In Japan, high quality companies tend to be more expensively valued. How might they perform in the long run?
By Sophia Li, Portfolio Manager, FSSA Investment Managers
Among the many questions that we are frequently asked are: Will we switch to lower quality cyclicals or banks when there is a style rotation? What is our view about the recovery post-Covid and where will interest rates be? Moreover, what do we think about the potential currency swing on Japanese equities or the cancellation of the Tokyo Olympics?
But, one of the biggest lessons from 2020 is that attempting to forecast the market is a fool’s errand. We are quite sure that nobody forecasted a global pandemic, the worst recession since the Great Depression, and then a record year for equity prices.
At FSSA, we seek to invest in quality companies that we believe can maintain their return on invested capital (ROIC) and profit growth relatively independently of the macro environment and without leveraging. We avoid stocks that are heavily cyclical or highly leveraged, and those with outdated business models.
However, it is fair to say that quality companies appear to be more expensive relative to the rest of the market, based on the 12-month forward price-to-earnings ratio (PER). Would our portfolio holdings still be able to deliver decent returns over the next 5-10 years or longer?
To attempt to answer this question, we looked at the nine largest holdings in the Japan strategy1. We calculated the maximum PER we could have paid in 2006 (a Japan equity market peak, right before 2008 Global Financial Crisis) for each company to go on and deliver annualised returns of 8% or 10% over the next 15 years (a reasonable target).
We also looked at the Topix as a reference point – annualised returns for the benchmark was 3.5% over the 15-year period, so for comparison purposes we calculated the corresponding PERs in 2006 based on this return threshold as well.
The chart below shows that the lowest “required” PER to generate a 3.5% annualised return over 15 years (and therefore outperform the Topix) belongs to Hoya (48x), followed by Sony (56x) and Tokyo Electron (58x). They are overshadowed by the eye-watering 2,658x PER for M3. In other words, if we had bought these stocks at the beginning of 2006 – at these PER valuation levels or lower – and held them for 15 years, they would have performed at least as well as the Topix.
At FSSA, we seek to invest in quality companies that we believe can maintain their return on invested capital (ROIC) and profit growth relatively independently of the macro environment and without leveraging.
If we had theoretically bought M3 (which is currently trading on a forward PER of 128x) in 2006, we could have paid as much as 1,402x PER for an 8% annualised return over the next 15 years (or 1,064x PER for a 10% annualised return). This indicates that in the short-term, investors often undervalue a company that can generate sustainable growth for a prolonged period of time.
As stewards of our clients’ capital, we believe quality should always outweigh price. These companies all share some of the following characteristics that indicate a superior franchise – dominant market share, strong pricing power, innovation, an asset-light business model, high recurring revenue, the rare ability to create new avenues of growth, and a cash-rich balance sheet.
Most importantly, underpinning all of these factors is a strong corporate culture and team of people – which, in our experience is the ultimate source of lasting competitive advantages.
1 As at 15 January 2021. Of the Top 10 Holdings in the FSSA Japan Equity strategy, Recruit Holdings was listed in 2014 and therefore could not be included in this calculation.
Source: FSSA Investment Managers, Bloomberg, as at 15 January 2021
Source: Company data retrieved from company annual reports or other such investor reports. As at 31 December 2020 or otherwise noted.
The information contained within this document is generic in nature and does not contain or constitute investment or investment product advice. The information has been obtained from sources that First Sentier Investors (“FSI”) believes to be reliable and accurate at the time of issue but no representation or warranty, expressed or implied, is made as to the fairness, accuracy, completeness or correctness of the information. Neither FSI, nor any of its associates, nor any director, officer or employee accepts any liability whatsoever for any loss arising directly or indirectly from any use of this document. This document has been prepared for general information purpose. It does not purport to be comprehensive or to render special advice.
The views expressed herein are the views of the writer at the time of issue and may change over time. This is not an offer document, and does not constitute an investment recommendation. No person should rely on the content and/or act on the basis of any matter contained in this document without obtaining specific professional advice. The information in this document may not be reproduced in whole or in part or circulated without the prior consent of FSI. This document shall only be used and/or received in accordance with the applicable laws in the relevant jurisdiction.
Reference to specific securities (if any) is included for the purpose of illustration only and should not be construed as a recommendation to buy or sell the same. All securities mentioned herein may or may not form part of the holdings of First Sentier Investors’ portfolios at a certain point in time, and the holdings may change over time.
In Hong Kong, this document is issued by First Sentier Investors (Hong Kong) Limited and has not been reviewed by the Securities & Futures Commission in Hong Kong. In Singapore, this document is issued by First Sentier Investors (Singapore) whose company registration number is 196900420D. This advertisement or publication has not been reviewed by the Monetary Authority of Singapore. First Sentier Investors and FSSA Investment Managers are business names of First Sentier Investors (Hong Kong) Limited. First Sentier Investors (registration number 53236800B) and FSSA Investment Managers (registration number 53314080C) are business divisions of First Sentier Investors (Singapore). The FSSA Investment Managers logo is a trademark of the MUFG (as defined below) or an affiliate thereof.
First Sentier Investors (Hong Kong) Limited and First Sentier Investors (Singapore) are part of the investment management business of First Sentier Investors, which is ultimately owned by Mitsubishi UFJ Financial Group, Inc. (“MUFG”), a global financial group. First Sentier Investors includes a number of entities in different jurisdictions.
MUFG and its subsidiaries are not responsible for any statement or information contained in this document. Neither MUFG nor any of its subsidiaries guarantee the performance of any investment or entity referred to in this document or the repayment of capital. Any investments referred to are not deposits or other liabilities of MUFG or its subsidiaries, and are subject to investment risk, including loss of income and capital invested.
Sophia Li, Portfolio Manager, joined FSSA Investment Managers as a graduate in 2009 and has developed an extensive coverage of companies in North Asia. She is the lead manager of the FSSA Japan Equity fund and FSSA Asia Pacific All Cap fund.
This article was adapted from 2021-03 FSSA Japan Equities Client Letter (part 3 of 4).