Japan’s economy is in uncharted waters and James Salter, who has 26 years’ experience in the country’s equity market, is feeling increasingly disorientated with the prevailing investment current.
‘It’s like being Jack Nicholson in One Flew Over The Cuckoo’s Nest. I have gone into a lunatic asylum and feel sane but as time goes on I’m beginning to wonder whether I am actually insane as well,’ he says.
Prime Minister Shinzo Abe’s bazooka tactics aimed at reviving Japan’s long-depressed economy, appear to be having the opposite effect on Salter’s $3.4 billion Polar Capital Japan fund.
But even though his Dublin-domiciled strategy has fallen behind its peers over the past three years, the manager is adamant he’s not joining the crowd chasing the flood of cheap money in Japanese markets.
In fact, he has a stark warning for those who are: ‘This is going to be one of the great mistakes of people’s investment careers – to have benchmarked themselves and brought their tracking error in so low, that they have effectively moved to a passive style of fund management just at the wrong moment.
‘The tech bubble provides a fitting analogy. At that time it was very easy to change investment methodology from just having stocks on PE ratios to justifying them on PEG (price/earnings to growth) ratios, looking at growth-to-price.
‘For example, if a stock was on 100x earnings but was growing at 100% it would have a PEG of one. Defensive shares in Japan at the moment can have a multiple of 25x and investors see that, think the earnings yield is probably 3% and convince themselves it is cheap.’
For the moment at least, Salter appears to be paying the price for his contrarian stance. Having previously led the Japanese equity sector, and being Citywire AAA-rated from February 2010 to November 2011, he is now unrated and some way behind.
His Polar Capital Japan fund returned 79.8% in yen terms over the three years to the end of April 2015, versus 110.37% from the Topix TR. This places Salter in the fourth quartile of performance in the Equity – Japan sector.
Salter says even though Japanese equities are potentially at the start of a multi-year rally, investors’ preference has been for low beta, low economically-sensitive shares – namely defensive stocks which have re-rated significantly off the back of increased market liquidity.
This shift has challenged Salter’s investment process as he has focused on both stock-specific stories and more cyclically-facing sectors and has retained a structural underweight to defensive names throughout this period.
‘The fact is Abe and Kuroda have embarked on a radical change in policy, which none of us will be able to prove, one way or another, has worked or not,’ he says.
‘Nobody knows where all this will end and whether the liquidity will create bigger inflationary problems around the world in the longer-term. How will total government debt be paid off, do they change the BOJ statutes and effectively write off bonds?
‘We are in ground-breaking territory and I think it is a fascinating time. I do believe a better economy will be one of the ways that these defensives will unwind.’
For the meantime though, Salter accepts he is in an unfavourable spot. Resisting big strategic shifts, he remains a committed stock picker. Nevertheless, his unfailing bottom-up stance hasn’t translated into more visits to the country, quite the contrary: ‘I have been less,’ he says.
‘The market is so against my style, I hunkered down and thought: “How much am I going to gain by going over there?” The obsession to just buy these defensive shares is basically all there is.’
Running with a tracking error of 6%, Salter has focused on the financials and consumer discretionary sectors, as well as increasing small-cap exposure up to 37%, just shy of his record 40% position.
One of his favourite small-cap picks for the future is financials firm Japan Securities Finance.
‘It is a brokerage firm which lends to brokers, who then lend out money on margin. An activist has taken a position in it and we are doing very well from that this year. We have held the stock for five or six years and the shares are up 27% this year and that’s a business which has already bought back 5-6% of the company. We think it will do a further buy-back.’
Elsewhere, Salter recently switched out of household name Toyota and recycled the cash into sector rival Mazda. ‘We sold our position in Toyota, which was quite a contrarian move. The company has offered exceptional value, but we now think there’s more potential in holding Mazda,’ he says.
‘It has been badly affected by the weakness in the euro and the Australian dollar versus the yen but in share price terms the worst is probably over.’
Opposing the passive paradigm
Ultimately, Salter says, he is looking to remain nimble in a market which has become a herd.
The move by giant Japanese government pension fund GPIF to increase its equity holdings and reduce bond positions has had a notable impact.
Salter said this shift, followed by other pension funds, has led to a huge uptake in passive products, which has further compounded his problems.
This ‘push for passivity’, as he calls it, has put pressure on those looking beyond the index. ‘This has put more experienced managers such as myself and perhaps Man Group’s Stephen Harker – who has managed to bounce more than I have this year – under a lot of pressure because we have been castigated as yesterday’s heroes,’ he says.
‘I am not a believer in this new paradigm of moving towards passivity. I think there is a role for stock pickers out there.’
Salter remains upbeat about his investment philosophy and as an investor in his own fund feels no pressure to change tack. However, he realises some clients may want to move out.
I haven’t changed my approach because I think it boils down to how you mature. About 25 years ago my view on investing was very immature and short-term because, personally, I was always broke. As you get into your mid-40s you feel more confident and I found myself being more relaxed professionally.
I have always been relaxed as a fund manager but unrelaxed from a commercial perspective. I could go home and think: “My money is really safe in my fund” and then I would get a call from sales and marketing saying: “Someone says you’re an idiot, why are you doing this?”
With plans to swim across the English Channel in September, Salter sees plenty of similarities between the challenges of his work and his sporting ambitions. He may be treading water now, but his conviction is that by sticking to his strategy, the tide will turn.
François Chauvet is founder of Paris-based risk boutique APTimum. Here he outlines how the Polar Capital Japan fund compares with its peers.
This table indicates how closely correlated the Polar Capital Japan fund is with its peers. There is an average systematic correlation of 96.29% between this fund and the 30 most similar strategies in the Japanese equity sector. It shares a lot of characteristics with broad Japanese equity fund approaches but there are also similarities to Japanese small and mid-cap equity funds, as well as Pacific equity portfolios.
On a sector basis, the greatest systematic risks are linked to the fund’s exposures to the financial and IT sectors, which account for over half of the overall risk in the $3.4 billion portfolio. Salter expresses a strong preference for small-cap stocks on a bottom-up basis, but the fund shows a bias towards large-cap growth stocks, which make up nearly 40%. From a style perspective, value stocks account for only one-fifth of the fund.
While finance and IT are the main areas of sector risk in Salter’s fund, the manager has notable exposure to consumer discretionary, materials and industrials.
Compared to peers, Salter’s fund has taken a much more aggressive approach over the past three years. As a consequence, in market rallies, his risk-adjusted performance has suffered and has led to periods of underperformance.