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“Go for Alpha” sums up how to invest successfully in Japan. Takayuki Kohata, Lead Portfolio Manager, discusses the opportunities offered by Japan in an interview with Raphael Haselberger, CFA, Head of Product Specialists for Liquid Alternatives

Mr. Kohata, Japan is your home, you know the country and its people, the companies in the region. How much potential does this market have?

Takayuki Kohata: You’ll be surprised, but I’m not bullish about Japan. It's not a market that you simply invest in because there's so much growth potential. Japan is facing many fundamental challenges that are placing a massive burden on its economy. On the one hand, there's demographic development: there are a great many old people, and the working population has been shrinking for years. On the other hand, the Japanese government has very little chance to invest in infrastructure or other economic stimulus programs because of its high levels of debt. A look at the valuation of Japanese equities doesn’t give us much cause to celebrate, either. Even after the most recent downturn, the overall market – measured against the TOPIX index – isn't cheap.

So, under these conditions, why should investors be interested in Japan?

Takayuki Kohata: Because Japan is a great market for stock-picking. There are an unbelievable number of opportunities if you change your perspective, i.e. instead of looking at the market top-down, taking a bottom-up approach and looking for companies with strong balance sheets that are holding their own against competitors. Such companies have been using their capital for some time to get themselves into an even stronger position by making targeted acquisitions. We’ve seen significant growth in bids for Japanese companies, for example. At the same time, this gives companies a good opportunity to sell off lines of business that they are not focusing on, or that are unprofitable. In short, many Japanese companies are using the M&A market, which is fairly active again, to improve their profitability. We can see this very clearly in rising profit margins.

Have you observed this trend across the entire Japanese market?

Takayuki Kohata: There are a few structural trends that very many companies are following. From a historical viewpoint, profit margins in Japan have always been much lower than in Europe or the US. This is changing because Japanese companies are no longer striving to become as large as possible, and to generate high revenues. They're now aiming to maximise their profitability and increase their return on equity. To do this, it’s important that they use the high cash reserves they have on their balance sheets to invest or buy back shares. Another major issue is the management culture at Japanese companies. We're seeing a trend here towards more independent external directors. Japan is far behind other countries in terms of the proportion of women in management positions. There's still a lot to be done.

Are there significant differences between companies?

Takayuki Kohata: Yes, definitely. And the gap between winners and losers is constantly widening. That’s clearly evident from the yields on individual stocks. We can see that only a very small proportion of companies have performed in line with the market average in the years since 2010. At the same time, there are many companies that have performed considerably better. Around 750 businesses have outperformed the market by 140 percent or more. All those that have actively pursued a strategy of increasing their profitability in recent years are among the winners. However, there are also clear losers. Almost 500 companies are 40 percent or more below average market development. It's precisely this discrepancy that we exploit for our strategy.

Explain that in more detail. How does your approach work?

Takayuki Kohata: I said at the beginning that I’m not bullish about the whole market. We invest specifically in those companies that we believe are on the winners’ side. But that alone is not enough. We also bank on the potential returns offered by losers by going short on these stocks. Incidentally, this is much easier on the Japanese stock market than on many other markets, as short-selling is not restricted here, which means that we can make full use of these opportunities and concentrate on the company-specific alpha.

“When I take risks, I look for advantages and disadvantages that go far beyond what I would describe as normal market noise.”

Don’t other investors have the same idea?

Takayuki Kohata: The Japanese market is smaller than the European and US markets, and nowhere near as efficient. Of around 10,000 hedge fund managers worldwide, only about 100 operate in Japan. The ratio of hedge fund assets to market capitalisation is also comparatively low in Japan, at just 0.5 percent; in the US it’s 6 percent, in Europe 8 percent. As a result, Japanese companies are not particularly attractive to the major investment banks, and many companies are not even monitored by analysts. So if you have the resources and the skills to analyse this market and take a close look at companies, you’ll find a lot of potential that very few people know about. That’s exactly where we come in. I have been active on the Japanese stock market for over 20 years. I’ve worked for different companies and know the various strategies. This knowledge, the expertise we have in our team, our local presence – all of that helps us.

Let’s talk about your strategy. What can it do and who is it suitable for?

Takayuki Kohata: The key is in the name: Allianz Equity Long Short Strategy. We focus on the Japanese stock market and are market-neutral. We don’t earn our performance through beta; instead, we specifically look for alpha – on the long and the short side. We call this “double alpha strategy”. We do this in a very focused way and typically have 20 to 30 long positions and 30 to 40 short positions. Our investment horizon is comparatively long, and we often enter into positions for several years. Our goal is to achieve a net return of 6 to 8 percent with volatility of 6 to 8 percent.10 The strategy will suit all investors seeking comparatively stable returns, and an investment that is not correlated with the Japanese stock market.

You embarked on this strategy in March 2019. How has it gone so far?

Takayuki Kohata: I think it's most impressively demonstrated by the performance figures following the stock market slide in March 2020. The TOPIX slipped far into negative territory at times, but our portfolio remained stable and on positive ground (see Chart A/). From when the strategy was launched in March 2019 up to the end of April 2020, we achieved a net performance – i.e. a return after deduction of all costs and fees – of 2.2 percent with volatility of 4 percent.11 The market as a whole recorded a drop of 3.4 percent in the same period, with unbelievable volatility of 20 percent. Our strategy thus proved successful when the market collapsed and most hedge funds lost a great deal of money.

You’re an experienced fund manager. Will you share your recipe for success?

Takayuki Kohata: Over the last 20 years I’ve worked in a lot of places and have learned a great deal. There are three key indicators that I’ve taken away from this experience, which are central to my investment philosophy. One is the discounted cash flow – a key concept that we find with both Warren Buffet and the American hedge fund manager Ray Dalio, even though their investment philosophies are so different. It means simply that with today’s investment, we are making a discounted lump-sum payment on a company’s future cash flow. The second key indicator is the intrinsic value of a share. I determine this for every stock I invest in, taking into account any surplus cash that a company has on its balance sheet. The third important variable is the safety margin. For me, these three figures are crucial to every investment decision. When I take risks, I look for advantages and disadvantages that go far beyond what I would describe as normal market noise. Share prices can always fluctuate by 5 to 10 percent. I look for the major winners and losers with upside or downside potential of 50 percent or more, and exploit the potential they offer.

A/    THE PORTFOLIO HAS PERFORMED WELL IN A DIFFICULT AND VERY VOLATILE MARKET

Source: IDS GmbH – Analysis and Reporting Services, Allianz Global Investors; as of 30 April 2020.

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