Akari: japanese equities market neutral strategy

For Japan, August 2, 2018 was a momentous occasion.

That was the day when the country’s stock market overtook China’s to become the world’s second biggest, regaining the title it lost four years earlier.

Valued at just over USD6 trillion, Japan’s stock market is undoubtedly one of the most liquid in the world. However, ironically, it is also among the most inefficient: share prices can deviate markedly from fair value.

fig. 1 mind the gap

Analyst estimates and company guidance for Nintendo's FY2019-2020 operating profit in JPY bln

Why these discrepancies? It’s partly to do with information scarcity. Compared with its peers, the Japanese stock market is under-researched – about 42 per cent of companies listed in the TOPIX index have no sell-side analyst coverage whatsoever.

This compares with about 1 per cent for the equivalent index in the US, the S&P 1500.¹ But even those companies which do have broker coverage experience a wide dispersion in analyst estimates - there is often a significant gap between company guidance and what counts for consensus market forecasts. 

Take the case of gaming and entertainment giant Nintendo. Among 21 analysts who cover the firm, there’s a 40 per cent gap between the highest and lowest estimates for the operating profit for fiscal year ending March 2020 (see FIG. 1).

The company's own guidance, in line with the most conservative estimate, stands 15 per cent below the consensus forecast. And Nintendo is not an isolated example – the experience is the same for many other Japanese companies, which can lead to wild swings in share prices during earnings results seasons.

Another distinguishing feature of Japan’s stock market is its investor base. Its deep liquidity and low transaction costs have made it popular with foreign investors, who make up on average at least half of daily trading volume.²

That has an significant bearing on market dynamics. During episodes of stress, such as an emerging market crisis or a China-driven sell-off, this group of investors tends to liquidate their Japanese assets, regardless of corporate fundamentals, and use the money to cover losses elsewhere.

Conversely, during rallies foreign investors tend to chase the market higher, often reacting to specific corporate events or domestic developments (see FIG. 2). As such, their presence tends to expose the market to swings in global investor sentiment, which can lead to higher volatility.

fig. 2 gaijin influence

TOPIX moves (%) and net purchase by foreigners on a 12-week moving average basis in JPY bln

At the same time, the market is host to another distinctive block of investors whose trading activities do not always pay regard to corporate fundamentals.

These include the Bank of Japan and the Government Pension Investment Fund, which together are the biggest shareholders in well over 400 companies on the Tokyo Stock Exchange’s first section, nearly one quarter of all issues. What is more, the BOJ now owns nearly 80 per cent of Japan’s exchange-traded fund market, having bought almost JPY29 trillion of the product since 2013.³

It is because of these idiosyncrasies that the Japanese stock market lends itself especially well to alternative investment approaches.

Our investment process starts with screening around 2,200 Japanese companies for liquidity and market capitalisation.⁵

Among those which make the cut, we analyse corporate fundamentals from the perspective of global value chains, meeting company management in the process. We put a particular focus on market moves and forecast changes around the earnings season – a period when we tend to find rich trading opportunities given significant gaps in sell-side earnings estimates.

Here, our investigations go far below the surface. For example, we may gather intelligence from a diverse set of companies – including small-cap in which we do not invest – to validate a growth outlook of a certain firm we’re looking to invest into. This also helps us gauge the extent of the gap between various sell-side estimates and our own earnings forecasts.

This screening takes the potential investment candidates down to about 200-300. We then use our extensive industry experience in buy-side, sell-side and running proprietary trading books to choose optimal entry and exit points and maximise opportunities which the market presents.

In doing so, we take into account Japan-specific technical factors, including supply and demand of stocks, different trading patterns of domestic and foreign investors, seasonality and share buybacks.

fig. 3 no attachment

Monthly correlation of various investment strategies

We fine-tune the portfolio, taking into account factors such as size, liquidity and technical signals. At the same time, we seek to eliminate residual market risks.

Our final portfolio has around 150 positions across up to 80 strategies.

Japan is a market that is often overlooked but offers potentially rewarding opportunities. Our distinctive investment approach focusing on the world's third largest economy has proven to be resilient during times of market stress and should therefore appeal to investors who wish to diversify their existing global equity portfolios with returns that are uncorrelated with those of other asset classes.

fig. 4 downside protection

Five worst months of the TOPIX vs Strategy, %*