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Japan’s big secret

15 Jul 2019

Show jumper Hiroshi Hoketsu is hoping to break new ground next year. If he is chosen to compete at the Olympics in Tokyo, he will be the games’ oldest ever competitor at 79 years old. Unsurprisingly, this would not be his first appearance at the world’s largest sporting event. That came in 1964 when the games were last held in his native Japan.

But it will be a very different Japan in 2020 to the one where he first climbed onto a horse set off in search of Olympic glory 56 years ago. Back then the economy grew by 11.2% while inflation averaged 3.8%. It is a different story today.

The economy is still struggling to recover from 1992’s asset value collapse and the 10 years of stagnation that followed. In 2018, GDP expanded by 0.8% while inflation also failed to reach 1%. Government debt was more than 200% greater than GDP, a result of almost 30 years of failing to boost the economy.

Yet Japan is the world’s third largest economy and home to some of the world’s most visible brands. Shares in Hitachi, Mitsubishi, Sony, Panasonic, Nissan, Toyota, Honda and Olympus can be traded on the Tokyo Stock Exchange. And for long-term investors looking to gain exposure to stocks in the land of the rising sun, there could be a few bargains to be found.

“What we like about Japan are the valuations. They are the cheapest among developed markets equities,” says Lars Kreckel, global equity strategist, asset allocation, at Legal & General Investment Management (LGIM).

He adds that more than half of Japanese companies’ trade below book value and the majority are net cash. “This is not something that you see in other countries.” The Japanese equity market has de-rated significantly since the valuation highs of the late 1980s and currently trades at a discount to the MSCI World index. But this is not the only reason why valuations are considered attractive compared to their developed world peers.

Investors may be concerned that in Japan those over 65 years of age make up a quarter of its citizens. Tight corporate profit margins and the country being usurped as the second biggest economy in the world by China also do not help inspire confidence. “All of those things together have led Japan to be a structurally under-owned market, but a market that tends to get bid up aggressively on a cyclical basis,” says Paul Markham, a global equities manager at Newton Investment Management.

Kreckel likes Japanese equities from a medium-term perspective believing that they have a lot of potential. “The issue is a lack of catalysts,” he adds. “I struggle to paint a particularly bullish picture in the very short term.”

There is no getting around that if you are long on Japanese equities they are sensitive to China-US trade war news-flow.

Lars Kreckel, Legal & General Investment Management

The asset manager is monitoring Japan’s equity market closely. “We need a catalyst and we do not have a high conviction that we are heading for one,” Kreckel says. “We are looking for the right moment to add to positions.”

Arthur Kwong, BNP Paribas Asset Management’s head of APAC equities, agrees that there is “no obvious catalyst” to buy listed Japanese companies.

Kwong adds that Japanese equities have been on an upward trend since 2012. The problem is that earnings consensus appears to be a little too bullish with almost 60% of companies reporting growth forecasts that are below consensus. “The overall picture of guidance is disappointing, but that could leave room for a positive surprise,” he adds.

Next year’s Olympics in Tokyo might provide the lift that some sectors need, such as higher demand for hotels and retail, but it appears that any buy signal is likely to be economic. “Social harmony in Japan is at the heart of its corporate dynamic,” Markham says. “There is too much cohesion and not enough desire to disrupt. For equity investors that is a negative.”

REFORM, REFORM, REFORM

However, there is one area that should grab the attention of long-term investors. Part of the economic recovery plan that Prime Minister Shinzō Abe is following is corporate governance reform. This includes making companies more shareholder friendly in a bid to attract more international investment.

“There is a positive corporate governance story in Japan,” Kreckel says, but it may have gone largely un-noticed by investors. Indeed, Markham adds that the “bits that the market is ignoring the most” are the improvements in corporate governance.

“Historically, you could say with some justification that a lot of Japanese companies should not have been listed,” he says, explaining that many preferred to operate like private companies and found shareholders an irritation.

This means that dividends and the number of non-executive directors were low relative to other developed markets. Yet in the past few years the government, the Bank of Japan and the regulator have been encouraging companies to become more shareholder friendly by raising their governance standards. “What we have seen is companies gradually starting to be more transparent around profit forecasts, return on equity targets, higher payout ratios, and so on,” Markham says.

Indeed, Japan’s state employee pension fund has been encouraged to take large stakes in the equity markets in recent years on the understanding that companies would improve their cash returns and appoint independent directors.

So there has been a realisation that shareholders should be valued, but it appears that change is moving slowing as, according to Markham, in Japan change does not happen overnight. “It is a conservative country with a small ‘c’.

“Having said that, some of the best-known companies in the market have been upping their dividends,” Markham says. “That is the part of the story that we think is under appreciated by markets.”

RETURN TO OWNER

Dividend growth in the world’s third largest economy has outperformed the global average in the past five years, although it is coming from a low base. Cash returned to shareholders was 70% higher than it was in 2014, compared to a 25% improvement for the rest of the world, asset manager Janus Henderson says.

This strong performance continued into the first three months of this year, with shareholders receiving 8.7% more from the cash piles held by companies listed in Japan sharing $5.5bn, on an underlying basis. Every Japanese company held or raised their cash returns in what proved to be a record quarter for the country.

Dividends have gone higher than share prices. They are still not on par with those in Europe or the UK, but it is another one of those topics where Japan used to be an outlier. “You would expect that trend towards increased dividend payments to continue,” Kreckel says.

“Dividends have been rising steadily over the past few years and there is no reason to expect that to change,” he adds.

“The economy is moving in the right direction, perhaps not as quickly as a lot of people would like, but the direction of travel under Abenomics has been positive from an international investor’s perspective,” Kreckel says. “Corporate governance is the star of the show.

“The new Stewardship Code seems to have born some fruits,” he adds. These fruits appear to be share buybacks, which he says in the year to date are at twice the rate they were 12 months ago. “Every month so far has been above the comparison for 2018.” There has been a cultural tendency in Japan for directors to be conservative with their balance sheets, which is why it is not unusual to see a company with 20% to 30% of its market cap in cash. This is now changing as directors are being urged to do something with their cash to reverse the drag on return on investment and margins as well as investment in its competitive position rather than just leave it sitting in the bank earning next to nothing as interest rates are -0.1%.

Markham says that it is frustrating that the full long-term implications of these improvements have not been priced in. “That is something that we would expect to see as investors realise that it will continue to be a trend, which we believe that it will be.

“That is something that is gradually being address by corporates but will never be reversed completely,” he adds. “One should not expect that to happen.”

The next change that investors would welcome is more of a relationship between management and share prices. Those leading Japanese corporates are light on stock options and do not own a great deal of e quity, so the company share price does not hit them in the pocket if it is trading at a discount.

COLD WAR

If it’s the economy that will make investors take notice of Japanese companies, then the ongoing trade war between the US and China is not helping to inspire confidence.

“The Japanese stock market is cyclical in its nature and more cyclically exposed to China than others,” Kreckel says. “So whenever doubts appear around China’s growth rate the Topix Index is sensitive to that. We have seen that in the past few weeks. So that is something that is difficult to get around and is one of several reasons why Japanese equities have been lagging over the past few months. “There is no getting around that if you are long on Japanese equities they are sensitive to ChinaUS trade war news-flow,” he adds.

It is not just about trade, but also the growing number of Chinese tourists that visit Japan each year is vulnerable, too. “There is a perception, a not incorrect perception, that the Chinese see Japanese manufactured goods as being of high quality and aspirational in nature,” Markham says. “So you often see large groups of Chinese tourists visiting Japan and doing lots of shopping.”

But this may not be an issue for Japanese companies as they have a footprint that stretches across Asia, particularly in Thailand, and the US.

“In terms of manufacturing they are not relying on only one country, that is why the tariff should not affect them too much,” Kwong says. “You could argue that they should benefit from the diversification.

“Japan has already diversified its footprint so it is not going to be hurt by the tariffs,” he adds. “Some companies will benefit, but the risk will not hit Japan directly.”

Other events coming up include the government planning to hike VAT in October, but Kwong is not too concerned. “The impact should be moderate. We are not too worried about it. The market has already factored it in.”

Despite the lack of investment catalysts, the outlook for long-term investment looks promising. “For now, Japanese companies are not subject to a lot of risk from the trade war, they are doing buybacks and selective sectors have good earnings outlook,” Kwong says. #

Like Japan, Hoketsu will be hoping for an improvement in 2020. In the 1964 Olympics he finished in fortieth place.

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