Is Japan the land of the rising fund?

After 20 years of underperforming global equity markets, the managers of Japan funds have been issuing rosier forecasts, suggesting that UK investors increase their exposure to Japanese equities. But whether Japanese shares are cheap is still a matter for debate.

Bulls argue that Japanese equities seem a bargain when measured on the price-to-book ratio, which compares a company’s market capitalisation to the value of its assets. Japanese equities are trading on an average of 1.2 times their book value, representing a discount to the global market.

Income investors are also turning to Japan in the hunt for dividends as companies’ profits there are expected to improve, which could result in more cash being returned to shareholders. At present, the average dividend yield on companies in the Topix index is 2.3 per cent, above the 1.3 yield on 10-year Japanese government bonds.

Another plus is that Japan is now the largest exporter of goods to China. Its neighbour’s growing prosperity is expected to boost the earnings of Japanese exporters. If the yen, which currently stands at an exchange rate of Y137.75 against sterling and Y90.2 against the US dollar, were to weaken, as some expect, exporters would get a further boost from offering more competitive prices.

Simon Somerville, manager of Jupiter’s Japan Income fund, says the “ideal” Japanese company is “one that has good exposure to Asia, China and emerging markets, with some exposure to Japan and as little as possible to the western economies”.

Paul Chesson, manager of Invesco Perpetual’s Japan fund, already has half of his fund in blue-chip exporters such as Toyota Motor and Yamaha Motor, with the rest in sectors poised to benefit from a recovery in the domestic economy, such as banking, stockbroking and real estate.

“I’m very comfortable with recommending the market quite strongly, even though I think the yen is overvalued,” Chesson says. “I’m not hedging my portfolio because I think that yen weakness is part of the stimulus.”

Jeremy Beckwith, chief investment officer at Kleinwort Benson, expects more investors to buy into Japan funds. He says: “Japan has massively underperformed over the past 20 years, both against other Japanese assets and other international equity markets, which means that both domestic and international investors are underweight Japanese equities in their portfolios. So there’s scope for lots of investors to turn buyers on any good news.”

But some analysts remain skeptical, arguing that share prices reflect too much confidence in improving company earnings. “You can go and find more than enough statistical ammunition to back up your position whether you’re a bull or a bear,” says Jamie Jenkins, head of Japanese equities with F&C. Some point out that what is “cheap” on a price-to-book basis can look expensive on an earnings basis. They argue that the yen’s strength is impeding companies’ efforts to improve their profitability.

In recent months, Japanese large-cap stocks have underperformed small caps but can still look overvalued on a price/earnings ratio. Toyota shares still trade on 33 times 2011 forecast earnings, Sony on 21 times, and Canon on 23 times. Even on this year’s forecast earnings, from March 2010, the wider market trades on 32 times earnings. This looks “rich”, according to Jupiter’s Somerville.

Not all believe in the weakening yen/export boost scenario, either. F&C’s Jenkins thinks growth in exports could slow, so his portfolio favours real estate, retail and construction stocks whose fortunes hinge more on the domestic economy’s strength. “The million dollar question is: to what extent does the export recovery continue?” asks Jenkins. “They’ve had an incredible run in the past 12 months but can it last?”

Stephen Harker, manager of the £850m GLG Japan CoreAlpha fund, also refuses to place too much importance on exports. “Until the China bubble came along, Japan had not been particularly successful as an exporter,” he says. “Currency weakness, up to 2007, allowed the export share to jump and caused commentators to worry about excessive dependence on exports.”

Both Jenkins and Harker also question the popular claim that the yen is likely to weaken in the coming months. “I’m not making that bet,” Jenkins says. “Whether the yen rises or falls depends on what happens to the interest rate differential between the US and Japan and when the Federal Reserve hikes interest rates.”