Embrace changes at Japan Inc.
Japan’s economy appears to be losing momentum after a rush of optimism that lifted markets in 2013. In a Q&A, Sam Perry, Senior Investment Manager at Pictet Asset Management, explains why investors should not lose sight of real changes happening;
Japan’s economic data has turned softer in recent months and Prime Minister Shinzo Abe’s approval rating has dropped below 50% for the first time. How does this affect the outlook for Japanese markets?
SP. Recent events may have affected sentiment in the short term, but the main driver of Japanese stock markets, we believe, is the change in the behaviour of Japanese companies. After the bursting of the financial bubble in 1989, Japan went into a classic debt deflationary spiral, where banks shrank balance sheets by withdrawing credit from borrowers, and over-geared companies dramatically cut their levels of debt and hoarded cash. This shift from high leverage to cash accumulation has been intensely deflationary. As a result, net cash levels of the corporate sector had jumped to 30% of gross domestic product by 2012.Now there’s evidence that companies are finally starting to use this idle cash pile. Dividends are rising – Japanese dividend yields are now almost the same as those in US, buybacks are increasing and there is a renewed focus on return on equity.
Apart from rewarding shareholders with dividends and buybacks, what else are Japanese companies doing with their cash?
SP. Japanese companies are increasingly engaging in M&A activity. Earlier this year, drinks maker Suntory bought US spirits company Beam Inc. for a total deal of $16bn, in what is the third-biggest overseas acquisition ever by a Japanese company. What is more, companies are starting to leverage up for acquisitions. Last year’s Japanese leveraged buyout of Germany’s bathroom fittings firm Grohe is a good example. In a $4bn deal, Tokyo-based buildings group Lixil acquired Grohe, whose enterprise value is half its own, by forming a joint venture with the state-backed Development Bank of Japan. This is not just an Abenomics phenomenon. In July 2012 – before Abe took office – Glory Ltd, a cash machine manufacturer, bought the UK company Talaris Ltd for £650m. With complementary technologies and sales strengths in different regions across the globe, it was an excellent strategic transaction. It was also, for a small company like Glory, a very significant one that required the firm to raise large amounts of debt for the first time since the late 1990s, prompting the president of the company to say: “We have always been known as a cash – rich company, but you can only save for so long.”Abenomics should therefore not be regarded as the main story – in many ways Abe’s economic policies simply add further momentum to the positive developments already under way in the corporate sector before he came to power in November 2012.
Can you give us some examples of how some of Abe’s policies are helping Japanese companies?
SP. We think Abe’s corporate tax reform is a dramatic change. By cutting the corporate tax rate, which is the second highest after the US among the 34-member OECD economies, Abe is trying to encourage domestic business investment and promote growth. The government has already cut the corporate tax to about 36% from 38.5% and plans to reduce it below 30% in stages, with the intention of moving down to the Asian average of around 26%. This would spur capital spending at home and also lure foreign direct investment. This coincides with another policy focus of the Abe government, namely trying to boost the return on equity (ROE) of the Japanese corporate sector. Today, ROE in Japan stands at 9%, compared with 15% for the US. A corporate tax cut of 10% is expected to boost ROE by 1.3 percentage points in our view. Moreover, corporate leverage in Japan – which is about 50% lower than that of the US – is expected to rise. This would also help narrow the ROE gap with the US.
How do asset allocation changes at Japan’s giant pension funds affect the market?
SP. Japan’s and the world’s largest pension fund, the Government Pension Investment Fund (GPIF), plans to announce the result of its asset allocation review in September. While its equity holdings have grown considerably over the last year and a half, it is widely expected to raise its equity allocation further to 20% from its current 17%. This is likely to bring fresh equity inflows of about ¥3.6trn.