A different Japan is taking shape for investors. Following a number of micro-economic and corporate governance reforms, Japanese stocks are breaking from tradition and rising despite a flat Yen. The mix of a reviving economy, a low exchange rate, and high domestic confidence following Abe’s decisive election victory last month, is creating an openness to change.
Real reform is creating deep structural shifts in Japanese corporate culture and a more investor-friendly attitude is taking hold in boardrooms. Against this backdrop of unprecedented change, and returning investor confidence, I identify seven key reasons why investors should re-assess the investment case for Japan.
This time it (really) is different
Seasoned investors can be forgiven for being sceptical given Japan’s unfortunate track record of stopping short its own recovery. Indeed, Japan appears to have cultivated a talent for snatching economic defeat from the jaws of victory: in ’96-97 growth was cut short by a raft of consumption taxes; in ’03-04 QE was prematurely ended when signs of economic life began to flicker.
However, we are now beginning to see the fruits of sustained market-stimulating, micro-economic reform and sweeping corporate governance changes. Recent private sector data showed a seventh consecutive quarter of expansion. Now, the economic revival is poised to deliver Japan’s second-longest boom in the post-war era. Furthermore, Prime Minister Shinzo Abe’s fresh mandate will bring continuity to monetary policy and signals further political stability to markets.
Corporate governance: agent of positive change
1 June 2015, the day Japan’s new Corporate Governance Code became official policy was viewed not without a degree of scepticism by markets. However, at the time, and despite the cynicism, we believed the changes would have a real impact. Even taking the most pessimistic view, we felt the market had the potential for double-digit compound gains over the next two years. Hence, we have built a 15% exposure to Japan – double the index weighting.
Unlike most of Asia, corporate governance problems in Japan had rarely involved company promoters or management embezzling funds from their firms. But poor investment decisions and capital management were deeply endemic with the effect of depressed stock market valuations. While Japan Inc.’s stifling bureaucracy will take years to fully dissipate, we are now seeing real progress. Abe’s so-called “Third Arrow” of corporate reform has increased the proportion of independent directors and encouraged board diversity. Moreover, boards are adopting a more investor-friendly western style approach with a laser-focus on profitability and return on equity.
Japanese companies citing return-on-equity and return-on-assets targets in medium-term plans: ROE and ROA in 2014 and 2016
While we are seeing change, ultimately it is from a low base. Women and independent directors are still a rarity; truly independent directors even more so. As investors, we demand details on how companies are improving board independence and diversity when we engage with Japanese companies. This is not merely because of our ESG requirements, but because we believe it is the key to long-term earnings growth and decreased risk.
The best place for value & momentum
For us, Japan still represents the best place for both value and momentum. As equity markets globally continue to look stretched, Japan stands out as a beacon of relative value – and is starting to see strong investor support. Indeed, on number of metrics, Japan is the cheapest it has been in a decade relative to the rest of the world – as a result, we are seeing accelerating flows into the market.
Yen is decoupling from equity markets
One of the most positive developments for investors is the diminishing influence of the yen. Traditionally when the yen fell in value, exports would rise and those related exporter stocks would rise. However, if you looked in US dollar terms and took the FX out, these stocks were going nowhere. Yet this year we have seen the yen stay flat but exporter stocks rise. This is a positive sign that Japanese equities can decouple from the yen’s oscillating fortunes.
In terms of sectors, investors do not have to be too discriminating; most areas are rising and for the bottom-up investor, there is a rich seam of opportunities. Moreover, outside of exporters, domestic plays look interesting – with consumption and infrastructure stories stranding out. Ultimately, gains should be broad-based, so investors should look across the spectrum of opportunities. The one area we would caution against is high-priced defensive stocks; investors had taken refuge here, but it has now become a perilous haven.
Entrepreneurial flair is awakening
The investment case for Japan was diminished by its perceived overly bureaucratic culture. This did have a large degree of merit, but such persistent stereotyping has caused investors to overlook an entrepreneurial flair that has reawakened in Japan.
ATeam, named after the 1980s hit US TV show, is a founder-owned business trading on the Tokyo Stock Exchange. A $500m market cap company developing game applications and internet services for daily living and e-commerce, the firm epitomises this new entrepreneurial spirit, as it pushes boundaries by channelling tech innovation – if you want to book a wedding venue in Japan, chances are you’ll be using their app.
Then there are successful businesses such as Macromill, a $1.1bn market cap market research and digital marketing business. With an American CEO and a large European operation run out of Holland, they show how, little by little, Japan is changing the way it does business.
Active approach can deliver consistent alpha
There is a lot to like in Japan, including the end of deflation, the influx of foreign tourists, technological innovation and world-class infrastructure. It is a society that has created a very broad range of companies and industries in which to invest. Over the last five years, we have been rewarded by a market that is up 70% and our active approach has consistently uncovered an array of benchmark-beating idiosyncratic mid-cap stocks, from Karaoke equipment maker Daiichikosho to drugstore operator Kusuri no Aoki.
Looking out to the future return horizon, it is important to remember that over the last five years P/E ratios have changed little – standing at around 15x. Almost all gains are due to EPS growth of 60% across the market; we believe there is more investor value to be unlocked.
Scope for further returns
When we invest, we like to harness the shape of change. As well as improving ESG dynamics, Japanese balance sheets are improving. For example, Japanese companies still only pay out about 30% of their profits in dividends, even though Japanese accounting typically means reported profits are close to cash profits with little room for ‘funny business’, such as asset revaluations. As Japanese boardrooms become more shareholder-friendly, we see dividends improving.
Lifting profits-to-dividends by a still modest 50% would mean shares would offer a yield of roughly 4%. In a country where the BOJ manages the ten-year bond to around zero interest, and depositors are lucky to get zero on cash balances after fees, this is a return profile too attractive to be ignored and will offer further support for the equity market.
Chad Slater is joint chief investment officer at Morphic Asset Management.