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Japan’s Value Rally Persists

Examining the 1.2% gain of the MSCI All Country World ex US Index in the second quarter, the biggest style effect is evidenced in Japan where there continues to be a strong bias in favor of cheaper stocks, which outperformed the most expensive stocks there by nearly 700 basis points (bps). That brings the advantage for cheaper stocks over more expensive stocks, which tend to be higher-growth and higher-quality companies, to a 1,500bp difference year to date.

As we’ve explored previously, the performance of certain factors can shift markedly in just a few years. Time will tell if this value rally gives way to better performance for more expensive, higher-quality, faster-growing companies in Japan.

Outside of Japan, there didn’t appear to be strongly defined style patterns. The heatmap above shows that there weren’t consistent headwinds or tailwinds when examining performance by measures of quality, growth, and value. There did, however, appear to be a style divergence between regions.

In the Eurozone, the fastest-growing stocks performed in line with the slowest-growing stocks. In emerging markets, the concentration effect of heavyweight stocks, including TSMC and Tencent, flattered the returns of the highest-quality, fastest-growing cohorts, even while cheaper stocks outperformed. In Asian markets excluding Japan, the most expensive stocks only modestly outperformed the least expensive this past quarter.

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A Quality Problem

For almost half a century, a niche within empirical finance has dedicated itself to sifting through accounting data in search of company traits that influence stock prices. Despite the plethora of factors unearthed, figuring out the precise drivers behind their behavior is still a bit of a mystery. For investors, simply identifying a factor isn’t enough; you also need to understand who’s on the other side of the trade—and why. Otherwise, who’s to say if a historical pattern will repeat in the future.

The difficulty in pinning down exactly what’s behind such canonical factors as quality, value, and momentum shouldn’t be a surprise. Factors can only be observed after the fact, but the underlying mechanisms that produce them are hidden. They are birthed from the complex interplay of buying and selling against a backdrop of economic and geopolitical shifts, all woven together by intricate feedback loops. Because they emerge as properties of a complex system, and because their returns wax and wane over decades, pinpointing a definitive root cause is quite the challenge.

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Japan’s Reforms Lift Stocks of Lowest-Quality Companies

Japan remains the single-largest country weight in the MSCI All Country World ex US Small Cap Index. However, the country’s weak economic growth, aging population, tight labor conditions, and chronic deflation have long made it a challenge to find high-quality, growing companies there.

Government regulators and the Tokyo Stock Exchange recently introduced a flurry of reforms aimed at improving corporate governance and shareholder returns. As discussed in our fourth quarter 2023 report, these actions have primarily benefited the cheapest stocks, given that they are typically associated with the least-profitable and slowest-growing companies. Additionally, the Bank of Japan has raised short-term interest rates, ending its decade-long era of negative rates. This landmark move boosted Japanese value stocks in the first quarter, further exacerbating the region’s style headwinds.

As the chart above to the right shows, the cheapest stocks in Japan outperformed the most expensive by nearly 1,600 basis points in the first quarter. For the trailing 12-month period, it’s worse: The spread between the most expensive and cheapest quintile was nearly 46%. The left and center charts show that investors also have favored slower-growing and lower-quality companies.

We don’t know how long this value rally will persist. In the short run, some of the changes have clearly exacerbated, and could prolong, style headwinds for higher-quality, faster-growing companies. But over the long term, the changes in Japanese business policy and mindset are positive developments. As more businesses raise their standards, the number of high-quality companies in Japan may increase.

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Quality Is Becoming More Affordable in China, Less So In India

While challenges in China persist, Chinese companies look better than China’s economy.

Some key parts of the Chinese economy continue to stabilize. Manufacturing activities expanded in March for the first time in six months, led by new orders from domestic customers as well as by export orders. The government is pushing for more domestic production in strategic industries such as green technology and advanced manufacturing. Growth in services activities has remained good, with travel and tourism continuing to rebound. We are also seeing increasing localization as Chinese companies prefer Chinese suppliers over multinational corporations to de-risk their own supply chain. This is leading to domestic market-share gains for many companies. Finally, valuations for some high-quality companies look compelling at these levels.

Quality growth stocks in China have derated significantly since 2019 and are now trading at a nearly 40% discount to developed-market counterparts and emerging markets (EMs) as a whole. Conversely, while valuations of Indian companies have moderated slightly over the past year, they continue to be expensive relative to the rising valuations in developed markets. Quality growth stocks in India still trade at a significant premium to other EMs.

India’s evolving economy is promising, as witnessed by our analysts on a recent trip to the country; however, the stock market rally in response has probably gone too far, especially with regards to small and mid-cap stocks. Today, valuations remain stretched across most sectors.

Note: Top QG quadrant is defined as companies with a QR score > 0.5 and a GR score > 0.5. VR Score based on weighted average.