By Tom Bradley

One of the more ‘non-consensus’ strategies we’ve pursued over the last few years has been the Global Equity Fund’s commitment to Japan. Although there have been periods when Japan has contributed to client returns, on balance it has been a drag so far.

In a recent interview, Sandy Nairn, the CEO of Edinburgh Partners (the manager of the Global Equity Fund) talks about Japan and how he sees the strategy playing out. The relevant excerpts are reprinted here.

And what about Japan? Where does she fit in to this picture?

We continue to have a sizeable exposure in Japan [29% of the Global Equity Fund at the end of June and 5% of the Founders Fund] and our confidence remains robust following recent research trips there. Some holdings have been sold after strong appreciation, but we have found alternative investments in Japan with which to replace them and the current turmoil in markets is providing us with more opportunities.

Japan is at the early stages of a QE programme and has already done a range of things. The rise in equity prices that we have seen reflects the fact that fear of the cataclysmic economic consequences of an overvalued exchange rate has been corrected. But so far that is all that has happened.

The second piece that we are still only beginning to see is the sight of Japanese companies restructuring and doing things that would have been unthinkable ten years ago. We have seen Applied Materials and Tokyo Electron, for example, announce a merger. I don’t think you would have seen that happen a few years ago.

You have also seen Panasonic shut down various legs of its business and act in a determined manner to make its business more efficient, so as to get its margins up to a more sustainable level. What I think is happening is that many more Japanese companies now both understand what they need to do and are more willing to do it. They have seen how their peers in Japan who have taken the same steps are now reaping the benefit of an uplift in profits, first from the currency, second from their past restructuring and third from the effect of shutting down businesses. That has had a powerful effect on earnings.

The third and final stage will come when the domestic economy is reformed. That is a longer term thing, but I think will inevitably happen. Japan still has a long way to go. Take a company that has made 1% to 2% profit margins in the past, and where the market now sees those margins going to 3%. If that then goes to 6%, you will have doubled your profits again, and that is before even thinking about the top line growing. So the leverage from doing what some companies in other parts of the world would have done years and years ago is pretty large.

But it could take quite a long time to see the results?

Yes. While a number of major companies have moved down this path, others have not got there yet. The tanker is already turning, if you like, and 12-18 months from now I am sure that will have become the consensus view, whereas now it is just hope and belief. If profits do come through, I think we will see a change in sentiment toward Japanese management. I have been surprised by how radical some of the changes have been in a Japanese context.

For me, the first two ‘arrows’ presented by Mr Abe of monetary reflation and Yen devaluation were simply corrections of previous policy errors and were only necessary conditions. The so called ‘third’ arrow is the truly transformational one, the sufficient condition if you like. An over-regulated, supply side constrained economy could be consigned to history and the latent ability/intellectual property of an economy which has been suppressed for decades could be liberated.

This is the transformational element and more often than not its impact is underestimated. Mainly because it gets to pull the levers, the economics profession in general focusses on fiscal policy and demand management. Supply side reform is about creating conditions and waiting for the commercial response. The evidence from Japan is that so long as the reforms continue the response is underway. Moreover, the length and depth of suppression mean that the impact will be dramatic.