Letter From Tokyo Shigeru Oshita, Chief Portfolio Manager, Japanese Equities A taxing issue for consumers VIEW FROM ABOVE Left out in the cold MARKET OVERVIEW October 2014 Vehicle emissions – a catalyst for change? INVESTMENT INSIGHTS View From Above A taxing issue for consumers In the last edition of Letter From Tokyo, I talked about the increase in consumption tax, which increased in April from 5% to 8%. At that time, I was relatively relaxed about its likely impact, largely because of the fundamental strength of the Japanese economy. With the tax increase now six months old, it is worth looking at its actual impact on Japanese consumers. While the impact on overall consumption has been modest, consumption trends appear polarised between cheaper daily consumables and more expensive, higher-end products. Retailers are passing on the tax increase and in an environment where real wages are not increasing, consumers on low incomes are adjusting to higher prices by consuming less. Conversely, those on higher incomes are continuing to make purchases with sales of more expensive products almost unaffected. How have retailers responded? Those focused on low value, commodity-type products (e.g. apparel) are struggling and have responded by cutting prices, although with limited success. Volumes have not increased even at lower price points and these retailers are likely to reduce prices further across a wider range of products. Again, polarisation is apparent across different product categories. A major Japanese television retailer reports that while sales of TVs below $500 have fallen, sales for big-ticket products, such as 50-inch TVs, remain strong. My conclusion is that Japanese consumers are clearly differentiating between products. They are purchasing, or prepared to pay more for, quality products that offer clear value while being more discriminating towards general products. "Consumption trends appear polarised" This document is intended for institutional investors and investment professionals only and should not be distributed to or relied upon by retail clients. Market Overview Left out in the cold The launch of the new JPX-Nikkei 400 Index has been seen as a strong incentive for Japanese companies to become more focused on capital efficiency and improve their corporate governance. Companies gain entry into this index based on quantitative criteria such as return on equity (RoE) and by committing to meet the principles of a governance code. It is seen as a corporate ‘badge of honour’ to be included. "This index is proving to be a catalyst for change" The issue of companies seeking to meet the criteria for index inclusion is actually indicative of a wider change I have detected from Japanese companies in general. There is now a far greater awareness of the importance of shareholder value, and a focus on RoE becoming a key performance target. Two companies that illustrate this trend are machinery company Amada food processing firm NH Foods. In the case of Amada, it has committed to increasing its payout ratio to 100% (50% dividends, 50% share buybacks). NH Foods has responded through a share buyback funded by issuing convertible bonds. Both companies have been rewarded by investors for their greater awareness of shareholder value. Investment Insights Vehicle emissions – a catalyst for change? Regulations governing vehicle emissions are tightening across the globe, presenting clear opportunities for particular companies. With continual increases in emission standards comes the requirement for auto manufacturers to upgrade components and technology. I have come across several Japanese parts manufacturers I believe are well placed to exploit this continual change. The winners in this process will be those companies who adapt and respond, manufacturing high quality components able to command and maintain high margins. Japanese filter and sensor suppliers NGK Insulators and NGK Spark Plug are examples of companies that are rising to this challenge successfully. Not only are they addressing a growing demand, but unlike other commoditised auto-part suppliers, their products require sensitive process controls using ceramic materials and therefore have high value content. Their dominant market share provides economies of scale in production with the high value nature of their products securing high profit margins. A further reason for my optimism is that the market for auto components capable of reducing pollution levels is now truly global and has expanded to cover commercial vehicles, not just cars. Emerging markets such as China are moving towards European environmental regulation levels for vehicles sold in their countries. I believe several Japanese companies are well placed to exploit these global trends. "Emerging markets are moving towards European levels of regulation" Building the foundations for recovery Following 20 years of falling construction investment in Japan, I am now detecting the first signs of recovery. I think the main reason for this relates to the earthquake and tsunami that hit Japan in March 2011. This catastrophic event was a wake-up call for many, resulting in major new projects and the upgrading of Japanese infrastructure. Vulnerable buildings are being rebuilt or upgraded in order to provide greater earthquake resistance. I think the construction sector has also come to life because of acceptance that something has to be done to relieve Tokyo congestion. With 60% of traffic around Tokyo unrelated to residents or business, three new ring roads are being developed to divert traffic and improve travel times. The average speed on the main ‘express’ highway around Tokyo currently is barely 40kph. The improving economic environment in Japan has also led the Abe government to promote significant new public and private development. An obvious example is the level of new investment around Tokyo prompted by the 2020 Tokyo Olympic Games. These new projects are not simply restricted to Tokyo. Other regions are also benefiting as investment is made in upgrading airport runways and increasing bullet train capacity to cope with higher expected visitor numbers. However, what is apparent is that not all construction companies will benefit from increased construction activity. Often these new construction projects are complex, requiring specialist construction techniques. Given the more specialist nature of many of these new projects, I would expect current profit margins within the industry to improve. The Japanese Equity Growth Fund is managed by Standard Life Investments’ partner SuMi TRUST Shigeru Oshita Chief Portfolio Manager Japanese Equity Growth Fund "Upgrading Japanese infrastructure is now underway" Important Information All information, opinions and estimates in this document are those of Standard Life Investments, and constitute our best judgement as of the date indicated and may be superseded by subsequent market events or other reasons. This material is for informational purposes only and does not constitute an offer to sell, or solicitation of an offer to purchase any security, nor does it constitute investment advice or an endorsement with respect to any investment vehicle. Any offer of securities may be made only by means of a formal confidential private offering memorandum. This material serves to provide general information and is not meant to be legal or tax advice for any particular investor, which can only be provided by qualified tax and legal counsel. 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