Observations in International Equities: Japan and China Diverge

Observations in International Equities: Japan and China Diverge

Craig Blessing: At Thornburg, we follow a bottom-up high conviction approach to managing international equity. That’s been a good approach for the last couple of years. As individual stock selection and not country or sector allocation has led the performance of most of our strategies. 2023 was a good year, but as we look forward into 2024, there are still attractive opportunities out there. And how do those opportunities make the case that investors should broaden their horizons beyond the U.S.? Joining me today are Brian Burrell and Joe Salmond.

So, another market where sentiment has been weak for a long time as Japan, but not recently since the TOPIX has returned 50% over the last three years and the Nikkei is about to reach its old 1989 highs. Why is that? And is there anything in the Japan story that says to either of you that sometimes E, S or G factors are important to look at when valuing a company?

Brian Burrell: Yeah, I think it’s a great example. Japan’s exciting right now. It’s been since 1989 that we’ve seen stock markets at these levels and that’s a huge psychological change that is occurring in the domestic Japanese retail investor base.

But let’s take a step back and look at the big picture. Why is Japanese stock market working? Well, you know, if we go back to 2012, the net profit margin and the return on equity (ROE) were less than half of the current level. So, we’ve had this huge expansion in profitability and returns of Japanese corporates.

So, as we go out, meet these companies will peel back the onion one layer further and say, why is that? Why are these companies improving? And what we see is a huge shift in governance that G in the ESG you mentioned.

And I think it’s underappreciated how powerful it is when you have say, an independent board, which is increasingly becoming the norm in Japan about how that holds management teams accountable, how it improves capital allocation.

And that filters through to improve profitability. So, you take a company like Hitachi, this is a company that has been a conglomerate more or less the GE of Japan. They’ve refocused their business, broadened kind of global independent board members started looking at where they’re actually competitive and allocating capital there. This has raised their return on invested capital and you’re starting to see that multiple reflect this increasing profitability.

So, all across the board, we’re seeing Japanese companies improving their governance, it’s improving their capital allocation, and that’s leading to good stock market returns. Now, I’m lucky enough to go over there in about a month, and I’ll be talking with a number of these corporates. And one of the things I found most interesting in setting up my trip is that a lot of Japanese corporates are actually proactively reaching out to investors and saying, “Hey, what do we need to do to improve?” What are you looking for?” And good governance in this type of sentiment? The willingness to improve governance is something that is a market change in my career covering Japanese equities. So, I think there’s some promising opportunities in Japan, and you’re starting to see that reflected in the equity market performance.

Craig Blessing: When looking for attractive investments. Part of our process is to look for divergences, a company, a country or a sector that’s been performing in a different way than the rest of the market and might be undervalued.

There’s probably no bigger example in the international markets over the last few years than China, which is as we speak, making multi-year lows in both valuation and price. Yet against a backdrop of a difficult and evolving macro situation.

We’ve been investing in China for a long time because we find a lot of attractive bottom-up opportunities there. But how do you reconcile a bottom-up opportunity you may be seeing with the macro backdrop in China, which seems somewhat challenging?

Joe Salmond:. There are certainly a lot of difficulties that China is facing. It’s got a lot of global issues that it’s dealing with, and it has a lot of domestic things to work through. And I think they can be heavy-handed from the market’s perspective sometimes, which makes it difficult for investors. But what has been kind of shocking to me is how people have just walked away from China, that people just pretend that China doesn’t exist anymore. They don’t want to talk about it, they don’t visit. And I think that’s a mistake. They will have to work through their problems if every country has to keep their citizens happy and at some point, they will have to figure out a solution to that. And then at the end of the day, you still have the number two economy in the world.

And I think for the foreseeable future that under any scenario that’s the case. And while we may have this Western narrative of deep globalization, China getting left behind in fact, they are making a massive amount of exports to the emerging market and they are really building those relationships up to a new level. So, while they’re facing some challenges, they’re also seeing amazing opportunities and I think avoiding it because it’s difficult in the near term is a mistake because, like you said, the valuations are incredibly attractive. When that turns around, you’ve got great growth opportunities and ways to go into new markets. And at some point, that’s going to be a great opportunity to find great investments. And you don’t want to be starting from the ground up at that point.

I think it’s somewhat the opposite of Japan at this point, which was unloved for a long time. A lot of people weren’t paying attention and now they’re having to scramble. Where we’ve always cared about Japan, we’ve always been doing the work. And I think that’s the key to China is understand the risks and the opportunities and position yourself around that.

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