Investment Matters

Japanese equities: then and now

In the year 607, Shotoku, Price Regent of then named Wa, signed a letter to the then Emperor of China, Yang of Sui, as “the Son of Heaven, in the land where the sun rises”.

1400 years later, the name has still stuck, China’s eastern neighbour is still referred to as the “origin of the sun” – Nippon, or Japan.

Yet, since the implosion of the Japanese economy in the late ’80s, the land of the rising sun has been the home of falling equity prices.

A decade of rapidly expanding credit, rampant speculation and excesses had left the country’s stock market in the doldrums (“the lost decade”).

However, over the last decade, we have seen a resurgence in Japan’s Nikkei which has begun to regain levels unseen since the late 80s.

We look at what has attracted us to Japanese equities and the reasons behind our recent tilt towards them.

Cheap

On several measures, Japan’s stock market is currently cheap relative to international peers.

Japanese companies are currently highly cashflow-generative relative to prices paid for them.

Furthermore, as demonstrated below, they appear cheap based on a P/E basis.

Even when normalising for the differences in sector weightings between countries (for instance, the S&P500’s heavy weighting towards technology companies in the US) we find that Japanese equities remain cheap.

Japan looks cheap, even on a sector-neutral basis

Sector Neutral PE Ratios


Source: Minack Advisors

However, as we have cautioned before, P/E ratios are more complex than they appear prima facie.

A P/E ratio should also be viewed in the context of the expected growth in earnings.

We look at the earnings growth story below.

Structural story: growing earnings and inflation benefits

As seen below, the recovery of Japanese stocks over the past decade has coincided with a significant increase in corporate profits.

This is despite only moderate levels of investment over the period.

Profits have grown with moderate levels of investment

Total listed sector profits


Source: Minack Advisors

This was also accompanied by rising profit margins, which pre-pandemic had risen significantly higher than their 10-year average.

Profit Margins in Japan expanded significantly pre-pandemic

Profit margins in Japan

Source: Minack Advisors

In sum, relative cheap valuations have been coupled with growing earnings and expanding profit margins.

We see further upside to this in an inflationary environment, where Japan’s large export-driven manufacturing base is likely to benefit. This is due to the capital-intensive nature of these companies, which results in relatively fixed costs – a boon in an environment where prices are rising.

Corporate governance reform: east meeting west

Public perception of Japanese corporate governance has been less than flattering.

Many still remember the governance ecosystem of old. This is one where there was cash hoarding, poor disclosure a lack of board independence and corporate stagnation under a keiretsu system of cross-holdings (where large corporates would own each other’s shares – leading to limited accountability to shareholders).

By all accounts, this has begun to change.

The Corporate Governance Code introduced in 2015 and promoted by the Government Pension Investment Fund (GPIF) have promoted greater accountability to shareholders.

This includes minimum requirements for shareholder returns (return on equity), improved proxy voting and greater director independence (as well as disclosure of conflicts of interest).

As a result, disclosure is improving, board independence is becoming a focus and cross-holdings between companies have largely unwound.

With this has come a strong focus on returns. Companies are now being run with a greater eye towards shareholder returns and profit.

While the most recent Asian Corporate Governance Association (ACGA) survey highlights there is still room for improvement, this is beginning to translate to better returns to shareholders.

Positioning

We implemented a modest “tilt” of clients’ exposure towards Japanese equities in late October of 2020.

Returns have been modest thus far. Post pandemic, corporate sales in Japan have been slow to recover as its economy continues to be impacted by COVID-19.

However, as highlighted above, we see that several aspects position Japanese equities well in the recovery from COVID and beyond.

As such, we may look to increase clients’ exposure further given recent strength in the Australian dollar.

Hedging