With equity markets across the globe looking stretched--and ripe for correction as volatility picks up--Japan has been singled out as good value by many commentators this year.

And it seems investors are paying attention. Funds in the Investment Association (IA) Japan sector saw their best net inflows in two and a half years, while the IA Japanese Smaller Companies sector saw its best flows in more than a decade in February, according to Morningstar Direct data.

Investors from the UK alone pumped £464 million into Japanese equity funds last month, with the IA Japan sector now seeing six months of consecutive inflows. £1.6 billion has now been invested into these funds in that time.

Despite being one of the smallest sectors, IA Japanese Smaller Companies is the best performing over three, five and 10 years. The £53 million of inflows in February was the most on record.

One of the distinguishing features of Japanese markets since the end of the global financial crisis has been the rise of mid caps--having returned 235 per cent in the past nine years, well outpacing both large and mega-cap stocks.

There are certainly some compelling reasons to buy into the Japanese equity story, with attractive valuations, a reformist Prime Minister and the ongoing change in corporate governance.

Attractive valuations

On relative valuation grounds, compared to other global stock markets, Japan remains attractive. “It’s still cheap on every metric relative to the rest of the world,” says David Vickers, multi-asset portfolio manager at Russell Investments.

While Vickers says that compared to its recent past the Japanese stock market can look quite expensive, if you look further back in time “Japan actually looks very cheap”. The main Nikkei 225 index currently stands 44% below its 1989 peak.

But Tristan Hanson, manager of the M&G Global Target Return Fund, cautions against taking that too literally. “Japan did get to very expensive levels, so I would look more at the absolute level of valuation, rather than drawing too much of a comparison to its long-term history,” he says.

At around 14 times forward earnings, the market certainly looks attractive, Hanson continues. “But I wouldn’t say it was any more outstanding than emerging markets or Europe.”

Corporate change

One key positive for equity investors in Japan is the change in companies’ attitudes towards shareholders. It’s a shift, who has been investing in the country for over 20 years, has seen in recent times.

The number of listed Japanese companies with external directors is currently at a record high, as is the amount of cash firms return to shareholders, in the form of both dividends and share buybacks, according to  Richard Kaye, manager of the Comgest Growth Japan Fund.

“And on the ground, we are seeing that as well. Half of the companies in our portfolio we have held for more than five years. We’ve got a long relationship with those companies and many of them when we started were very reluctant to even meet us or share any information when they did meet us,” he says.

Many companies are now understanding the importance of keeping a stable minority shareholder base: "The companies have a natural need to engage and we’re seeing many examples of this".

With Japanese companies now accounting for just over 9 per cent of the MSCI World Index, the second largest single-country weighting behind the US, this is an important development for investors.

More from Morningstar

• Your market downturn toolkit

• The ups and downs of dollar-cost averaging

• Make better investment decisions with Morningstar Premium | Free 4-week trial

 

David Brenchley a reporter for Morningstar.co.uk.

© 2018 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.