Why Japan's stock market could keep soaring - plus three stock picks there

By Philip van Doorn

Christian Heck of First Eagle Investment Management makes the case that Japan's stock market is still inexpensive as its companies improve

The Japanese stock market came to the fore in the U.S. financial media last year, when the Nikkei 225 index returned 31% and Warren Buffett's Berkshire Hathaway made a splash by investing in five Japanese general-trading companies.

And Japan's market may still have a long run ahead of it given the untapped potential for efficiency improvement and better deployment of capital, according to Christian Heck, a portfolio manager at First Eagle Investment Management in New York.

Heck is part of the team managing the First Eagle Overseas Fund SGOVX SGOIX, which take a conservative approach to investing mainly in developed markets outside the U.S. The fund is more concentrated on Japan (which comprises about 16% to 17% of its $12.4 billion portfolio) than it is on any other country.

In February, the Nikkei 225 JP:NIK hit its first record high since 1989, reflecting the scope of the bubble for Japanese stocks 35 years ago.

During an interview, Heck gave several reasons why Japan's stock-market run can continue from here:

Over the past three years, the Nikkei 225 has returned 51.5%, while the S&P 500 SPX has returned 37.5%. (All returns in this article include reinvested dividends.) Meanwhile, the number of Japanese yen to the U.S. dollar has increased to 148 from 109. So, the Japanese stock market "hasn't moved much in dollar terms," Heck said. "Japan has many exporting companies, so it is not fair to look at them only in yen terms."The Nikkei 225 trades at 23.5 times trailing earnings, while the S&P 500 trades at 24.8 times trailing earnings. But while they appear to be valued similarly on this basis, according to Heck, about 50% of companies in the Nikkei 225 have net cash on their balance sheets - that is, their cash exceeds their debt. This percentage for the S&P 500 is only about 10%, he noted. This is relevant because "when you look at P/E, the balance sheet doesn't get taken into consideration," he said.Another way to valuation for a company or stock index is enterprise value (the market capitalization of a company's stock, plus its debt less its cash and other liquid assets) divided by earnings before interest, taxes, depreciation and amortization, or Ebitda. This is useful when considering Japan, Heck said, "because leverage makes P/E look pretty good." The Nikkei 225 trades at 13.2 times trailing Ebitda, while this valuation for the S&P 500 is 16.8. The reason to use Ebitda for this valuation comparison, Heck said, is that half of the Japanese companies are earning interest on their cash.What might be even more important for Japan's stock market from here is that Japanese companies "have more latency - more slack - than Western companies," Heck said. With more cash and less-efficient business structures than Western companies, there is a lot of potential for efficiency improvement, he noted.The Tokyo Stock Exchange has been pushing listed companies to improve their capital allocation and efficiency. The exchange has even recommended that companies trading below book value, or with returns on equity below 8%, submit action plans to improve financial performance. Heck believes this development is "huge," because "a Japanese company doesn't want to be publicly shamed into explaining how they will become more capital efficient." He added that companies in Japan "tend to have divisions that should not be part of the business."

Three stock picks

The ticker for the First Eagle Overseas Fund's Class A shares is "SGOVX," while the ticker for the fund's Class I shares is "SGOIX." Both share classes are rated four stars (out of five) within Morningstar's "foreign large-blend" category.

The Class A shares have a maximum sales charge of 5% and annual expenses of 1.15% of assets under management. The Class I shares have no sales charge and an expense ratio of 0.88%. They are available through financial advisers.

The First Eagle Overseas Fund is conservatively invested, with capital preservation as one of its goals. The fund was 10% invested in gold bullion at the end of 2023, with another 5% in gold-related stocks. This helps explain why the fund has underperformed its benchmark, the MSCI EAFE Index, over the past 10 years. The average annual return for the index during this period has been 8.1%, compared with 3.9% for the fund's Class A shares and 4.2% for its Class I shares. (All fund returns are after expenses.)

"We are concerned with protecting our clients' assets. We look to avoid 40% to 50% drawdowns, and we have managed to do that," Heck said. Over the last 20 years through March 12, net of expenses, the First Eagle Overseas Fund's Class I shares have returned 296%, ahead of the 287% returned by the MSCI EAFE Index in that period.

Turning back to Japan, First Eagle's data indicates that the Oversees Fund's investments in that country together had an average annual return of 9% over the 15 years through Dec. 31, compared with a 5.9% average annual return for the Japan component of the MSCI EAFE Index.

Here are three individual stocks in Japan that Heck discussed. For each, the ticker on the Tokyo Stock Exchange is listed first, followed by the ticker for the American depositary receipt listed over the counter.

Fanuc

Fanuc Corp. (JP:6954) (FANUY) has the leading global market share for industrial robots, according to Heck. These include robots used on Tesla Inc. (TSLA) assembly lines.

In Japan, "demographics have been poor for a long time, and it is an industrial country. It has been automating factories for 40 years," Heck said.

The long-term case for Fanuc, he added, includes the reindustrialization of Western countries following supply-chain disruptions during the COVID-19 pandemic.

Fanuc's shares are down 7% from a year ago, while the Nikkei 225 has returned 42%. The stock has been under pressure because of its exposure to China. Heck estimated that Fanuc's stock was trading for 10 times the company's "sustainable Ebitda," which he said was "not particularly expensive for a best-in-class business."

Hoshizaki

Hoshizaki Corp. (JP:6465) (HSHZY) has a dominant market share for various types of commercial kitchen equipment in Japan, especially those "on the cold side of the kitchen" such an ice makers, beer dispensers and dishwashers, according to Heck.

The company has also become the global market leader for ice machines over the past 20 years, he said, while having a dominant service-technician network in its own country.

This is another company with net cash on its balance sheet, trading for about 11 times Ebitda, according to First Eagle's adjusted numbers.

Heck said the valuation was especially attractive when compared with the valuation of "16 or 17 times Ebitda" paid by Ali Group in July 2022 to acquire Welbilt, a Florida-based competitor of Hoshizaki.

Mitsubishi Electric

Mitsubishi Electric Corp. (JP:6503) (MIELY) is an industrial conglomerate with expertise in various aspects of power generation and control, similar to Siemens AG (XE:SIE) of Germany and ABB Ltd. (CH:ABBN) of Switzerland, according to Heck.

The company has a variety of businesses, some of which are "very valuable," Heck said, including programmable-logic controllers used in factories and a dominant elevator business in Japan.

Mitsubishi has also been pruning its portfolio of businesses at an accelerating pace to improve efficiency and profitability, he added.

"The mandate from the Tokyo Stock Exchange helps," Heck said, "as it nudges them in the right direction."

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