25 May 2022
Nicholas Price, portfolio manager of Fidelity Japan Trust PLC, reviews recent market movements in Japan amid a sharp rotation of away from growth stocks and sectors. He discusses what lies ahead for investors and outlines the compelling long-term opportunity among small and medium-sized companies with sustainable growth prospects.
Key points
We have had a turbulent start to the year, with the war in Ukraine, rising inflation and lockdowns in China threatening to derail global economic growth. We have also seen an extreme style rotation in markets that has led to the outperformance of value names and sharp declines for growth stocks. These sharp market moves have come amid accelerating rate hike expectations that have driven up interest rates in the US.
The Japanese stock market has started to price in these developments, which has seen, for example, banks and insurance stocks outperform quite strongly over the year-to-date period. Conversely, growth-oriented sectors such as precision instruments, services and electric appliances have been the most significant underperformers.
Against this backdrop, it is unsurprising that the trust has struggled given our focus on investing in mid to small-cap growth stocks. In particular, companies tied to secular growth trends such as factory automation and electric vehicles that performed strongly last year have been subject to profit taking in the year-to-date period.
Another factor of the recent market phase that generated headwinds for performance has been the narrowness of price movements. This produced strong intra-sector divergences and as a result, natural hedges have not worked. For example, shares in Toyota Motor, which is an underweight position in the portfolio, are up versus TOPIX over the year-to-date period, but group company Toyota Tsusho, an overweight holding in the portfolio, is down in relative terms. Given the extreme nature of these movements, we expect them to correct at some point.
Importantly, the price-to-earnings ratio of the portfolio has come down considerably and is in line with the market on a forward basis (CY2023). This is unusual given the much higher growth rates and higher returns of our holdings. We think the severe correction in growth has now largely played out in Japan and we expect the companies held in the trust to do well in terms of relative earnings growth.
While the correction in valuations looks to have largely played out, the unwinding of global monetary easing is accentuating the importance of bottom-up stock picking and a keen focus on companies that can continue to grow earnings over the mid-term.
With this in mind, we are focusing on defensive/sustainable growth names and services companies that can grow earnings in a more difficult environment through the second half of 2022 and 2023, as well as those that can positively surprise the market on mid-term growth. Additionally, we are looking at oversold growth names that are globally competitive and trading on compelling valuations. For instance, some small-cap growth names have become value stocks, so there is a good opportunity for multiple expansion in the future.
We are also keeping a close eye on the spike in commodity prices, especially oil, as this will exert a further squeeze on manufacturing margins. On the flip side of that, we are seeing opportunities in companies that supply equipment to the energy sector (and are beneficiaries of energy diversification in Europe) and are at the bottom of their respective cycles.
Another area of the market where we continue to see attractive opportunities is in the unlisted sector. There were 125 initial public offerings (IPOs) in Japan over 2021, marking the highest number of listings since 2006. Moreover, from a bottom-up perspective, we are seeing a lot more entrepreneurial activity in Japan compared with five to 10 years ago. While new listings (both in Japan and globally) are coming under pressure amid heightened geopolitical and inflationary risks, we continue to see new growth companies coming through, which will create future opportunities in the IPO market.
Being on the ground in Japan, and seeing many different companies, means that we are well placed to help entrepreneurs in the latter stages of their pre-IPO journey. We expect there to be a further increase in such opportunities, which offer a source of differentiated returns and we are therefore looking to gradually increase our exposure to unlisted securities.
Overall, we continue to evaluate new and under-covered opportunities, while focusing on companies that can grow that can grow sustainably over the coming months. We remain optimistic that this approach is well placed to reward investors over the long-term, notwithstanding recent short-term performance headwinds.
Important information
This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Fidelity Japan Trust PLC can use financial derivative instruments for investment purposes, which may expose it to a higher degree of risk and can cause investments to experience larger than average price fluctuations. The shares in the investment trust are listed on the London Stock Exchange and their price is affected by supply and demand. It can gain additional exposure to the market, known as gearing, potentially increasing volatility. Investments in smaller companies can carry a higher risk because their share prices may be more volatile than those of larger companies. Changes in currency exchange rates may affect the value of an investment in overseas markets. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only.