Japanese equities – a market of misunderstood problems and opportunities
By Robert Swift
We have argued for a while that Japan has not ‘suffered from’ deflation but has benefitted from deflation in goods and services prices which has made the economy much more competitive. We have also argued that this widespread mistaken idea of ‘problematic’ Japanese deflation needs to be avoided elsewhere, has caused terrible policy errors by central banks, which in response to what they falsely believe is the root cause of Japan’ low nominal GDP now target positive inflation.
It is hubris that they could precisely settle on the right number and the right kind of inflation. They can’t and never could. We now have the nasty problem of deliberately inflated asset values with which to contend because of this terrible and prolonged policy mistake. In a mistaken belief in the need to get goods and services inflation, we have been delivered an asset bubble.
Deflation, which makes export prices more competitive, is no different from currency depreciation, which likewise makes export prices more competitive. No one thinks competitive depreciation is to be avoided at all costs?! Sometimes it can be useful. Just so with price deflation as long as it is not manifested in the collapse of asset bubbles but confined to goods and services. Deflation in goods prices makes companies invest to keep production costs down and create new products. It is this private investment that creates wealth and real jobs, not government spending.
The primary reason for low Japanese nominal GDP growth is the demographic aging of the working population. It really has nothing to do with deflation. Adjust for this demography and you have a very productive workforce and an increasingly wealthy economy. Japan has outperformed almost everywhere else on a per capita inflation adjusted basis.
So why has the stock market languished, until recently at least? We think the market is very attractive as investors who focus upon stock specific risk. The spread of opportunity in Japan is very wide and will reward good stock selection. We think that some Japanese companies are beginning to treat shareholders with more respect and increasing dividends and reducing wasteful expenditure on unnecessary plant and equipment. Not all Japanese companies will reward shareholders with change, but those that do will far outperform those that don’t.
We also agree that there has been a combination of past and current poor policies adopted both by the government (which don’t look like changing practice soon) and by companies (some of which have made positive change). It is the growing evidence of corporate change that we think will drive the market higher. We think the stock market is in the process of being rerated and that we are on a multi-year period of Japanese outperformance.
Stay long or overweight.
Here are the reasons why; the evidence that corporate Japan finally ‘gets it’ and some stocks to ponder.
1. Japanese companies have been incentivised to overinvest and to skimp on dividends. This is changing. Higher dividends will improve corporate capital allocation, raise return on equity and make Japanese equities more attractive.
Generous depreciation allowances encourage Japanese companies to invest too heavily. Appropriate for a time when Japan had a need to refurbish and prepare for an export drive, these depreciation allowances are no longer needed. Given their shareholders’ aging demography, Japanese companies should be investing less and distributing more cashflow as dividends. They are – or some are.
In aggregate it takes about twice as much capital investment in Japan to generate a unit of growth as it does in the USA. One probably underinvests and the other overinvests, but Japan is a conspicuous outlier compared to all the other countries too. This relationship is known as the Incremental Capital Output Ration or ICOR. At the company level it means that there is a lot of ‘crapex’ or wasteful expenditure, driven by the desire to reduce the visibility of corporate profits and thus reduce taxes. It means you can probably eat off the factory floor when you visit the company as an analyst, since it is so frequently refurbished to an incredible standard, but the flip side is that Japanese shareholding retirees are starved of dividends which they could use to spend and pay their (healthcare) bills.
Check out this chart for different ICOR for the G5 from Andrew Smithers. He is the first to have shown the misplaced obsession with nominal GDP and the root cause as deflation.
Japanese companies should be distributing more cash as dividends and reinvesting less. There are signs they are – finally.
They have a long way to go. Check out these two charts from Credit Lyonnais.
2. Japanese companies are asset and cash rich. Japanese overall debt is high but owned by the Japanese themselves.
Japan is still a Net Creditor nation and generating current account surpluses. It will matter more what the Japanese think of your bond market before it matters what you think of theirs! Do not be too alarmed by comments about Japanese gross debt figures. It is the net debt figure that matters. In this regard Japan is ok. To be sure, there are some poor and wasteful policies, but fundamentally much of the corporate sector is possessed of good products, globally competitive, with a productive workforce.
The sum of corporate Japan’s profits is equal to the government’s budget deficit. Put another way, the government is mistakenly spending money to boost the economy and run up budget deficits, when all they must do is remove the depreciation incentives for the private sector to over invest and consequently collect some more corporate tax, as the true profits are revealed. In other words, the Japanese government budget deficits are huge but needless and more than matched by the corporate surplus.
Under PM Abe Japanese corporate margins are up by 50% from previous levels. The pendulum has swung too far toward corporate profit RETENTION and too far away from dividends and wages. Rising dividends often mean higher share prices. More than 50% companies are net cash in Japan vs 19% in USA and cash to market cap is 23% versus 9% for USA.
3. Governance and Board reform is underway and will improve dividends and shareholder treatment.
Japan has had its fair share of accounting scandals (e.g. Olympus Optical) in recent years and its boardroom policies and board member selection positively antediluvian. This is however changing. The Nikkei company and the Tokyo Stock Exchange launched an index about 4 years ago, the Nikkei 400, to specifically include and weight companies based upon governance metrics, return on capital and profitability. Many Japanese listed companies are clamouring to be included in this new index, because some of the largest investment pools, such as the Government Pension Investment Fund, explicitly use this as a benchmark in preference to the other indices such as the Topix or Nikkei 225 which are not weighted toward ‘good governance’.
The construction rules are:
- 3-year average ROE: 40%
- 3-year cumulative operating profit: 40%
- Market capitalization on the base date for selection: 20%
- Appointment of Independent Outside Directors: at least one-third or a minimum of three. If one-third of the total number of directors is less than two, at least two.
- Adoption or Scheduled Adoption of IFRS
- Disclosure of English Earnings Information via TDnet (Company Announcements Distribution Service in English)
Better governance is strongly associated with better share price performance and dividends and fewer accounting shocks. We saw this trend in Europe and now expect this to occur in Japan. See that charts below comparing the payout ratio and board composition for Japan and Europe. It is quite possible that Japan follows Europe to the benefit of shareholders.
So what to buy?
Stocks we like come from the globally competitive and often overlooked hardware technology sector where Japanese companies such as Disco, Hoya, Nidec and Tokyo Electron are the equal of USA and Taiwanese companies. Not all technology emanates from the USA and to solely focus on the USA stocks is a mistake.
We also like Autos where exposure to emerging markets (Suzuki) and increasing respect for shareholders (Honda which has just declared it has a dividend policy with a resulting share price pop) will likely result in increasing revenue and dividends.
Even the financial sector is attractive where Orix, a capital equipment leasing company (with a global fund management business in there as well) is likely to benefit from increased global investment in preparation for the One Belt One Road (OBOR) in China and what we hope will be a “refreshment” of dilapidated USA infrastructure.
As we write this, the Japanese market has risen to 25-year highs. There may be an event known as ‘reculer pour mieux sauter” however use this as a chance to invest further. We will be.