relating to factory automation. Keyence makes operating margins of around 50% and has grown earnings by over 11% p.a. over the past 20 years. Rakuten is an entrepreneurial internet company, whose on-line shopping mall has considerable overseas potential. In general terms, the whole area of mobile internet looks increasingly interesting as data usage returns pricing power to operators and new businesses develop on standardised operating systems.
Another area of growth comes from competitors’ unwillingness or inability to change traditional practices. This gives an opportunity to more innovative companies, which can develop fast-growing and highly profitable businesses. Successful retailers, such as Nitori, have developed models which circumvent layers of wholesalers and suppliers and proven their businesses to be extremely profitable despite a difficult macro environment. Selling furniture into a contracting housing market, Nitori has managed 26 years of consecutive profit growth. In financial services, SBI Holdings and Sony Financial have developed pure on-line models, to which incumbent operators have been slow or unwilling to adapt.
Japanese companies are also much more adept at cost-cutting than they were. This may not deliver sustained growth but, as one survey showed, non-financial Japan has made itself much more profitable by lowering its breakeven by 13 percentage points in FY09. Many companies will, as a result, have achieved peak profit margins last year but with far lower revenues.
Japan is often seen as a market for value rather than growth investors. The argument is usually based on the observation that value indices have outperformed growth. What this ignores, however, is that many growth managers have also outperformed. It also overlooks the fact that many growth stocks are quite lowly rated and that, interestingly, the valuation (P/E, P/B) difference (using MSCI data) between “growth” and “value” is narrower in Japan than in the US or Europe, representing an excellent opportunity to exploit.
Donald Farquharson is investment manager with Baillie Gifford & Co
