Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Hidden champions and ‘Omotenashi’: Japanese equities beckon
Despite its status as a sophisticated developed market, Japan has been on the out with foreign investors for decades. GDP growth is anaemic, while interest rates and inflation have been close to zero per cent, and there’s been little reason to allocate to it. But the chaos in the rest of the world means that’s starting to change.
“Given the weak macro environment, Japanese companies have learned a very good lesson from the past economic bubble,” says Sophia Li, portfolio manager for FSSA’s Japanese equities strategy. “They’re extremely risk averse, and on the other hand, have picked up an approach to sustaining their growth and returns that doesn’t rely on the macro environment – only industry growth. They need to be innovative.”
The BlackRock Investment Institute remains neutral on Japanese equities (while downgrading equities everywhere else) owing to its still-easy monetary policy and increasing dividend payouts, though it concedes that slowing growth is a risk. Other investors believe that the current bout of inflation could break Japan’s historically deflationary mindset, spurring more consumer spending and investment, though it remains to be seen whether that inflation will become embedded.
Japanese companies are the “absolute leader” in factory automation, Li says owing in part to the country’s aging population and poor labour productivity. There are also businesses that benefit from that aging population. One of FSSA’s holdings used to be the dominant baby diaper manufacturer; it’s now making its product for adults. Japanese companies are also particularly good at high precision medical technologies, and its consumer brands are driven by what Li calls “Omotenashi”, or “very good service”, providing high quality products at affordable prices.
“In Japan, you can find a lot of hidden champions,” Li says. “Maybe their names aren’t well known to households, but they have dominant market share in certain niche industries.”
Still, the strategy’s performance has been poor compared to the benchmark, Li says, owing to its underweight to commodities and energy (Japan doesn’t have many natural resources) and its bias to quality companies, which aren’t cheap in Japan owing to the lack of growth in the overall market. But the valuations of these companies have over-corrected in a “very violent” rotation to cyclical oil, gas and mining companies.
“We see that the valuations have corrected a lot compared to six to nine months ago, and the growth outlook of these companies is usually more insulated from the macro concerns around the world – the US recession risk,” Li says. “So we’re more optimistic about the companies that we own.”
“In our portfolio, we have a balanced approach – half of the strategy is invested in purely domestic companies, and their fundamentals are more insulated. On the other hand, the other half is invested in global leaders in consumer, healthcare, and automation industries. What keeps me up at night is all about what’s happening in the US and inflation and other developed markets than what’s happening in Japan.”
