Junichi Inoue, Head of Japanese Equities, discusses why the Japanese stock market performed well last year despite its cyclicality and shares his outlook for a recovery in 2021.

Key Takeaways

• Japanese stocks related to the travel and leisure sectors were hit hard by the pandemic; conversely, video/computer gaming, software, IT and certain retailers benefited from the changing lifestyle brought about by COVID-19.
• In the latter half of the year, as companies adjusted to the pandemic, the market’s outlook turned more constructive, enabling more cyclical/laggard stocks to catch up.
• Going forward, we are optimistic on the prospects for Japanese stocks in 2021 and think it is reasonable to expect a similar level of performance to 2020 on the back of a broader earnings recovery and favorable valuations.

Japan’s annual bluefin tuna auctions are typically well-covered events. The first fish auctioned off at Tokyo’s Toyosu Fish Market every year has tended to garner the most media interest, mainly for the exorbitant prices they sell for. Past years saw year-on-year records being broken consecutively. This year, the event made headlines for a different reason: The first tuna was sold for only 21 million yen (roughly US$202,000), or just a tenth of 2020’s winning bid, according to a Bloomberg news report.

The motivation behind the bid is quite a pragmatic one. A 200kg bluefin tuna can be used to make around 8,000 pieces of sushi. Assuming 500 yen a piece, the winning bidder – typically a famous national sushi restaurant chain – stands to lose money from these yearly ceremonial auctions. However, this had previously been a justified, perhaps even welcomed expense due to the positive publicity it generated.

This year, the change in Japanese consumer habits brought about by COVID-19 has meant no one was dining out; as a result, the appetite to keep up this yearly “marketing expense” also shrunk.

We think this development reflects the wider current consumer sentiment and could be an indicator of future trends in the Japanese stock market.

A Polarized but Positive Year

Beyond sushi restaurants, 2020 was a year that tested the resilience of many companies. Unlike tuna prices, Japan’s stock market performed well despite its cyclicality, supported by fiscal and monetary policy as well as strong corporate balance sheets. In 2020, the TOPIX registered a total return of 7.4% in yen terms and an annualized total return of 9.6% in yen for the 10 years to 31 December 2020.¹

Generally, Japanese stocks related to the travel and leisure sectors were hit hard by the pandemic while the manufacturing sector also experienced severe setbacks due to collapses in supply chains. Conversely, video/computer gaming, software, IT and certain retailers benefited from the changing lifestyle and consumption habits brought about by living in the shadow of COVID-19. In the latter half of the year, as companies adjusted to the pandemic, the market’s outlook turned more constructive, enabling more cyclical/laggard stocks to catch up. Going forward, we are optimistic on the prospects for Japanese stocks in 2021 and think it is reasonable to expect a similar level of performance to 2020 on the back of a broader earnings recovery and favorable valuations.

Opportunities and Risks

While the pandemic has made life challenging in 2020, one interesting investment theme that has emerged from the global crisis involves the consolidation of Japanese companies. The lack of pricing power has resulted in low margins and cash flow return on investment (CFROI) for many companies. Forced by the pandemic and helped by the extremely low cost of debt financing, many firms have announced restructuring and/or merger and acquisition plans to improve returns to shareholders. We also see attractive opportunities in domestic industrial production. There is substantial room for production recovery due to low inventory levels across supply chains as a result of the pandemic, and in our view operational leverage seems to be underestimated by the market.

Meanwhile, businesses with heavy fixed costs such as transportation and hospitality are likely to continue to suffer, particularly if COVID-19 cases rise further. Another key risk for Japanese stocks is an appreciating yen, which may dampen corporate earnings and appetite for capital expenditure for Japan’s exporters.

Suganomics

An area of interest for investors in Japanese stocks is the market outlook under the leadership of Prime Minister Yoshihide Suga. Like his predecessor, Prime Minister Suga is pro-market. However, in comparison he appears to be much more focused and directly involved in the day-to-day business affairs of private Japanese companies. We believe Suga’s style is likely to benefit the market as his policies look to be more predictable and transparent. Plans to completely digitize administrative procedures and for Japan to achieve carbon neutral status by 2050 are due to be presented in detail. We think these represent new investment opportunities, which have yet to be fully priced into stock valuations.

In terms of geopolitics, we think the trade dispute between the U.S. and China may become more constructive under a Biden presidency. We believe this to be a mutually beneficial outcome and that Japan, too, will be a beneficiary of any improvements in trade relations between the two rivals.

Keeping a Steady Focus

Based on how bluefin tuna prices were trending at auction, one might have reasonably expected another record-breaking year in 2021. However, stripping away the hype and media buzz reveals the much lower intrinsic value of the fish. Similarly, while there can be gains from simply trading stocks, we continue to believe that it is the best-quality companies that are capable of creating shareholder value over the longer term. The uncertainty of 2020 highlighted the importance of staying true to our investment approach of focusing on long-term value creation. We believe investors should consider Japan as a leveraged play for a recovery in global growth in 2021.

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¹Source: FactSet, data from 1 January to 31 December.

Tokyo Price Index (TOPIX) is a metric for stock prices on the Tokyo Stock Exchange (TSE). TOPIX is a capitalization-weighted index that lists all firms in the “first section” of the TSE, a section that organizes all large firms on the exchange into one group. The second section of the TSE pools all of the smaller remaining companies.

Cash flow return on investment (CFROI) is a valuation metric that acts as a proxy for a company’s economic return.