What's Worked in Japan
Japan is notorious among investors for “lost decades.” Japan’s Nikkei 225 stock index has been essentially flat since the turn of the millennium. Had you invested a dollar in Japan’s large, expensive firms in the summer of 2000, 16 years later you would have 99.9 cents by our calculations below.
Though Japan’s largest stocks performed poorly over the period, the picture in the smaller-capitalization market looks significantly different. Had you invested a dollar in Japanese small value in the summer of 2000, 16 years later you would have $7.48, a 13.4% annualized compounded growth rate.
We have studied three decades of the Japanese equity markets to develop our strategy, focusing on understanding which types of stocks perform best and how to maximize returns by choosing an effective reference class of stocks. We believe the opportunity in Japan to profit from these insights is significant, especially given the limited amount of active equity management and the large number of public companies.
Figure 1 below is a chart showing the average annual returns in US dollars by size and value since 1990.
Figure 1: Average Annual Equal-Weighted Returns for 4 Japanese Size and Value Styles 1991 - 2016 (USD)
Source: Fama-French 6 Japanese Portfolios Formed on Size and Book-to-Market (2 x 3). Returns include dividends and capital gains. Big stocks are those in the top 90% of June market cap for Japan, and small stocks are those in the bottom 10%. The B/M value breakpoints for big and small stocks are the 30th and 70th percentiles.
Figure 2 below shows how an investment in each style would have compounded since the summer of 2000 based on the daily returns in Figure 1.
Figure 2: Indexed Performance for 4 Japanese Size and Value Styles (Equal Weighted, USD)
Source: Fama-French 6 Japanese Portfolios Formed on Size and Book-to-Market (2 x 3). Returns include dividends and capital gains. Big stocks are those in the top 90% of June market cap for Japan, and small stocks are those in the bottom 10%. The B/M value breakpoints for big and small stocks are the 30th and 70th percentiles.
We are not alone in noticing the outperformance of small value Japanese stocks. According to an analysis by Barron’s last fall, small caps in Japan this millennium have outperformed during 75% of rolling three-year periods and 85% of rolling five-year periods. And the charts above suggest that small value has done even better.
At Verdad we specialize in levered equities. We have found that, from a risk perspective, levered small value in Japan has behaved a lot like the broader small value universe in Japan but has outperformed in absolute returns. From June 30, 2004, through June 30, 2015, dollar-denominated returns on Japanese small value compounded at a rate of 12%, and our reference class of levered small value stocks compounded at over 20%.
Below is a chart showing 10 years of Yen-denominated annual returns for the Nikkei 225 index, Japan small value, and our reference class of levered small value stocks. We have added the foreign exchange movement for each portfolio year to illustrate yen rallies (and devaluations).
Figure 3: Yen-denominated Returns (June 2004 - June 2015)
Source: CapitalIQ, Fama-French Japanese Small Value Equal Weighted, Verdad Research. Returns for portfolios formed June 30 of indicated year.
The chart suggests that small value performed as well or better than the big and relatively expensive Nikkei index and showed reduced volatility and drawdowns in 2007 and 2008. We observed that our reference class of levered small value stocks outperformed every year and likewise had reduced volatility and drawdowns relative to the Nikkei.
In the depths of the 2007–2008 financial crisis, the S&P 500 had a max drawdown of approximately 53%, the Nikkei 225 drew down 48%, Japan small value drew down 31.5%, and our reference class of levered small value Japanese stocks drew down roughly 32.3% (all in dollar terms). The similarity in the drawdowns between Japanese small value and Japanese levered small value may not be surprising, given that out of approximately 3,700 publicly listed Japanese stocks, the most bankruptcies in any given year since 2000 was 33, at the peak of the crisis in 2008. Since 2014, we have only seen three publicly listed bankruptcies in Japan.
To investors whose impression of Japanese equities may be informed solely by the Nikkei, this millennium would have shown zero returns, moderate volatility, and a trade that looks highly predicated on yen devaluation. With small value in Japan, investors got something different: outperformance, lower volatility, reduced drawdowns, and less dependency on FX. With levered small value in Japan, investors got all the benefits of small value and more alpha.
In Q1, Japan saw the fifth consecutive quarter of positive GDP growth, marking the longest growth streak in 11 years, yet Japanese valuations remain at absolute and relative lows for this millennium. Given these factors and the long-term track record of the levered small value approach in Japan, we are excited to have officially launched the Verdad Japan Fund, L.P.