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More art than science

Tuesday, July 24, 2018

For the best part of 30 years, Japan has been the market to avoid for most investors. For half of this period, GAM Investments’ Ernst Glanzmann has been trying to make sense of the riddle of how to invest in Japan successfully and his singular approach has yielded some undoubted benefits. As he celebrates a personal milestone of 15 years in the role, Ernst shares some insights and anecdotes from his colourful career in this ‘no holds barred’ Q&A.

Can you describe your journey into portfolio management?

I began my career as an investment professional when I became a junior equity analyst at Bank Leu directly after the bursting of the Japanese equity bubble in 1989. It was a bit like being thrown in at the deep end because shares were heading south dramatically after a roaring bull market and people looked to me to predict what was going to happen next. To this end, I spent a lot of time on ‘credit worthiness’ analysis as clients wanted to know whether the shares of a company they held could go bankrupt within due time. In those days, the concept of ‘buying the market’, which has become so popularised in the post-crisis era, was completely alien to the human psyche and I believe that it is only a matter of time before this ‘fundamental consciousness’ returns to the fore once more.

Experiencing the collapse of the banking sector right at the outset of my career afforded me a rare opportunity to see how authorities handle an unprecedented crisis. In the midst of the turmoil in 2008, officials at the Federal Reserve, the European Central Bank and the Bank of England all talked in terms of averting a Japan-type scenario. However, in the late 1980s, Japanese officials could only draw on the lessons from a smaller crisis in Asia that began in Hong Kong in the 1970s, or look right back to the 1930s. After I left Bank Leu in the autumn of 1990, I spent a further 10 years as an analyst at Bank Julius Baer before becoming a junior portfolio manager. When my boss and mentor left the firm to start his own business in 2003, I was offered the chance to run the portfolio myself.

How did you put your personal stamp on the portfolio?

Back in 2003, Japanese banks were experiencing a major transition. They had cleaned up their balance sheets completely and cleansed their books of non-performing loans. Under the stewardship of my predecessor, the portfolio had no exposure to banks at all, which was the right call at that time, but now that banks were ‘investable’ once more I felt that the portfolio required a radical makeover. This was a pivotal moment in my career and I am happy to say that the outcome was positive.

As an analyst working in a bear market environment, I always struggled with the task of recommending stocks that I felt would not go up but down less than the market (‘winning by not losing as much)’. Only solid firms with a proven business model seemed the right thing to own. This basic attitude let me to explore the writings of luminaries such as Warrant Buffett, Charles T. Munger and Benjamin Graham among others. All this culminated in the formation of an investment strategy I refer to as “Leaders” (a high-quality equity discipline investing in Japanese equities). Essentially, I take the view that top-notch companies can sustain their above average growth rate of net profits much longer than most investors believe. This quasi “mis-pricing” leads to a value gap that could be realised by holding the shares for a very long period, much longer than many people would maintain conviction. By investing in solidly growing businesses the compounding benefits start to work in a very favourable way.

What is the most important thing you have discovered over the years?

Valuation is more art than science. Fear and greed are two powerful emotions in the equity market. They are driven by powerful psychological influences, such as intuition, instinct, and herding (among others). The same earnings growth can have a high valuation at one point in time and a low valuation at another point in time. This becomes crucial when you enter a position for the long term. If you buy expensively, forthcoming returns might be hurt noticeably due to an emotional roller coaster. Over time, though, the long-term growth rate of a company’s earnings per share will be similar in many cases to the share price appreciation - fundamentals hold sway in the end and, short-term distortions will eventually be smoothed out.

What are the key attributes that characterise your investment style?

Depth and trust, discipline and patience: All easier said than done! I try to understand a business model as much as an “outsider” can do. It helps me from succumbing to panic selling. Moreover, it gives me confidence in the management of a company we are invested in - a trust which allows me to better distinguish between “market noise” and significant information. Discipline and patience are essential in order to successfully achieve the elusive concept of compounding returns. Discipline is about resisting temptations to invest in something that does not really fit the strategy. Basically, I have four main criteria which allow me to identify solid business models and I use them as checking points as I go along: 1. Minimum average return-on-equity of 10%; 2. Low leverage; 3. Minimum 5% average sales and net profit growth; 4. Low capital intensity. Discipline is also important when a position is taken. We only buy at a discount of 30% to our fair value analysis. Overall, patience is needed in order to fully benefit from compounding effects spurred by sustainable superior profit growth of selected firms over a long holding period.

Are you optimistic about the outlook for Japanese equities?

People should consider investing in Japanese equities for deeply fundamental reasons. Net profit of all Datastream Total Market Japan Index members (an equivalent to the Topix Index) grew 11% annually in the past 15 years when converted to USD, while the members of the Total Market Global Index grew only at half the speed (6%). Interestingly, the Japan Index merely rose 5.6% per annum while the Global Index gained 7.2%, more or less matching earnings growth. Consequently, Japanese equities appear much more compellingly valued today, following a decade of shrinking price earnings ratios and a subsequent stabilisation (to around 15 times - which remains cheap by global comparison) during the last five years.

I maintain my view that listed firms should be able to sustain long-term profit growth of around 8% per annum in the foreseeable future. The main reasons for this assessment are: continued steady global growth; artificial intelligence and the ‘Internet of Things’ activating continued new business opportunities; and more efficient work processes. A tight labour market and on-going work style reform are poised to both spur capital expenditure and support wages and consumption. It is remarkable to see that investment in new facilities continues to grow strongly. In addition, capital deployment policies should increasingly favour the return of cash to shareholders. A more specific corporate governance code, very prominent shareholder service agents and a growing number of activist shareholders are all keeping up the pressure on firms to return more capital to their investors.

From our perspective, I seek to invest in businesses that can repeatedly grow their earnings at a decent pace, focusing on strong companies while trying to avoid the value traps. Essentially, I am looking to take only the best out of the market rather than hug a benchmark index. My team conducts lots of interviews with successful business leaders and we can really sense the enthusiasm and eagerness to build on achievements. This vibrancy and dynamism is infectious.

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The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.
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