Lazard: Follow the earnings growth breadcrumbs

Japanese stocks have been basically overlooked by investors for the last 30 years. Talk us through the history of the Japanese stock market, where we are now and why this moment is important today.

June-Yon Kim: I think you have to rewind all the way back to the 1980s. A lot of people will forget the fact that Japan was actually the largest market in the world during the bubble of the 1980s. People talk about the Magnificent Seven, but at the end of 1989, 10 of the largest companies in the world in terms of market capitalisation were actually Japanese. 

Because of that, Japan was a very overvalued market during that financial bubble, and it took literally decades for that to normalise. Because of that valuation headwind, Japan has struggled as an equity market for 20 years or so after the bubble. 

More recently, over the last decade, with the advent of Abenomics and also as valuations have become much more normalised, we've actually seen pretty good equity performance. Unfortunately, relative to the US, it hasn't been outstanding and that's why I still believe today it is being ignored.

What kind of earnings growth expectations can investors expect from Japanese equities?

Over the last 10 years, earnings for the MSCI Japan [Index] have compounded at about 7% per annum, which is slightly higher than the US or Europe, surprisingly. I think going forward, we could expect a similar level, if not even a little bit better, because the fact is, one of the important things when thinking about Japan is that when you invest in Japan, you're not buying the country. You're buying these listed companies.

The outlook for these listed companies is extremely exciting, if you're bullish on the world, nearly 50% of the revenues for a lot of the larger companies in Japan come from outside of Japan, and this is why the trajectory of earnings is so attractive for these companies. Furthermore, a lot of companies are over-capitalised, so what you're going to see is a reduction in share count, and that would also push up that EPS growth number that I just mentioned.

What are some of the characteristics that you look for when identifying those companies that have above-average earnings growth expectations?

First and foremost, we're fundamental investors. We're looking for how they're positioned within their industry and sector. What's their competitive advantage? What's their competitive moat? How are they positioned vis-a-vis their competitors? And really, [we are] trying to understand the fundamental outlook for the company more so than anything else. The quality of management, the underlying outlook for the end markets, anything that a typical fundamental investor would look for, but we're looking for expectations where, relative to consensus expectations, they haven't been fully discounted more so than anything else.

Where are you seeing oversized earnings growth today in Japan?

There are two areas with potentially better-than-expected earnings growth. One would be financials, particularly the banks. The banks would be significant beneficiaries of a normalisation in interest rate policy. How that would work is with the increased policy rate that will translate into increased lending spreads for the Japanese banks. 

The second area where we could see potential better-than-expected earnings growth would be the material sector. One example of this would be a company called Shin-Etsu Chemical (TYO: 4063). Shin-Etsu has two main lines of business. One would be their PVC or materials business, which would benefit from an improvement in US housing demand. The other part of their business is they are the largest manufacturer of semiconductor wafers. As we see a recovery in the semiconductor manufacturing area, Shin-Etsu would benefit from increased demand for wafers overall.

Is there a bank that you're really liking that you want to point to within the financial sector?

We're overweight Mitsubishi UFJ Financial Group (TYO: 8306). They're Japan's largest bank. They have a very good underlying domestic business which would benefit from that potential improvement in policy rates or increase in policy rates, and at the same time through their minority ownership of Morgan Stanley, they benefit from that wealth management growth that Morgan Stanley has seen in the United States and elsewhere in the world.

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