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 We avoid stocks that are heavily cyclical or highly leveraged, and those with outdated business models.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.
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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 2020-03 FSSA Japan Equities Client Letter (part 3 of 4).