While the recent rebound in the US equity market is already impressive, Fidelity’s US portfolio managers believe there is potential for further gains.

“The case for US equities is compelling; it remains the location of choice for leading brands and technology firms and it offers exposure to the wider global equity market,” said Fidelity US Portfolio Manager, Aris Vatis.

There are a range of investment themes, says Mr Vatis, that investors can benefit from:

Tapping into emerging market growth – Some investors are concerned with the risk of a ‘hard landing’ in China, yet still believe in its long-term growth story. However, investing in high-quality US stocks can offer exposure to Chinese growth drivers and wider emerging market consumer growth, without exposure to the higher volatility associated with direct investments in the region. 

Multinationals like Coca Cola, Proctor & Gamble, Johnson & Johnson and McDonalds now generate large portions of their revenue from emerging markets. Most of these companies are considered stable, safe businesses. Demographically, emerging markets provide a massive source of demand for the goods and services these companies provide.

A technology leader – In technology, the US is a leader. Assembly may be increasingly done in China, but much of the intellectual property rights and the returns on capital typically reside in America. Smartphones and tablets are a good example of this with Apple and Google key players in this market. Demand for these products has been driven by the evolution of the mobile internet.

Supporting this growth, President Obama has revealed ambitious plans to connect virtually all Americans to the “wireless web” in five years. Already, billions of dollars are being invested into the country’s communications infrastructure, which will not only support mobile internet users, but also offer access to cloud computing services; the ability to store content and remotely access it via multiple devices.

There are other companies beyond the obvious that are benefiting from this growth, which investors can consider. For example, Qualcomm is a leader in mobile phone semiconductors and is now expanding into tablet devices – the company benefits from strong free cash flows, driven by royalties generated by handset vendors using their chips and patented technology.

Leading the multimedia revolution – Improving broadband download speeds has led to a revolution in how multimedia content is delivered and consumed. The rise of smartphones and tablets has also helped to support this trend. MP3 players created a profitable market for legally downloaded music, which cannibalised the sales of traditional media, such as CDs. These disruptive technology shifts create excellent investment opportunities. And this is exactly what is happening in the multimedia space right now.

Increasing demand for video content has led to fierce competition between multimedia distributors like Netflix, Apple, Amazon and even Wal-Mart. And America can lay fair claim to being the “content king” thanks to its movie industry. Stocks like the Walt Disney Company and Time Warner are good examples of businesses that are likely to benefit from the royalties earned from distribution rights. Both companies have seen huge increases in demand for the content they produce. Although this is a sector that is still in its early days, it has tremendous growth potential, which should be realised in the years to come.

Energy Independence for the US – There is a strong possibility that the US will become energy self-sufficient in the future. This is based on the commercialisation of shale gas discoveries, rising domestic oil production and renewable natural resources. 

Already, thanks to improving technology and new discoveries, the US has almost eliminated the need to import natural gas. As new projects to access previously inaccessible oil reserves approach maturity, US oil production is also set to increase. Additionally, large-scale projects to improve infrastructure are required to support these projects.

This is not a trend limited to the US – demand for oil globally is likely to continue to grow in the coming years. This is good news for companies that specialise in drilling technology. For example, National Oilwell Varco has a 50% share in the global oil drilling equipment market. Strong barriers to entry into the industry should serve to protect the firm’s current market position, ensuring the continuation of high returns on investment capital and strong free cash flow generation.

“US companies are in great shape, they are international in scope and they are operating in a host of attractive industries that are benefitting from favourable multi year thematic drivers,” says Mr Vatis.  “Regardless of where an investor lives then, US equities deserve to be a key component of a well-diversified equity portfolio.” 
This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”).  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity Worldwide Investment. This document is intended for use by advisers and wholesale investors. Retail investors should not rely on any information in this document without first seeking advice from their financial adviser. This document has been prepared without taking into account your objectives, financial situation or needs.  You should consider these matters before acting on the information.  You also should consider the Product Disclosure Statements (“PDS”) for respective Fidelity products before making a decision whether to acquire or hold the product.  The relevant PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading from our website at www.fidelity.com.au. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Details about Fidelity Australia’s provision of financial services to retail clients are set out in our Financial Services Guide, a copy of which can be downloaded from our website at www.fidelity.com.au. © 2012 FIL Responsible Entity (Australia) Limited. Fidelity, Fidelity Worldwide Investment and the Fidelity Worldwide Investment logo and F symbol are trademarks of FIL Limited.

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Since the March earthquake, the Japanese economy has plotted a v-shaped recovery as supply-chain disruptions were quickly resolved and manufacturing facilities were brought online ahead of schedule. Production normalised in most industries and sentiment indicators rebounded.
As a result, Japan has recovered well and the prospect of a third supplementary budget and substantial reconstruction demand should also prove quite helpful for growth in the future.

However, while domestic supply-side constraints have eased, external demand factors have deteriorated, slowing the pace of Japan’s recovery and impacting negatively on stock performance. Following the strong rebound in the third quarter (the consensus forecast was for annualised real GDP growth of around  6.0%), economic activity is expected to slow in the coming months, with structural fragilities in Europe and the US, as well as fresh supply-chain disruptions stemming from the floods in Thailand, representing key risk factors.

Meanwhile, the strength of the yen is also a major headwind for the Japanese market, fuelling concerns about the outlook for corporate earnings, especially at export-oriented firms. Japanese authorities have intervened in the currency markets and implemented additional monetary easing, but yen strength appears likely to persist in the absence of concerted action. Despite the strength of the yen’s rise against the dollar and the euro, it is worth remembering that the real effective yen rate, a measure of Japan’s competitiveness, is actually still well below its 1995 peak.

Corporate Japan remarkably resilient despite headwinds
Despite headwinds, at the microeconomic level, Japanese companies have seen a significant improvement in earnings and profitability. They have strengthened their earnings base, improved cost efficiencies and appear to have become more accustomed to coping with persistent yen appreciation. They have also increased their overseas presence, particularly in Asia, adapting to sluggish domestic demand and structural shifts in the global economy (eg. emergence of Asian and other developing economies).

Meanwhile, cash reserves at listed Japanese companies have risen to record highs and free cash flow generation has improved significantly. In addition to enhancing shareholder returns through buybacks and dividends, companies have wisely been seeking to capitalise on the strength of their balance sheets and the yen to acquire businesses overseas. This strategy has been supported further by the recent expansion of the government’s foreign investment loan programme, which is aimed at curbing yen strength by getting Japanese companies to increase their foreign currency assets. In the first six months of fiscal 2011 (April-September), Japanese companies made ¥3.1 trillion of overseas acquisitions, a 130% increase on the same period a year ago.

The re-emergence of corporate governance issues
Recent scandals at Daio Paper and Olympus have raised some concerns about corporate governance in Japan, threatening to further cloud investors’ view of the domestic market. With overseas investors accounting for almost 70% of stock trading in Japan, a feeling of distrust in Japanese firms could further thin trading volumes.

While these recent cases have understandably raised doubts about the transparency of management, it is important to remember that they relate specifically to individual companies and are not reflective of corporate Japan as a whole. Indeed, over the past ten years or so, a significant shift in Japan’s shareholder base has helped to increase pressure on management to improve governance and enhance shareholder value.

An oft-cited limitation of Japan’s corporate environment in the past was ‘keiritsu’- an economically inefficient system of tight inter-corporate linkages (the Japanese word literally means ‘headless combination’) built around cross-share holdings between groups of companies. However, this particular driver of potential corporate malfeasance is much less relevant today because the cross- shareholding ratio (the ratio of holdings of other listed companies by listed companies on a market value basis) has fallen from around 33% at the start of the 1990s to a record low of 11% (as of 31 March 2011). At the same time, the ratio of Japanese shares held by overseas investors has risen from less than 5% to around 27%, something which is supporting the adoption of western corporate governance norms.

Furthermore, it is reasonable to say that Japanese companies have improved their organisational structures and decision making processes more generally. As a result, they are far better placed to respond quickly to changes in the economic environment and/or their respective industries. A recent example would be Panasonic’s decision to downsize its mature and loss-making businesses, and to focus more on new growth areas such as high-margin energy-efficient household appliances.

Cheap across the board- but selection still the key
Japanese equities now look extremely cheap against a wide range of measures. The market is not only cheap relative to its own long-term history on asset and earnings based metrics like price-to-book and cyclically adjusted price-to-earnings ratios (also known as ‘Shiller PE ratios’) – it is now cheap on a global sector-by-sector basis. Analysis from Deutsche Bank shows that Japanese equities were the most expensive in the world on a sector-by-sector basis 100% of the time in the late 1980s. However, in the intervening years that premium has reversed to the point where, now, Japanese sectors are the cheapest in the world 60-70% of the time.

Another way to assess the valuation of stock markets is to look at the ‘equity risk premium’ (ERP). This is calculated by deducting the current 10-year domestic bond yield from the expected return of a given equity market. As the chart below shows, Japan has a current ERP of 4.9%. This is lower than what’s currently available in China and the UK for example. However, a better gauge of value is gained by looking at past numbers for the same market. Doing this reveals that Japan’s ERP looks very favourable, with the widest positive differential versus its historical average out of all the major global equity markets. Indeed, this leads Soc Gen to make the notable conclusion that, ‘relative to Japanese government bonds’ the Nikkei appears to be the cheapest (main) market in the world compared to its historical norm.

All this said, investors need to be aware that cheap markets do not always equate to value, because often low valuations are fully deserved. The key then is to be very selective and to seek out those quality companies that are well managed but about which the market, for whatever reason, has become unjustifiably negative. Such instances are comparatively rare, but in the current environment of overall investor nervousness, we believe they certainly do exist.

Conclusion – a stock-picker’s market
While macroeconomic issues continue to mask a healthy corporate sector in Japan, Japanese equities remain underappreciated by investors.

Over the past 10 years, Japanese companies have strengthened their earnings base, enhanced cost efficiencies and improved free cash flows. Despite some recent negative news stories, a shift in the composition of shareholders has actually contributed to improvements in governance and shareholder returns. Furthermore, the Japanese market has finally worked off its valuation premium and now compares very favourably with its own long-term history and its global peers on virtually all main measures.

Over the medium term, a combination of solid corporate fundamentals, more shareholder-friendly activity, historically low valuations and poor sentiment is likely to provide a very favourable backdrop for stock selection in Japan.

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