Japan’s approach to corporate governance pays off, says Nikko AM’s John Vail
John Vail, head of global investment strategy for Nikko Asset Management, the $161 billion global asset management firm headquartered in Tokyo, says local firms are experiencing a significant rise in profitability.
Over the past decade Japan has experienced somewhat of a corporate revolution, the results of which we are starting to witness through an extraordinary rise in profitability. This growth, for the most part, is not reflected in the confidence of investors, which is particularly evident amongst some of those in Europe. Instead, they continue to focus on the macroeconomic picture, specifically the policies of the Abe administration and on the likely future actions of the Bank of Japan.
In doing so, they are missing what is increasingly a microeconomic rather than macroeconomic story in Japan. In essence, despite nearly flat nominal growth in gross domestic product (GDP) during the past ten years, profit margins in Japan have risen sharply, and in near-parabolic fashion during the last two years.
This we expect, will be of particular interest to European investors with an exposure to Asia. Although well documented, Japan has undergone major rationalization, both in terms of business restructuring and corporate governance. There used to be about a dozen major players in most industries in Japan at the turn of the century, but now three is normal. The rationalizations of these mergers took time, as Japan usually spreads the pain for workers, but the benefits were almost universally expected. Until recently, however, every time the results seemed about to come through there would be another crisis, whether the collapse of Lehman Brothers or problems with the Chinese economy or a super-strong Yen.
The past year or so has been free of those sorts of crises; indeed, we’ve seen a return to “normal” conditions. As a result, the improvements in corporate governance and rationalization, and hence in profitability, are emerging in their true colors.
Whilst a significant part of this huge profit uplift that can be attributed to Abenomics, particularly its insistence that a strong Yen must be curtailed through an aggressive monetary policy, one could argue it is also the result of the very hard work by corporations in the past ten years.
What we are seeing is similar to the process that occurred in the mid-90s, when dividends first started their structural uptrend.
Some European investors may have noticed that Japanese companies at around this time changed their philosophy from the pursuit of market share at all costs toward an emphasis on corporate profitability. This was prompted in part by attacks in the mid-2000s by “greenmailers”, as well as by mergers and acquisitions specialists, both foreign and home grown. This gave corporate Japan quite a scare, and forced a fundamental re-thinking of priorities. Profit margins moved structurally upwards, but the dividend payout ratio of the market nearly doubled to around U.S. market levels, while buybacks have also surged.
The upshot of this is that we are moving from a macro-driven market to a micro-driven market. The question remains, what exactly does that mean? Essentially, it means investors can now afford to stop worrying obsessively about the Bank of Japan’s next move and begin looking at corporate profitability and returns to shareholders, just as investors and fund managers do in other markets.
Increasingly, Japan has become a stock-picker’s market, with rather less of a policy-watcher’s market. Such bottom-up increases in the profitability of companies are becoming more important while big, top-down policy variables such as the value of the yen are becoming less important.
Encouraged both by the very low level of valuations and the erosion by inflation of fixed-interest investments, we are beginning to see an equity culture form in Japan.
As this occurs, more and more companies are being formed amid a considerable increase in enterprise. Currently, Japan is ranked sixth by the World Economic Forum in the category of innovation. Further evidence that the country is committed to improving the culture for entrepreneurs. There are now internet start-ups and entrepreneurs everywhere, with the Japanese government trying to provide them with the best business environment possible. Any previous stereotypes depicting the Japanese economy as being dominated by hidebound corporate giants was never really true, and most definitely is not today.
However, of the outlined developments do not completely dismiss macroeconomic policy as a complete irrelevance. Rather, having completely overcome the widely-held expectation of more monetary easing from the Bank of Japan in the first half of this year, we find ourselves at odds with a growing consensus against easing in the second half. It’s our view that this will take place over the summer in response to external factors, including the slowdown in the Chinese and euro-zone economies.
When considered alongside the powerful story on profitability, this means Japan is likely to enjoy a double boost. Once again however, this is being missed by many investors who, having called monetary policy wrongly earlier in the year, seem intent on doing it all over again in the second half of 2014.
The common perception of Japan is now outdated. The country is better than most sceptics contend in terms of corporate profitability. Of course, corporate profits in Japan are not merely a feature of domestic growth but of global growth, as well. It is our firm belief that stocks can continue to rise even if the yen steadies. When you consider that many investors’ believe only a weaker currency can guarantee rising share prices, this would completely re-affirm the strength of Japan’s corporate resurgence.