By Scott Ronalds

We’ve written a fair amount on how stocks aren’t cheap these days (see Let’s Not Toss Valuations Out the Window). Price-to-earnings multiples (P/E’s) are at the higher end of their normal range, and corporate profit margins are at record levels in the U.S. Historically, this has been a bad combination because profit margins are cyclical and are vulnerable to reverting back to lower levels at some point, which would negatively impact earnings.

Elevated valuations and a lengthy run-up in the market make it a more challenging environment for investors. This isn’t to say, however, that there aren’t pockets of opportunity. In the view of our global manager, Edinburgh Partners Ltd., one such pocket is Japan.

We last provided an update on our Global Fund’s positioning in Japan last summer. Currently, over 30% of the portfolio is held in Japanese stocks, making the country the biggest area of investment. In a recent interview with Independent Investor (a British publication), Sandy Nairn, the CEO of Edinburgh Partners, provided his thoughts on why he’s so positive on Japan. The excerpt is below.

Thanks to the decline in the yen companies in Japan are now ferociously competitive. It may even be that the exchange rate has now become too cheap. Although this kind of statement can make you look foolish very quickly, I doubt the yen will go down much further. Recent events mean the environment has changed dramatically since I first started analysing Japanese equities back in the mid-1980s. Back then return on equity, dividends and buybacks might have been on international investors’ minds, but were rarely on those of domestic Japanese investors or company management.

This has now changed. Return on equity is one of the core metrics for any company, and Japanese companies are embracing it as an objective in a way they haven’t done before. The Government and wider society have agreed that tax revenues must rise, that deflation has to end and the deficit must be brought under control. Achieving this requires both rising wages and rising profits. Both formal and informal policy is heavily directed towards these ends.

What is becoming more clear as time goes by is that this is a genuine and powerful trend. One example is the minimum return on equity threshold required for a company to be an eligible investment by the government pension fund. Given the overcapitalised nature of balance sheets in Japan, increasing the return on equity requires increasing buybacks and raising dividends as well as improving profit margins. Companies now explicitly recognise this.

In addition to these shareholder friendly moves by companies there are also important supply side reforms including both broadening those in the tax net and simultaneously reducing the tax rate. There are a lot of positive changes happening and they are still not fully reflected in market valuations.

The Global Fund holds 13 Japanese companies, which include export-oriented household names such as Panasonic, Toyota and Yamaha Motor, as well as companies focused on the local economy such as East Japan Railway, Nippon Telegraph & Telephone (NTT) and Nomura Holdings.

The fund’s investments in Japan provide Steadyhand investors with exposure to not only cheaper stocks, but also a region that has been low on the radar of many global investors.