Fri, 09/05/2008 - 07:00
John-Paul Temperley, co-manager of the Martin Currie Absolute Return Japan Fund, says the Japanese stock market is currently in the middle of a tricky results season, as companies face rising raw material costs, adverse exchange rate movements and new accounting rules on depreciation, but for some the difficulties will ease as the year goes on.
HW: What is the background to your fund?
JPT: The Absolute Return Japan Fund was the first hedge fund we launched at Martin Currie. It is an equity long/short fund investing across the market capitalisation spectrum in Japan. It currently has assets of USD248m under management, is domiciled in Bermuda and is listed on the Irish Stock Exchange.
Our aim is simple - to produce consistent returns along with a low degree of correlation to the Topix. We have a stock-picking approach and seek to generate alpha on both long and short positions in the Japanese market. We limit drawdowns and - where necessary - contain volatility through active balance sheet management and disciplined risk management.
I co-manage the fund with Keith Donaldson, the head of our seven-strong Japan team. Both Keith and I have been closely involved with the fund since its launch and together we apply 38 years' combined investment experience to its management.
HW: Who are your service providers?
JPT: All our hedge funds at Martin Currie have independent service providers. Our fund administrator is BNY Fund Services (Ireland) and the prime broker is Morgan Stanley International. Ernst & Young is the fund's auditors, and its law firms are Lovells in the UK, Ropes & Gray in the US and Mello Jones & Martin in Bermuda.
HW: What is the profile of your client base?
JPT: We have a global client base. Our hedge funds are available to both US and non-US investors, and clients include institutions, family offices, high net worth individuals, private banks and funds of funds. We run a pooled account for the fund along with three segregated accounts that mirror the pooled fund.
HW: What is your investment process?
JPT: Due to its many inefficiencies, the Japanese market offers superior opportunities for alpha generation. These inefficiencies include the highly thematic behaviour of domestic buyers and the 'herding' of analysts, who overvalue the consensus and underestimate the extent by which things can change. Private equity is beginning to exploit these inefficiencies and we believe active managers can, too.
Our style is based on a top-down/bottom-up approach that highlights top-line growth opportunities, the quality of company management and relative valuations. In essence, our long book is made up of holdings in quality companies that are involved in sectors that offer good top-line growth, while the short book is made up of companies that are in negative growth areas where the quality of management is under question.
A technical overlay enables us to capture optimum price points. Structural positions make up the bulk of the positions within the portfolio. But we also pursue opportunistic trading-oriented strategies that are aimed at providing short-term returns and may be based on technical analysis, such as identifying overbought or oversold shares.
HW: How do you generate ideas for the fund?
JPT: Using our proprietary margin analysis and sector screening tool, we screen the Japanese market for companies likely to enjoy top-line growth, which have a competitive edge in their respective markets and which will be able to increase profit margins over a two-year period. We also look for companies with a demonstrable commitment to maximising shareholder returns, either through the adoption of a progressive share buyback, their dividend payout policies or by further enhancing returns on equity. For the short book we look for companies that exhibit the opposite of these characteristics.
Our research process also involves direct contact with the management of numerous Japanese companies. We have one-on-one contact with more than 1,000 companies every year. In addition, we make use of high-quality sell-side analysts to challenge the ideas we generate and to give us a thorough industry background to any decision we take.
Each member of our seven-strong team takes responsibility for a number of market sectors. In the sectors that we cover, we each perform analysis of broad industry trends and generate stock recommendations. As part of our longstanding collegiate structure, we meet regularly to discuss our recommendations. This forum, in which experienced generalist managers challenge each other through rigorous debate, drives the research agenda and gives us a structured approach to idea generation.
This process, with its emphasis on fundamentals, generates the vast majority of the fund's positions, long and short. However, we also look at technical factors such as volume surges and other indicators of when a stock is overbought or oversold to generate trading ideas.
HW: What is your approach to managing risk?
JPT: The management of risk is an integral part of our investment process. A risk analytics tool on my desktop enables me to perform real-time analysis of the portfolio's risk profile. I also receive reports from Martin Currie's dedicated portfolio risk and performance measurement teams on daily basis. Because we all work together on one floor in our Edinburgh office, we can communicate face to face.
We manage the fund with a gross exposure range of +60 per cent to +185 per cent and a net exposure range of -20 per cent to +75 per cent. Our maximum position sizes are 7 per cent on the long book and 5 per cent on the short book. In conjunction with the risk team, we manage risk budgets, analyse investment ideas, discuss portfolio positioning and review the fund's beta-adjusted exposure. We have no sector limits on the fund, however; we go where the best ideas are.
In conjunction with our risk team, we perform value at risk analysis. To give us a realistic view of potential short-term downside risk we analyse value at risk over a two-week period. We also have an industry-leading risk model that lets us customise and decompose portfolio risk in numerous ways. Multiple stress testing gives us the flexibility to analyse the potential impact of changes in macro factors and look at 'what if' scenarios for the fund over various time periods.
Working closely with our risk team has helped us both to perform well and contain the volatility of the fund through turbulent markets. For the first quarter of the year the fund was up 4.9 per cent, while the Topix was down 17.0 per cent.
HW: Has your performance been as per budget and expectations? Do you expect your performance or style to change going forward?
JPT: This July, the fund's US dollar share class will have an eight-year track record. Over those eight years, periods of good performance have significantly outnumbered the bad. Between launch and March 31 this year, the fund was up 67.0 per cent, compared with a fall of 16.7 per cent in the Topix over the same period. The fund's annualised volatility since launch is only 7.51 per cent, while its beta (versus the Topix) is just 0.2.
HW: What opportunities are you looking at right now?
JPT: Having seen a very sharp bounce in values, we remain uncertain about the future direction of the market; this looks like a bear market rally. Much depends on the outlook for the US consumer in term of the direction of earnings; the majority of Japanese companies rely on exports and overseas earnings rather than on the domestic economy. We are therefore keeping a particularly close eye on the fund's market exposure.
Despite this caution, Japan offers decent value in terms of forward price/earnings and price/book multiples. Earlier in the year we added positions in Toyota and Honda to the long book - both traded close to their respective book values. While these companies face headwinds, the value offered here was too good to be missed, both on a short- and long-term basis. In addition we have increased our long exposure to the banking sector, through the purchase of Mizuho and Resona.
HW: What events do you expect to see in your sector in the year ahead?
JPT: We are currently negotiating an interesting - if challenging - results season. Once that's behind us, we will have a much better idea about the market's future direction.
Sharp rises in raw material costs and the appreciation of the yen mean there is a real risk that manufacturing companies will make negative growth forecasts. And, as a result of changes in accounting rules and recent investment, rising depreciation is a real issue for many Japanese companies.
The negative year-on-year effect of these issues is likely to be felt most acutely in the first quarter of the new fiscal year, which runs from April to June. If companies base their forecasts on an exchange rate of JPY100 to the dollar, they will face negative impact of JPY20 per dollar compared with the same quarter of 2007. Similarly, it is likely that they will have already agreed to new, higher raw material prices, but will not yet have passed these costs on to their customers - there's generally a full quarter's lag before selling-price hikes take effect.
As such, there is a real danger that the first quarter will be a very difficult one for many companies. For some these difficulties should ease as the year continues. Year-on-year comparisons for the exchange rate get easier, and companies will pass on higher input costs to their customers, some more successfully than others.
In stock market terms, we believe that this will imply a high degree of volatility. Although many share prices have already fallen a long way, reflecting deteriorating earnings expectations, we believe the market will roundly punish any company whose earnings forecast is deemed to be disappointing; this was certainly the case in the last results season.
HW: How will these developments impact your own portfolio?
JPT: In the short term, the results season will present opportunities. As always, we will be looking to exploit the difference between consensus estimates and the estimates generated by our internal research process.
Weaker demand from the US consumer is subduing the outlook for top-line growth in Japan's overseas markets. In addition, the domestic economy is sluggish, with little expectation of any imminent acceleration of growth. With this backdrop in mind we have been uncovering a number of restructuring plays such in the retail, consumer electronics and industrial electronics sectors.
For example, we recently added to the long book NEC, a stock that is extremely poorly covered by sell-side analysts. It is currently undergoing a transformation in terms of its cost base, but because of poor analyst coverage this is currently overlooked by the market.
We also have positions in JVC and Funai in the consumer electronics area. Both companies appear to be becoming much closer and may form a new business venture in the near term that would entail a combination of low cost production (Funai) with product development and branding (JVC). In the retail sector various mergers are currently unfolding, which gives the fund lots of potential to exploit value. For example, we currently have a long position in J-Front.
HW: What differentiates you from other managers in your sector?
JPT: Firstly, at Martin Currie we identify change as the central dynamic behind share price movements. Our distinctive investment approach is designed to allow us to identify, evaluate and exploit change at an early stage.
Secondly, we have been running Japan long/short equity funds for almost eight years, through almost every type of market environment. It has been a learning process for us and has helped us keep the fund competitive where many others have failed.
Finally, we find that our institutional mindset and our robust operational platform are as important to our clients as our investment process and our long-term record. All of Martin Currie's hedge funds are supported by deeply-resourced and experienced dealing, legal, compliance and investment risk management teams, which promote transparency and risk-awareness across the whole process. Allied to this, all our hedge funds have independent service providers, which provides our institutional clients with a high degree of reassurance.
HW: Do you have any plans for further product launches in the near future?
JPT: We currently manage eight equity long/short funds, including regional equity funds investing in Japan, Asia, China and Europe, along with sector specialist funds investing globally in the resources, energy and financial sectors. We also manage a market-neutral UK equity fund.
Our most recent launch was the Martin Currie Omnium Fund, a fund of hedge funds that gives investors blended access to the entire range of Martin Currie hedge funds with no additional layer of fees.
We manage the growth of our hedge fund range in a controlled way, launching new funds only where our internal skills intersect with proven client demand. We always run model funds internally before taking them to market - our investment team is currently running five model funds.
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