RICHARD PHILLIPS: Good morning everyone. My name is Richard Phillips and I’d like to welcome you to today’s Japan CoreAlpha Conference Call with my colleague Steve Harker. Steve is going to review Q3 2017. We’ll speak for around 15 minutes and then we’ll open the lines to questions. As ever, if you do wish to submit a question, please click on the tab on the screen and submit it and I will cover it at the end. But without any further ado I’ll hand straight over to Steve.
STEVE HARKER: Thanks Richard. Q3 2017 has been relatively unremarkable in many respects, but I’m going to take you through what we’ve been doing and what the markets have been doing. First of all, I’d just like to mention our website, japancorealpha.com, where you can find a lot more information on the products and what we’ve been doing. Our team are uploading lots of information this week and probably early next week, so there’s an awful lot of new stuff to look at.
If we could start on page 3 and just reiterate what we are and what we do with no change. You can see on the right-hand side that the Top Cap Value and Mid Cap Value within Russell Nomura represents about 40% of that index and it correlates very closely with TOPIX. The big grid on the left-hand side shows where the CoreAlpha portfolio was at the end of September and true to form it’s all dark blue and mid blue and nothing has really changed. All we’ve been doing as always is rotating out of winners higher price-to-book stocks into lower price-to-book stocks and stocks that have lost in the hope that they will win in future.
If you can now move on to page 4, this is the Russell Nomura, the sixth box is how they’ve performed in Q3 2017, and I think really the only thing of any outstanding merit is the excess return from small caps, particularly Small Cap Value. We’re not really represented in that part of the market so that hasn’t helped, but over the course as a whole we’re marginally behind the Large Cap Value Index and we’re marginally behind TOPIX, so no great shakes.
Turning next to page 5 and I think this is really important. Each year, we’ve logged, from 1985, from January through to the end of December, the relative performance of Value divided by Growth. So when the line finishes above the black line, Value has won; most of the years since 1985 Value has won and there are a number of exceptions. There was an extraordinary event. This is perhaps repetition for some, but the TMT bubble in the late 1990s saw Growth stocks perform exceptionally well in 1997 and 1999. And then a recoil in 2000 and then subsequently in the following years Value won quite significantly.
So if you take those three exceptional years out, Value has tended to win; however, in 2016, at this time, at the end of September last year, Value was losing and as of today 2017 is more or less a repeat with Value about 6% behind Growth year-to-date. Last year, we had the Trump election victory in early November, which turned the whole thing around and Value ended up winning, as did we, and we had a fantastic second half of last year. Whether we’re going to get a turnaround of that or any dimension this year is obviously an unknown unknown. We just don’t know what the future holds. But I’m really pleased with how we’ve executed our portfolio management over the last, certainly over the last 12 months we’ve had a really seamless performance. And I think we’ve done a lot of good things in terms of taking profit and reinvigorating the portfolio with cheaper stocks with more upside-potential, we hope.
On page 6, again this is a repeat, the extraordinary correlation between the US 10-year treasury and the performance of Value/Growth. This goes back to 2009. Value divided by Growth is the grey line, the dark blue line is the US 10-year, and the correlation has increased over the last four or five years as monetary policy has been the dominant factor influencing equity pricing. We saw the big turn on the 7th of July last year. It ended, that up-run in Value ended on the 9th of December and since then Value has been underperforming and the US treasury has been coming down, the yield has been coming down.
But interestingly we’ve had two little humps in the US treasury in late June and again in September, and both of those have coincided with Value winning against Growth and our portfolio winning against the market. September was a slight positive month for CoreAlpha against TOPIX. And I think that is the thing that you should keep in mind. This is a really binary situation we’re in. In our opinion Value is giveaway cheap and we need interest rates, whether it’s in the US or in Japan, to go up in order to win. I think, you know, if you look at history, I think you have to assume that that is going to happen at some point.
Moving on now to page 7: this is our internal control chart in the engine room of CoreAlpha. It’s our excess return quarterly for the strategy going back to inception in 2006. More blue lines than red and the blue lines tend to be bigger than the red, so that’s all hunky-dory. Over the last seven, eight years, the volatility has been reduced because going into Lehman and coming out of Lehman we had two extraordinarily extreme portfolios against Large Value. And we haven’t got extremes of that kind at the moment and we’ve not had for eight years. We had two great quarters: Q3 and Q4 2016. Q1 2017 was surprisingly positive, Q2 2017 was a small negative and this quarter is barely negative, so nothing untoward and I think the ship is still sailing in the right direction. I hope that analogy is a good one.
And then on page 8, obviously we’re only investing in about 40% of TOPIX. Our correlation with TOPIX is much lower, volatility much higher. Q4 2016 was joint record best quarter compared with January, the first quarter of 2009. An absolute humdinger in Q4 2016 and then we’ve had two negative quarters followed by a marginal negative in Q3 2017 and if you look at the history there’s nothing untoward and unusual about that and I think we’re fine and we’re just waiting for the next reversal, whenever that comes, and if we look at history it does tend to come, so we’ll just relax and just wait.
Next, page 9. I’ll just talk about changes to the portfolio concentrating on the top 10 during the course of 2017. On the right-hand side you can see where we were top 10 at the end of the year. At the left-hand side you can see where we are now. There have been two changes. The core of the portfolio is still financials, steel and autos in terms of top 10 holdings. There are two exits from the top 10 in the last nine months. Canon, we sold quite aggressively in the spring after some rather nice performance, and that’s now just below the top 10, as is Nomura, which has just drifted down to a level below 10th place, so they are probably both still top 15 holdings. The other holdings haven’t really changed. We trimmed JFE and Nippon Steel when they were performing really well in the spring and they’ve had an iffy time more recently, but actually the steel sector did OK. It was in line in Q3 2017.
On the buy side, there are two new additions. And I’m going to talk about Mitsubishi Estate on the next slide so I won’t mention that here, but our biggest move forward has been in terms of Japan Post Holdings, which we subscribed an additional holding for in the recent IPO. It’s a secondary offering and we’ve taken our holding at the end of September to 4.0. We’ve bought some more in October and it’s now I think our fifth largest position in the CoreAlpha portfolio. The Royal Mail of Japan, if you like, with national savings and investment and a fairly large insurance company thrown in as an additional diversifier. This is the cheapest large cap stock I can ever remember seeing in a third of a century managing Japanese equities. And the other eight are still there.
If you look at the portfolio below this and exclude, we bought three things this year: electric, power and gas we’ve taken up. We’ve bought real estates and we have bought Japan Post Holdings. Those are the big three holdings increases. And I think probably the biggest significant cut is in Asahi Glass and Nippon Electric Glass. The glass companies sector was our third biggest position from a sector perspective at the end of last year and it’s now in the pack, it’s a reduced overweight, and that follows really terrific performance from both Asahi and Nippon Electric.
So, now turning to page 10, this is a brand new chart and I thought it was a really good way of illustrating the contrarian approach. The identification of and exploiting of mean reversion, and it looks at two sectors: chemicals and real estate. On the left-hand side you can see those sectors indexed to 100 at 1983, so you’ve got 35 years of data, and the key driver - broadly correlated they both go up at the same time and down at the same time most of the time, and the big influence on this is TOPIX. If you took the average of these two sectors it probably correlates incredibly well with TOPIX. They’ve both outperformed TOPIX a little bit over that long period of time, but very insignificantly.
But if you look at the right-hand side you can see that cyclically there is an enormous range of volatility of these two things and real estate has performed really, really well on three separate occasions. One in the early mid-80s, the second up to 2006, the third up to February of 2013, which was basically the initial spike following Abe’s election in 2012. So they’ve had three runs and they’ve been underperforming now since February of 2013, which is four-and-a-half years, against chemicals. So this is chemicals divided by real estate. And you can see that on the other side chemicals have been winning and they’ve been winning big time for four-and-a-half years.
Now, at that turning point in February of 2013 our weighting in chemicals was 9%, our weighting in real estate was 0% - contrarian investing assets at its best. We’ve held a big position in chemicals until quite recently and at the time of speaking we have nothing in chemicals now and we have taken our real estate weighting up to about 6.5% in recent weeks. So we are betting on mean reversion, we’re investing in stocks with lower price-to-book relatives, and we’re selling things that have done well where the price-to-book has risen relative to the market. And nothing has changed. I mean this is what we do all of the time, but I thought it would be quite interesting to show you what we’ve been doing in these two sectors to give you a flavour of what our transactions have been in 2017.
So I’m going to finish off now with two more slides. One, the Value of Value; this is the price-to-book relative of Large Value against the total market. Large Value has been derating for nearly 30 years since 1988, but it’s been operating in a fairly narrow range until about 2011 when it broke out at the bottom and we have reached at the end, in the middle of last year we reached quite extraordinary cheapness for Value and as soon as there was a catalyst, which turned out to be the reversal in interest rates, Value bounced back and to some extent normalised, but still extraordinarily cheap. Since the 9th of December yields have come down and again we’ve seen Value losing, but it doesn’t have any momentum. And nor does the US interest rate.
If you look at the period since 1999 when we had this extraordinary v-shaped collapse of Value against Growth - it was the TMT bubble - and if you take that period from the end of 1999 through to 2010, Value outperformed and re-rated relative to Growth and we performed fantastically well in that period. From 2010 to 2016 Value had a terrible time, both in terms of performance and in terms of derating, and we did not underperform by any significant amount against TOPIX and we beat Large Value.
Obviously the piece of elastic may be broken, but my sense is that July the 7th last year was a major, major turning point. And if this line goes up, I think, you know, we can’t make forecasts, but if this line goes up we have always won in the past and I suspect we would win in the future. I mean it’s a fairly clear cut performance driver of the CoreAlpha strategy. So what we need obviously is interest rates to go up, Large Value stocks to rise relative to Growth and the valuation disparity between Value and Growth to normalise, and I think that’s a reasonable bet to make on a decade long view.
Finally, on page 12, 2017 has been the year when we have done less in terms of transactions and in terms of stock changes than we’ve done for a long, long time, I think probably back to 2007, if not 2006. We’ve only, up to the end of September we only took four names out: Hitachi, Kansai Electric Power, Dai-ichi Life Insurance Company and Sumitomo Metal Mining. We’ve taken another one out in October. On the buy side, we only bought one new stock in the first nine months of the year and we have now added another one in the first few days of October.
So two in and five out in just over nine months and that is a very low rate for us and it reflects the fact that stocks haven’t reached our sell targets and there’s nothing new really coming in to the frame. As and when those things happen, we will refresh the portfolio, but as I said we’ve been buying real estate, we’ve been buying electric, power and gas, we’ve been buying Japan Post and we’ve been selling glass, and I think we’ve also been selling the life insurance as well earlier on in the year, which was a really good thing to have done.
So I think we’re in good shape and I think at that point I’ll hand back to Richard and if you’ve got any questions I’ll be happy to take them. Thank you.
RICHARD PHILLIPS: Thank you, Steve. Just to remind you, if you wish to submit a question please type it in on the tab on the screen and send it along. We have a couple of questions, Steve, and they’re both regarding politics at the moment. So, with the Japanese election in the next couple of weeks - they’re both the same - if Abe remains PM will policy change and will it matter, and could the Japanese election derail the equity market’s recent progress?
STEVE HARKER: A week ago people were starting to wonder whether Mrs Koike would get enough traction in the run-up to the election in order to get past the post. And I think the opinion polls were suggesting that it was a busted flush and that her ratings have gone down again. So I think, I haven’t seen Paddy Power Japan’s view of the election, but I think it’s pretty much a shoo-in for the incumbents. In which case Mr Abe I guess would be re-elected as prime minister or continue as prime minister.
There is a lot of speculation about Mr Abe and whether he can continue for health reasons and it’s been suggested that Mr Kishida, who really comes from a very similar background and has a very similar world view to Abe, would be the likely candidate to replace him. And it may well be that this election is a way of providing Mr Kishida with a long enough mandate to make a difference. But I think at heart the big risk, I mean risk in the sense of a change rather than a negative, is that the policy that Abe has, the economic policy of easy fiscal policy and easy monetary policy, which started in late 2012/early 2013 would be compromised, because Mr Kishida is much more mainstream conservative in economic matters, nd I think it’s more likely that if Kishida got in, Kuroda would not have a second term, that monetary policy would be normalised and tightened and fiscal policy likewise and that would be very yen positive.
I think it might be worth, I don’t really know much more about politics than that and I think the chances are that we’re essentially steady as you go, but I just would like to add that our portfolio for the last two-and-a-half years, three years has been overweight in export overseas earnings related companies and I think for the first time we’re neutral. We’ve taken, the process of buying low and selling high has taken out a lot of our export-related overweight and I think we’re probably roughly neutral in terms of overseas earnings. So we’re not positioned for a yen weakness now and that’s the first time for some while.
RICHARD PHILLIPS: Thank you, Steve. Well that seems to be all the questions we have for this session, so thank you everybody for dialling in and both Steve and I look forward to speaking to you in the Q1 update early in the New Year, but for now thank you very much.