Japan’s growth cyclicals: opportunity or trap?
Japan’s growth cyclicals: opportunity or trap?
Dan Carter and Mitesh Patel discuss opportunities and risks in the Japanese market, concluding that ‘chance favours only the prepared mind’.
In February, The Economist published an article titled ‘Why Japan’s Automation Inc. is indispensable to global industry’1 , and in it detailed many of the virtues of some of Japan’s best, and best known, businesses. The author chose four companies to illustrate their point – Keyence, Fanuc, SMC and Lasertec2 – but could very easily have chosen other well-known names such as Omron or Yaskawa. The piece contained much truth; that Japanese companies supply nearly half of the world’s industrial robots, that its own demographic crunch has necessitated the development of leading capability in the field, and that failing global supply chains are a long-term opportunity rather than a threat for such businesses.
Unfortunately for shareholders of the named – and similar but unnamed – companies, the article also marked a period of reckoning for their share prices, which have fallen substantially since.
Whilst the Economist article focused upon Japan’s automation companies, it could just as easily have been written with a broader cast of the country’s corporate aristocracy; companies like Murata or TDK, which make capacitors and other electronic components, aircon leader Daikin or motor manufacturer Nidec. These companies too are marked out for their technical prowess, high margins and exposures to growing mid to longer term opportunities. They are, in other words, growth cyclicals, great corporate examples of what Japan does best … and their share prices have also been trashed.
For admirers of such businesses (as we are), does this present an opportunity to accumulate or is this just the beginning of a period of underperformance best avoided? To attempt to answer that we must think about how we got here.
Unfortunately for shareholders of the named – and similar but unnamed – companies, the article also marked a period of reckoning for their share prices, which have fallen substantially since.
Whilst the Economist article focused upon Japan’s automation companies, it could just as easily have been written with a broader cast of the country’s corporate aristocracy; companies like Murata or TDK, which make capacitors and other electronic components, aircon leader Daikin or motor manufacturer Nidec. These companies too are marked out for their technical prowess, high margins and exposures to growing mid to longer term opportunities. They are, in other words, growth cyclicals, great corporate examples of what Japan does best … and their share prices have also been trashed.
For admirers of such businesses (as we are), does this present an opportunity to accumulate or is this just the beginning of a period of underperformance best avoided? To attempt to answer that we must think about how we got here.
History isn’t a reliable guide
Tighter global monetary conditions have taken the shine off richly valued, faster growing companies across all sectors and Japan’s growth cyclicals have been no exception. Investors looking to play the tightening cycle should look elsewhere (including to some of our Jupiter colleagues) for insights on the likely pace and extent of this interest rate hiking trend, for this is not our area of expertise. We would note, however, that valuation multiples for such companies peaked well before most central banks began to hike – the US Federal Reserve increased rates for the first time since 2018 in March of this year (and again in early May).
The price-to-earnings multiples peaked for Keyence, Nidec, Daikin and Murata way back at the end of 2020, as they did for so many other similarly categorised companies. The implication here is that just as the market anticipated the beginning of the tightening cycle, so it will for its end.
Unfortunately, history is not a particularly reliable guide as to just how forward-looking the market is likely to be. Multiples for these companies troughed in December 2018 precisely when the Fed hiked rates for the last time in that cycle, and just seven months before the next cut. On this basis alone then, it is probably too early to be rotating heavily into these kinds of names, but we see it as entirely sensible to put them on the watch-list so positions can be established when the time finally is right.
The price-to-earnings multiples peaked for Keyence, Nidec, Daikin and Murata way back at the end of 2020, as they did for so many other similarly categorised companies. The implication here is that just as the market anticipated the beginning of the tightening cycle, so it will for its end.
Unfortunately, history is not a particularly reliable guide as to just how forward-looking the market is likely to be. Multiples for these companies troughed in December 2018 precisely when the Fed hiked rates for the last time in that cycle, and just seven months before the next cut. On this basis alone then, it is probably too early to be rotating heavily into these kinds of names, but we see it as entirely sensible to put them on the watch-list so positions can be established when the time finally is right.
An inevitable dampening of economic activity
The thing with growth cyclicals, of course, is that they are not just growthy but also cyclical, exposed to general global economic activity which by most accounts is stalling. Late last month the ISM Manufacturing Purchasing Managers Index’s (PMI) March reading surprised to the downside, signalling waning US recovery.
If higher interest rates are to be effective in cooling inflation, a dampening of economic activity seems inevitable and so it makes sense that many investors expect more pain to come.
Across the Pacific in China conditions are even worse. There, the National Bureau of Statistics’ manufacturing and non-manufacturing PMIs for April read 47.4 and 41.9 respectively, both signalling contraction at the fastest pace since February 2020.3 Much of this is self-inflicted as the country battles to maintain its zero-Covid policy in an era of the highly transmissible but much less deadly Omicron variant.
Japanese industry-level data supports this uninspiring picture as machine tool order growth continues to slide.4 Meanwhile, the growth in shipments of electronic components is being outstripped by inventory build, and the Bank of America Factory Automation leading indicator, an aggregation of several series, is also overwhelmingly negative.
Once again, there is little to suggest that right now is the time to make aggressive allocations into growth cyclicals. Any new positions should in our view stand up on their own merits and be sized to take into account the likelihood of some potential cyclical headwind.
For their part, Japanese companies have been somewhat more sanguine, for all the good it has done them. Mail order machinery parts company Misumi forecasts profits to rise ten percent in the year to March 2023, meanwhile Fanuc is guiding for eight percent growth – hardly disastrous5 6 . Both stocks traded down sharply following the announcements, once more nothing in this negative sentiment indicates that impatience is likely to be rewarded.
If higher interest rates are to be effective in cooling inflation, a dampening of economic activity seems inevitable and so it makes sense that many investors expect more pain to come.
Across the Pacific in China conditions are even worse. There, the National Bureau of Statistics’ manufacturing and non-manufacturing PMIs for April read 47.4 and 41.9 respectively, both signalling contraction at the fastest pace since February 2020.3 Much of this is self-inflicted as the country battles to maintain its zero-Covid policy in an era of the highly transmissible but much less deadly Omicron variant.
Japanese industry-level data supports this uninspiring picture as machine tool order growth continues to slide.4 Meanwhile, the growth in shipments of electronic components is being outstripped by inventory build, and the Bank of America Factory Automation leading indicator, an aggregation of several series, is also overwhelmingly negative.
Once again, there is little to suggest that right now is the time to make aggressive allocations into growth cyclicals. Any new positions should in our view stand up on their own merits and be sized to take into account the likelihood of some potential cyclical headwind.
For their part, Japanese companies have been somewhat more sanguine, for all the good it has done them. Mail order machinery parts company Misumi forecasts profits to rise ten percent in the year to March 2023, meanwhile Fanuc is guiding for eight percent growth – hardly disastrous5 6 . Both stocks traded down sharply following the announcements, once more nothing in this negative sentiment indicates that impatience is likely to be rewarded.
Chance favours only the prepared mind
And that, essentially, is where we stand. A combination of events – not altogether unconnected – including global monetary conditions, the international business cycle and China’s self-inflicted slump are conspiring to deflate valuations for some of Japan’s best companies. Whilst there is little to suggest this cannot continue for now, we are thoroughly persuaded that it will not continue forever. For the time being we will be extremely selective in our allocations to growth cyclicals in our strategy, when we pounce it should be only for irresistibly unique businesses. Even here we must accept that our entry points could be some way short of the nadir. With so much uncertainty in the near term we are not entirely persuaded that fortune, at least right now, favours the brave. We are far more taken by Pasteur’s more measured version of that cliche – that ‘chance favours only the prepared mind’. Time to get prepared.
1 Why Japan’s Automation Inc is indispensable to global industry | The Economist
2 Lasertec, a maker of testers for the semiconductor industry, is something of an odd one out here in our view, but as a global leader in a market with structural long-term growth opportunities its inclusion can be justified.
3 China risks falling behind U.S. growth rate as lockdowns take toll – Nikkei Asia
4 Kikuchi, Mizuho Securities, May 2022
5 fr_21_4q.pdf (misumi.co.jp)
6 financialresult202203_e.pdf (fanuc.co.jp)
2 Lasertec, a maker of testers for the semiconductor industry, is something of an odd one out here in our view, but as a global leader in a market with structural long-term growth opportunities its inclusion can be justified.
3 China risks falling behind U.S. growth rate as lockdowns take toll – Nikkei Asia
4 Kikuchi, Mizuho Securities, May 2022
5 fr_21_4q.pdf (misumi.co.jp)
6 financialresult202203_e.pdf (fanuc.co.jp)
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