article 10-10-2014

Japan: Changes in Sentiment and Tokyo's Property Market

In his second trip to Japan this year, Portfolio Manager Dilip Badlani observed a change in sentiment, though his bullishness on Japanese micro-caps remains unshaken. 


In our last interview you talked about Shinzo Abe's "three arrows" and the country's renewed optimism in the economy. How was sentiment on your last trip?

It's been pretty interesting to see how sentiment in Japan has changed after being so bullish. When Jim Harvey and I visited in March, we noticed that there was a sharp increase in the number of foreign investors.

Now it appears that the interest has waned, and investors are focused more on finding ideas elsewhere. That being said, I still think there are a lot of great companies. It's a $5 trillion economy, and there are lots of opportunities for investors to find good small businesses at a discount.

At Royce, we view our Japanese investments similarly to those in any other country: as a long-term investment. We try to buy good companies at attractive prices and hold them for as long as the valuation remains compelling. We think there's still long runway ahead for Japan and for high-quality Japanese companies.

If Abe manages to stay in power—Japan has had several prime ministers come and go over the last decade—it will be good for the country because it will show consistent leadership and stability, which helps capital spending decisions, and we'll be able to see more of a clear policy that business leaders can factor into their thinking.

Does the negative news surrounding Japan make you feel differently about your approach to micro-caps in the country?

At Royce, we are bottom-up stock pickers. We don't try to predict the outcome of macroeconomic headwinds or let negative headlines disrupt what we do on a day-to-day basis, which is trying to find good, quality businesses that are trading at a discount to what we believe the enterprise would cost if we were buying it in its entirety.

In spite of Japan's extended cycle of deflation and economic and political uncertainties, the country still has some of the highest-quality products in the world. That focus on quality, which is ingrained into the Japanese culture, is very hard to replicate.

We think Japanese companies will continue to be quality leaders in their niches, so we're excited about the opportunities we're finding in Japanese micro-caps because there is always the possibility for a company that is making high-quality products to take share.

Japan's flavors and fragrances industry is one example of a high-quality niche business in Japan. On this trip I met with T. Hasegawa, which holds a dominant position within the industry, being the second-largest Japanese player.

What's interesting about Japan is it has its own unique flavors and fragrances, so it's a market that has traditionally been difficult for foreigners to penetrate.

The company has grown nicely over the last three decades, and is now concentrating on increasing its international presence. We think there are excellent opportunities for T. Hasegawa to grow, since demand for fragrances in Asia is still booming compared to the western markets.

So there is a lot of demand upside from Asian markets outside Japan. China is a big part of the company's growth strategy. T. Hasegawa is also planning to expand in ASEAN (Association of Southeast Asian Nations) and is opening up a marketing office in Thailand.

We view our Japanese investments similarly to those in any other country: as a long-term investment. We try to buy good companies at attractive prices and hold them for as long as the valuation remains compelling. We think there's still long runway ahead for Japan and for high-quality Japanese companies.

Returning to the topic of structural reform, what other areas are you looking at that play on this theme?

One of the biggest structural issues in Japan is demographics—the country has one of the oldest populations in the world, and fertility rates are quite low. The Japanese government encourages families to have children—there are ample facilities that are set up to help parents—so we think eventually that attitude may take hold.

Because of the demographic challenges, Japanese property prices have been in a deflationary slump for approximately 20 years. However, if we see a shift in perspective with people starting to feel more positive about having children, we may see an increase in Japanese property prices.

For someone who grew up in Asia, it's interesting to see that Tokyo real estate today is much cheaper than Singapore and Hong Kong. We believe that global investors will start looking at Japan more seriously once property prices start to even marginally tick up. In fact, leading global property companies, such as Jones Long LaSalle, have held seminars in Singapore advertising Japanese properties. Tokyu Livable, which is a real estate broker based in Tokyo, has also opened a sales office in Shanghai to sell properties.

One of the companies I met on this trip was Sun Frontier Fudousan, a company that revitalizes properties in Tokyo and tries to sell them shortly afterwards. If you visit Tokyo, you'll notice that there are a lot of buildings that were built in the ‘70s and ‘80s. Many of these eight- to 10-story buildings need renovations in order to attract new tenants or raise rents. These properties are Sun Frontier's main area of focus.

The company usually holds these properties for about six months before selling them, buying them at an 8% rental yield and trying to sell them at a 6% yield. Sun Frontier is able to do this because it also has a property brokerage business, so it's able to get a good gauge of where properties are available. Additionally, Sun Frontier also runs a property management business, which is a nice recurring cash flow business. As interest picks up and demand for property in Tokyo increases, we think Sun Frontier will be a prime beneficiary of that demand.

Tokyo property demand is already starting to come back. Property prices have gone up about 20% in the last two years. We think this is a good way to play the property market without having to buy a leveraged property developer.

Can you give us any last thoughts on Japan?

What's unique about Japan compared to most other parts of Asia is you come across companies with valuations you just don't see anywhere else. People tend to forget that a lot of corporate profits for Japanese companies come from overseas. So the weakening yen will at least help on a translation basis.

Prior to Chinese and South Korean companies expanding overseas, Japanese companies held dominant leadership positions in Asia, and were thus able to set standards across the continent. If you go to any Asian city outside of Japan, you tend to see a lot of Japanese products, all renowned for their quality.

Additionally, Japanese companies continue to develop unique products with exceptional design characteristics, and these products will always see interest globally. In conclusion, Japan should be a critical part of any global investor's focus.

Important Disclosure Information

Dilip Badlani is a Portfolio Manager of Royce & Associates, LLC, investment adviser to The Royce Funds. He is the portfolio manager of Royce International Micro-Cap Fund (RMI) and serves as an assistant portfolio manager for Royce International Smaller-Companies Fund (RIS) and Royce Global Dividend Value Fund (RGD). The thoughts and opinions expressed in this piece are solely those of the person speaking and may differ from those of other Royce investment professionals, or the firm as a whole. There can be no assurance with regard to future market movements. There can be no assurance that companies that currently pay a dividend will continue to do so in the future.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Royce International Micro-Cap Fund invests primarily in micro-cap stocks, which may involve considerably more risk than investing in larger-cap stocks The Fund may invest a significant portion of its assets in securities of companies headquartered in foreign countries, which may be subject to different risks than investments in securities of U.S. companies, including adverse political, social, economic, or other developments that are unique to a particular country or region. (Please see "Investing in Foreign Securities" in the prospectus.) Therefore, the prices of the securities of foreign companies in particular countries or regions may, at times, move in a different direction than those of the securities of U.S. companies. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund's broadly diversified portfolio does not ensure a profit or guarantee against loss.

Percentage of Fund Holdings as of 9/30/14 (%)

T. Hasegawa 0.63 0.00 0.00
Sun Frontier Fudousan 0.59 0.23 0.00

There can be no assurance that any of the securities mentioned in this piece will be included in these portfolios in the future. References to specific securities in this piece are not intended as recommendations and should not be relied upon as the basis for anyone to buy, sell, or hold any security.



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