Global investors need to have an open mind. At any given time, many countries and markets around the world may appear to be rife with risks and problems, and yet in many cases, these countries may also offer sources of return that may not be evident at first glance. The best global managers are the ones that probe below the surface and find those sources of return. An excellent case study for this idea is Japan, a country that many investors wrote off long ago—but one that managers have successfully mined for return opportunities during the country’s extended economic struggles.
In 1989, as the Berlin Wall began to fall, another 20th century institution, namely the Japanese market, started to collapse.
On December 29, 1989, the Japanese equity market peaked at a level of 2,881. Many readers may not recall the market’s euphoria for all things Japanese. Unbridled optimism ushered in an economic bubble of historic proportions. The fever pitch reached such a level that at one point the 379 acres under Tokyo’s Imperial Palace were assessed at a value greater than the entire state of California. However, the downturn was swift. By August 1990, the Japanese market had plummeted to half of its peak.
Roughly 29 years have passed and the Tokyo Stock Price Index or TOPIX (1,695) is still 42% below its 1989 peak. The aversion to Japanese equities today seems just as great as the insatiable demand investors’ exhibited just three decades ago.
One principal reason for the antipathy has been Japan’s lackluster economic performance. Annual real economic growth since 1994 has averaged less than 1%. Over that time period, the TOPIX has only fared slightly better. The Index has delivered 2.1% in local terms and 1.6% in USD terms given the slight depreciation of the Japanese yen.
Japanese policy makers have not been indifferent to the economic malaise. Stimulus measures have been both firm and consistent. In fact, government debt, the one area where Japan’s growth plans have succeeded, has expanded to 236% of GDP.
Putting recent experience aside for the moment, we would argue that a story is developing in Japan that investors may be missing. One of the potential reasons for the market’s unawareness to Japanese opportunities is its persistent and unwavering focus on growth.
It is not uncommon for investors to focus on growth as the single most important factor generating returns. Higher growth is “good” while lower growth is “bad.” And here’s the point in the analytical framework where investors may risk making a meaningful mistake.
While economic growth can be a critical factor in equity market performance, it is certainly not the only factor; and in many cases, likely not the most important. This type of single-factor analysis overlooks key variables at the company level such as return on capital, interest rates and entry points (i.e. valuation). Regarding the last point, it is completely plausible to generate above-average rates of return from a business in a state of decline assuming the purchase price reflects the economic reality.
From a macro perspective, we concede that Japan’s economy remains lackluster. From a micro perspective, however, a more interesting story emerges. There is a subset of companies within the Japanese economy undergoing a transformation. As part of this metamorphosis, management teams are paying greater attention to creating shareholder value.
Moreover, Japan’s equity market remains deep, liquid and well organized in our view. Pockets of considerable industry fragmentation are poised for a first-mover advantage, especially given the trifecta of cash-rich balance sheets, ultra-low interest rates and valuation support. Finally, a prolonged lack of interest in Japanese equities by foreign investors has arguably made the equity market reasonably inefficient by developed-market standards.
Good managers have been able to deliver returns that global investors would find attractive, even while investing in Japan’s “no-growth” economy. We track several funds that have successfully outperformed not only the TOPIX over the past 10 years, but the MSCI World Index as well. We follow these managers closely and know them well; they offer particular approaches to investing in a country that effectively remains an outlier in the investing world, and we believe they have the opportunity to continue delivering strong results.
Renowned Harvard economics historian David Landes once wrote, “…economic analysis cherishes the illusion that one good reason should be enough.” This certainly applies in the case of Japan. For many investors, double-digit returns from Japanese equity markets are not supposed to happen. It creates too much conflict with an existing worldview—whereby the dependent variable (i.e. equity returns) originates from a function that is arguably overly predisposed to a single independent variable (i.e. growth). However, for those willing to challenge consensus, the rewards could be meaningful. 
The views expressed are those of Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance and you may not get back the amount invested.
The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client.
TOPIX (The Tokyo Price Index) is a metric for stock prices on the Tokyo Stock Exchange. 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.
MSCI World Index, which is part of The Modern Index Strategy, is a broad global equity index that represents large and mid-cap equity performance across 23 developed markets countries. MSCI is a market leader in global equity indexes and has over $3.6 trillion in assets benchmarked to the MSCI World Index suite.
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