Stock-Picking amid Chronic Low Rates - Lessons from Japan

A prolonged period of low interest rates will affect us all, and the question of which stocks to own requires more careful consideration than ever before.

This is an edited extract from the presentation given by Clay Smolinski at the 2016 Platinum Asset Management Investor and Adviser Forums. It followed a presentation given by Andrew Clifford, “Interest rates to be lower for much longer”, providing an overview of the current macroeconomic environment from a historical perspective.

The passive index-tracking approach that has served many in the last few years appears to be becoming fashionable at exactly the wrong time.

The key effects will be threefold:

• Retirement incomes – many people retiring now or recently would have expected, and built their plans around, safe 5-6% yields being readily available. With this off the table, behaviour will be forced to change.
• Valuation – how do we value stocks if the risk-free rate of return is at or close to zero? We have seen price-to-earnings (P/E) ratios average about 15X (or earnings yields approaching 7%) over the past 50 years with risk-free rates averaging around 5%. If this falls to 1% for a prolonged period, where will earnings yields (and their inverse, P/E ratios) trend to?
• With negative rates specifically, we are in uncharted territory. Two years ago negative rates did not exist; now we have two of the world’s largest economies, Europe and Japan, operating under such conditions. This was once unthinkable, and the rules are still being learnt.

Although negative rates are unprecedented, we have seen extended periods of low rates before. Japan, being a country where the interest rate has been below 1% for over 20 years, offers an interesting case study. Platinum is unique among Australian asset managers to have managed a dedicated Japan fund for 18 years, which has over that period delivered 14.6% per annum against a market return of about 1.5% p.a. (MSCI Japan Index in $A)^[1]. We have direct experience of what worked in a low rate environment and, importantly, the distortions that low rates caused.

This paper will address three key strategies that worked and one to avoid, and will (in the footnotes) provide some examples of stocks we own today that meet these criteria. The analysis draws from a series of back-testing done by Credit Suisse HOLT as well as Platinum’s own quantitative studies. It is worth noting that the strategies shared by Credit Suisse would have also worked in the US and Europe, as they rely on investing common sense, but to a much lesser extent.

• Growth^[2] – Japanese investors became very enthusiastic for stocks that showed growth and would often bid them up to very high valuation levels. This can be explained by scarcity in a slow economy. However, simply buying growth would have been unsuccessful if it was not accompanied by keen attention to price. Our own quantitative work suggests that paying around 20X P/E (or below) for companies growing consistently at 7% or more delivered handsomely in Japan.
• Dividend yields^[3] – back-testing by Credit Suisse shows that consistent superior returns could be obtained in Japan (more so than in the US and Europe) by investing in the top quintile (i.e. the top 20%) of stocks with the highest dividend yields within sectors. Again, scarcity of income, this time across asset classes (i.e. stocks versus bonds or bank deposits), was the simple driver.
• Contrarian investing – Credit Suisse’s back-testing also suggests that paying attention to value and going against the crowd had substantial rewards. Buying the cheapest quintile of stocks across sectors based on the price–to-book ratio^[4] was more successful in Japan than elsewhere. In particular, a subset defined by Credit Suisse as “Restructuring” – cheap companies with low returns but improving momentum – was the best strategy of all, which indicates that detecting positive change among cheap stocks was the most effective approach.^[5]
• One to avoid – what Credit Suisse termed the “Quality Trap”. These are quality stocks that have become expensive but where their momentum is in decline. This can be dangerous. We often hear the standard marketing spin trotted out about why we should invest in great companies. Of course it is compelling logic and comforting to own the “best” companies, but they do not make the best investments. This is true in all markets over the long-term, but was especially so in Japan.

In summary, an investment approach like Platinum’s – paying close attention to price and going against the herd – makes a lot of sense and is effective, particularly in a market like Japan where there is little growth in the economy and interest rates are already close to zero. There was a widespread sense in Japan that the economy was very vulnerable to shocks and that the policy-makers had used up all their bullets. So when problems did arise, whether it was at a company level or a macro level, one would often see wild swings in sentiment and investors would get very pessimistic. If the world today indeed resembles the Japan of the last two to three decades, then we expect our tried-and-tested stock selection approach will have a good chance of delivering solid outcomes for our investors in the years ahead.

DISCLAIMER: The above information is commentary only (i.e. our general thoughts). It is not intended to be, nor should it be construed as, investment advice. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. Before making any investment decision you need to consider (with your financial adviser) your particular investment needs, objectives and circumstances. The above material may not be reproduced, in whole or in part, without the prior written consent of Platinum Investment Management Limited.