Land of the rising market
Readers will be aware that Japan is one of our favoured markets. The market performed well last year but scepticism remains as to whether this is yet another false dawn – there having been several in recent decades. The market has long offered ‘value’ – in part reflected by price-to-book ratios comparing well with other markets – but share prices have generally failed to respond. That started to change last year. Many challenges remain but omens for a sustained if gradual rally look more promising than they have for a while.
Challenges and opportunities
A long period of economic stagflation, an ageing population, a region amid geo-political tensions including a resurgent China, pedestrian global growth being a headwind for export-focused economies in general, combined with a traditional view that corporate management not shareholder friendly, have contributed to international investors shying away. There seemed too many obstacles for investors to climb. And the scepticism was getting no better. In the final two and a half years of the last decade, global investors had sold an unprecedented c.$130bn of local equities. The trade seemed a one-way ticket.
Yet different tailwinds of varying strength look to be slowly shifting the dial regarding sentiment. A key element of this has been the slow-burning corporate reforms introduced by Shinzo Abe – and followed through by successors. Japanese companies are long known for their strong balance sheets and high cash balances. But these reforms lay the groundwork for a period of sustained improvement in profitability. Indeed, the reasons for an increased exposure to the market are not because of economic growth, but rather the outlook for company profit and dividend growth courtesy of greater capital efficiency, margin improvement and a better focus on shareholder returns.
There is little doubt corporate governance has improved. There has been a big decrease in cross-shareholdings, a practice where publicly traded companies owned shares in each other, which tended to protect management from accountability and ensure a compliant shareholder base. Recent figures suggest the extent of cross-shareholdings has fallen from c.70% of companies in the 1980s to c.10% today. There is now greater corporate transparency and accountability. This favours shareholders, particularly when agitating for change, and assists in the implementation and efficacy of other government reforms.
For example, the number of independent board directors has increased significantly. Companies have also become much better at rewarding shareholders with higher dividends, which have in large part been paid from their high cash piles. Over the last decade, Japanese companies having been raising their payouts at an increasing rate – to the extent that estimates suggest the ratio of dividend payments to net profits has now caught up with US companies.
Yet there remains huge potential for Japanese companies to go further by way of distributions. The cash balances of non-financial companies are still nearly 60% of GDP – this is more than double the eurozone and five times the US figure. In particular, the growing presence of domestic and activist investors should maintain managements’ focus on the importance of dividends, and global investors will also be heartened given the prospect of a stronger Yen.
Further corporate reforms offer hope. For example, last year the Tokyo Stock Exchange (TSE) threatened to delist by 2026 those companies which continue to trade on a price-to-book value of less than one. Such a ratio suggests a company’s market value is less than its assets are worth, and that therefore its capital is not being used efficiently. Around half of all companies in Japan trade at such a discounted level – much higher than in other markets. Managements with such low valuations are required to present remedies. We shall see to what extent the TSE has bite, but the pressure is on for corporate Japan to raise its game.
And once again, the potential is huge. Balance sheets and bank deposits have remained overly robust in part because managements have sidelined the importance of the cost of capital when managing resources, while tending to ignore the fact that ultimately such funds belong to their shareholders. With corporate reforms gradually taking effect, better capital efficiency should lead to enhanced corporate value. The omens are good. Similar corporate changes assisted strong returns in the US during the 1990s, and in Europe the following decade.
The journey looks to be underway. Capital investment has already helped what appears to be a long-awaited structural improvement in corporate profitability. Return on capital is elevated, running at twice its historic average. Earnings growth in recent quarters is suggesting profit increases in the early-teens, and this is helping to feed through to increased exports. These are all straws in the wind, but important ones. Japanese companies have long offered sound finances and competitive products, but until now the missing piece of the jigsaw has been better profitability.
Meanwhile, the Japanese market continues to look inexpensive relative to the improved outlook, in spite of its run last year. A price/earnings ratio of less than 15 compares well with the US market, which is in the high teens. The EBITDA (enterprise value/earnings before interest, tax, depreciation and amortisation) figures, a good measure of potential, are perhaps even more encouraging. Japanese shares trade on less than six times compared to around 14 times for US shares. Such valuations suggest optimism.
And global investors are noticing. They have tended to be net sellers. Recent figures suggest the tide is now turning. Last year, on a net basis, over $43bn was invested in Japanese equities by overseas investors – the highest figure for a decade. The seeds of this sea-change can perhaps be traced back to 2020 when Warren Buffet announced that Berkshire Hathaway had acquired significant stakes in five investments that offered broad exposure to the Japanese market and economy. Together with his visit, this was understandably interpreted as a big vote of confidence, and the market responded accordingly. And the momentum remains. It is usually better to swim with the tide than against.
Perhaps another factor is worthy of mention. Its value cannot be measured but it is a tailwind, nonetheless. Japan enjoys a degree of political stability which compares well with other countries. There is certainty regarding policies. Furthermore, and importantly, at a time state economic interventionism is increasing in many countries, which invariably is less conducive to growth, Japan is moving the other way – corporate reforms are pushing managements to focus on greater capital efficiency and shareholder returns. This ultimately will assist in delivering better profitability and growth.
For the moment, the Government’s dovish approach to inflation is helping the economy and markets – this is not occurring elsewhere. It is allowing a modicum of inflation to take hold and companies are increasing wages and raising prices. This will be supportive of consumption and, given the low interest environment, could see money flowing into the various Government savings accounts which encourage investment in the domestic equity market.
One is not suggesting a return to the surging markets of the 1980s. Scepticism still runs high given the many false dawns and stagflation. There will be stones in the road. But the varying tailwinds mentioned above are of sufficient number and strength to suggest the Japanese market is finally turning a corner. Patient investors will be rewarded over time.
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