Emerging Britain – Learning Japanese lessons

The domestic UK economy seems to weaken on a weekly basis. A broken banking system and the woes of the Eurozone close at hand suggest to us that the path of economic growth will remain lacklustre. Thus, for growth opportunities we suggest that investors must look towards technology and companies with high intellectual capital that provide high barriers against competitive pressures or take advantage of overseas economies to drive revenue and profits growth.

Adam Posen, an external member of the Bank of England’s Monetary Policy Committee, gave an interesting lecture at the London School of Economics in May 2010, comparing the Japanese experience over the past 20 years and the potential outlook for the UK economy in the immediate period ahead. We think that Mr Posen is quite correct to draw attention to the fact that the Japanese economy outperformed other developed nations over the period 2002-08, when taking account of the level of output per worker. He suggests that this was a reflection of the technological innovation that is present in Japan.

We would suggest that the austerity programmes of the UK government and the lack of lending growth by banks may mean that underlying growth in the UK may have to become more reliant on innovation like the Japan of the past ten years. This would be a good thing, in our view, and becoming ‘more Japanese’ may be a blessing in disguise.

We believe that the Japanese experience is of interest not merely for two-handed economists but also for stock selection. Economic growth in Japan has been outstripped by export growth in the past 20 years. Between 2001 and 2008, exports grew 88 per cent while the overall economy grew by 7 per cent. Certainly, this is reflected in the relative performance of those stocks with a large percentage of their sales coming from non-Japanese sources, as shown in Chart 1, which shows that the overseas earners consistently outperformed.

Positive Chinese outlook
We note the burgeoning of the Chinese economy along the pathway of previous Oriental industrialisations. Chart 2 illustrates the GDP per capita for Japan since 1950, South Korea since 1969, China since 1991 and India since 2001. We would suggest that the path for economic development remains on track for China. Similar to Japanese and South Korean economies in being self-financed and running trade surpluses, we would suggest that the outlook remains positive for Chinese exposed companies for the next decade.

Long-term investors may wish to be reminded that the Chinese growth agenda was set out by the Chinese government back in 1987, in the Three-Step Development Strategy:
• Step One: to double the 1980 GNP and ensure that the people have enough food and clothing – attained by the end of the 1980s
• Step Two: to quadruple the 1980 GNP by the end of the 20th Century – achieved in 1995, ahead of schedule
• Step Three: to increase per-capita GNP to the level of medium-developed countries by the mid-21st Century, at which point the Chinese people will be fairly well-off and modernisation will be basically realised.

We would be of the view that the Chinese government will continue to encourage the economy to grow in order to attain the third step. While other emerging market governments may not be so explicit in their growth aspirations, we would suggest that emerging markets on the whole are likely to remain the source of economic growth. The IMF forecasts that emerging markets (including China) are expected to grow their share from 39 per cent to 49 per cent between 2009 and 2014. At the same time, the Eurozone’s share will fall from 21 per cent to 18 per cent.

Given the shared desire for debt-burdened governments of Europe to implement fiscal austerity, we would suggest that economic growth will be driven by emerging market and Asian economies. As such, we have constructed a basket of stocks with over 40 per cent of their sales to non-developed markets. We have restricted the number of resource-related stocks in this basket so as to not be too commodity dominated in terms of performance. We illustrate the past decade of performance of those stocks in Table 3.

Despite the outperformance, we continue to advocate adding to holdings of those stocks with high exposure to the faster-growing regions of the world. To our minds, the expected sales growth of these stocks may become more appealing if headwinds in the developed markets increase, as austerity programmes start to bite. In many ways, referring back to Japan and the dominance of exporters in their equity market may be a template on which to rely as a guide for UK stockpickers.

Multi-sector opportunities
Other stocks include the likes of Diageo, Savills, British American Tobacco and Millennium & Copthorne Hotels, which each garner more than 30 per cent of their revenues from emerging and Asian economies, just to illustrate that it is not purely an industrial cyclical stance, but that opportunities can be found across sectors, in our view.

We expect the secular cycle of emerging market economic growth that has pushed commodity prices higher over the past decade to continue. While the higher price of oil has caused global economic growth to moderate over the past 12 months, we would suggest that the need for energy resources will continue to favour those companies involved in energy exploitation.

Three names that we would suggest include Kalahari Minerals, Beacon Hill Resources and Aminex. They have interests in uranium, coal and oil respectively, which to our minds will continue to see continued demand from the likes of China.

There is a time for this type of equity exposure, in our view, for long-term equity investors. The trough in the Chinese Leading Indicator suggests that the Chinese economy will avoid a recession. In addition, there is growing evidence of a peak in inflationary pressure. As such, if the Chinese authorities move from raising interest rates, which has weighed on the performance of emerging market exposed equities, to cutting rates then the outlook would markedly improve for investors seeking growth-orientated opportunities with a focus on emerging market demand.

Domestic economic concerns in the UK shouldn’t put off investors from seeking opportunities in the UK equity market to gain exposure to growth stocks, in both the long and the short term.

Shore Capital is a financial services group that specialises in equity capital market activities, alternative asset management and principal finance. It has offices in Guernsey, London, Liverpool, Edinburgh and Berlin. Its equity capital markets division offers a wide range of services for companies, institutional investors and other sophisticated clients, including corporate finance, stockbroking and market-making. Its asset management division manages specialist funds, with a particular focus on real estate, growth capital and alternative asset classes. The group conducts principal finance activities using its own balance sheet.