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Investment Case for Japan

The Japanese stock market last traded at current levels in 1989. Asset prices collapsed at the beginning of the ‘90s and over the last three decades the economy has struggled with deflation and economic stagnation. Recent shifts have seen asset prices start to re-rate.

Truffle’s investment philosophy centres around identifying and exploiting share price inefficiencies. Short term prices are often dislocated from their “true” long term value. Overtime we expect share prices to mean revert to this value making it critical as we seek investment opportunities to evaluate the catalysts and drivers for a price change or value unlock. We also place a strong focus on avoiding the loss of capital. The gains required to recover capital losses mean investors seeking real returns over the long term are placed under significant pressure. Finding value, is therefore not only about identifying the winners but also avoiding the value traps.

Navigating the uncertain markets of 2024 requires a deep understanding of how both the one-off and persistent economic and investment risks are and will impact long term investors. To avoid capital loss in this environment, it’s important to distinguish between short term noise and longer lasting risk and find the investment opportunities where margins of safety are high. Current world events and themes such as geopolitics and onshoring are creating supply chain shifts and significant pricing pressure. Countries at war mean heightened trade tensions, with disruption to supply chains ultimately leading to higher product costs. The onshoring thematic is driving similar dynamics as companies face regulatory and consumer driven pressure to produce locally. For example, a Taiwanese chip manufacturer is setting up a factory in Arizona to secure their US customer base as regulation forces local production over best price. Economic and policy risks are another important consideration. While US inflation is flattening or trending down, its unlikely to reach the historical 2% levels that stock markets are anticipating. In this market environment, valuation matters.

While the US equity market has continued to generate the best relative earnings growth, a strong move to passive investing means the large index weighted shares continue to gather the most cashflows resulting in what we think is a crowded trade with the good news largely priced in across the market. Investors flocking to US stocks also appear over-optimistic about Artificial Intelligence (AI) over the short-term leading to record high PE multiples for today’s US tech giants. Investing in markets where current valuations are elevated is not without risk.

Japan on the other hand is emerging from two decades of deflation following collapsing asset prices off the 80’s asset bubble. A strong G7 country, Japan has one of the highest GDP per capita ratios in the world. As the economy went into a low growth, deflationary environment it became shameful to push up product prices or expect a salary increase. Japanese companies over this period did not focus on shareholder value creation and horded cash on their balance sheets as global investor sentiment waned. Today, Japan is benefiting from the introduction of significant corporate reform, which has seen the economy return to growth and the return of inflation. As a result, the Bank of Japan is in the process of normalising their interest rate policy of negative interest rates to more conventional monetary policy. Underpinning growth is the return of higher wages which are now growing at 2% in an environment which is more accepting of inflation.

The corporate governance reforms will lift profitability and shareholder returns as many of these high-quality companies have lazy cash rich balance sheets and are trading at attractive valuations. Many of these businesses are in the technology and engineering sectors yet trading at a fraction of the cost of similar businesses elsewhere in the world but particularly the US market.

Following on the broader corporate reform theme, the Tokyo Stock Exchange has embarked on a drive to encourage businesses trading below their book value to unlock shareholder value through a “naming and shaming” process. Companies could face delisting if they do not improve capital allocation and returns to shareholders, including dividend payouts, to boost valuations and returns. Unwinding of cross holdings should also be a positive catalyst.

The chart below shows the price to book multiple of the Japanese market (Topix) vs. some of the global peers and the Japanese small cap index. Today just under half of the Japanese companies on the Topix trade below book value vs. the USA at just over 3%. The Topix currently trades at 1.5X book value. The Current Return on Equity (ROE) of the Topix is just over 9% which we expect to increase to over 12% over the next three years as corporate reform accelerates and companies return more cash to shareholders and increase share buy backs.

We think this should drive a continued re-rating from 1.5X toward 1.8X book. In addition, we expect Japanese companies grow their earnings at 7% p.a. making for a healthy return in the form of good earnings growth and a structural re-rating plus a 2.2% dividend. Despite its recent outperformance, Japanese equity assets remain under owned and as shareholder returns improve, we should see both global and domestic investors allocate more capital towards Japan.

In summary, strong Japanese businesses with good, sustainable long term growth potential are trading at well below their intrinsic values. Structural changes in the Japanese economy and a strong drive for businesses to take action to unlock shareholder value are significant catalysts for share price re-rating. As global risks intensify and SA’s idiosyncratic risks persist, we aim to find investment opportunities in specific sectors and regions (like Japan), where the margin of safety is high and the risk of capital loss relatively low.

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