In an endemically low growth world, prone to accelerating forces of disruption, (more…)

Whilst the headline indices held up in 2015, the drivers behind the US equity market have been weakening for sometime. (more…)

Those who have seen our opinions on Japan will know that our arguments on expanding equity returns in the country are predicated on the condition that Japanese corporates implement reforms, aimed at increasing shareholder value.

We like to think of long term investment as being evidential, and are therefore seekers of proof for our beliefs.

We have already seen a string of positive developments. Most recently, Fanuc, a large cap Japanese robotics manufacturing business, has announced the hiring of an investor relations team. The company was previously known for purposefully avoiding shareholder contact. This is a significant development, with a 1.2% weight in the TOPIX index, Fanuc is leading by example. Other noteworthy changes include the reduction in cross shareholdings between companies, announcement of dividend increases and share buybacks.

With the prominent launch of the JPX Nikkei 400 Index, one particular measure of shareholder value creation has been pushed into Japanese CEO’s spotlight – return on equity (‘ROE’). The index gives it a 40% weight in its selection criteria, besides operating profits (40%) and market capitalisation (20%), in arriving at its 400 constituents.

ROE can be decomposed into three measures, according to an analysis first introduced by the DuPont Corporation in the 1920s. ‘Net Profit Margin’ multiplied by a company’s ‘Asset Turnover’ and finally multiplied by the ‘Leverage’ employed equals a company’s ROE. The below table defines these ratios further.

ROE factors

We have examined the three factors for the Japanese market, using the TOPIX index as proxy to assess where Japan is lagging the competition, i.e. other developed nations. In particular, we made a comparison to the S&P500.

We found a general decreasing trend in the ‘Asset Turnover Ratio’, which measures how efficiently corporates are employing their assets. This seems to have, however stabilised for the US, but is still declining in Japan. All in all, it is quite similar for both regions.

Topix - March 2015

Source: Bloomberg

Unexpectedly, leverage has been trending downwards, but is, at the moment, above the S&P 500 as US corporates have deleveraged even more significantly since 2008. Compared to Europe, however, both figures are currently at very low levels.

These two aggregate figures, of course, have to be considered in the context of the respective sector compositions underlying these indices.

The last measure, ‘Net Profit Margin’, is considerably lower for Japan. It has been so in a consistent fashion since the early 1990s, when our datasets start. This stark difference is resulting in the drag of Japanese ROEs versus the comparator countries’ corporates’ ROEs, even accounting for different sector compositions.

We believe that the greatest boost to ROEs will come from margin improvements and also from putting assets to use in a more efficient manner.

Asset turnover can be improved by shedding assets: for example, the vast amount of excess cash on balance sheets, accumulated as a result of corporates’ attempt to de-lever and to repair their balance sheets. Cash of that extent is dead weight, contributing little to profitability. Share buybacks and the increase of pay-out ratios are one example, how this can be achieved. Both are gaining popularity as course of action in Japan.

Also, the sale of non-performing legacy business units will improve the asset mix and enhance the turnover ratio as well as operating profit margins. This comes down to companies adopting more long term strategic goals, cutting unnecessary costs and therefore improving corporate profitability and ultimately shareholder value.

Another component of net profit margin that we expect to improve, besides operating profit margin, is corporates’ tax burden. The official corporate tax in Japan was over 35% at the end of 2014, compared to the official figure of 40% in the US. However, the actual figure paid by US corporates is much lower than that, whereas Japanese corporates have been paying an even higher rate than the 35%. At the end of 2014, the Japanese government agreed on a series of corporate tax cuts aimed at reducing the ultimate actual rate paid to below 30% over the next years. This will lift the tax burden and is a positive development for Japanese net profit margins.

The Japanese workforce remains highly inflexible. However, the number of part time workers is increasing and also the demographically induced structural decline of the workforce will help to reduce inefficiencies and streamline costs.

The reduction in taxes and the decline in the workforce should more than offset potential wage rises.

The last paragraphs have demonstrated that there is much room for improvement in margins and asset efficiency of Japanese corporates. We remain highly constructive and currently hold a 21.2% equity allocation to Japan in our TM Cerno Select fund, invested via one active manager and ETFs.

Last year, the Japanese Government Pension Investment Fund (GPIF) announced its intention (more…)

After decades of subdued growth, Japanese equity markets rallied in 2013 following Abe’s election and announcement of his triumvirate of measures. The three arrows, as his policy approach is called, consist of monetary measures, fiscal measures as well as growth oriented structural measures. The first two of these have been implemented early on and were well received by investors. Japan outperformed other developed markets returning +55% in 2013 compared to +34% for the US and +21% for Europe. However, Japanese equity returns this year have been held back by scepticism over the potential success of Abe’s third arrow. The TOPIX index is flat on the year at the time of writing, compared to +8.6% and +5.5% for the US and Europe indices respectively.

Structural measures envisioned as part of the third arrow aim to improve companies’ capital efficiency to promote economic growth. The main provisions of this program are to encourage companies to allocate their cash more efficiently and to promote corporate governance. Japanese companies have been notorious for hoarding their cash over the last few decades, a habit which gained new life following the Global Financial Crisis. In the reflationary environment that the government wishes to create, cash becomes an unprofitable asset.

Within developed, capitalist countries, companies have to manage the expectations of a range of stakeholders, namely: customers, suppliers, employees, shareholders, bondholders and lending banks. In some societies, a diffuse range of societal responsibilities are at play. Japan, being essentially a consensus culture, is one such society.

The itinerant Western investor, business schooled to respect economic value creation and growth above all other things, has tended to notice Japanese attributes that are inimical to the unbridled creation of economic value. In particular, the societal responsibility to employ people is taken very seriously and lay-offs are cataclysmic events for Japanese companies.

Asset turns in Japan are comparable with Europe and the US, however the twin effects of overstaffing and cash hoarding combined with endemically lower margins has meant that corporate Japan has lagged in terms of return on equity (ROE) or return on capital employed (ROCE) measures.

Table 1: Return on Equity as of 6 October 2014 – Japan, US, Europe

 

TOPIX

Nikkei 225

S&P500

MSCI EUROPE

Return on Equity

8.2

8.0

15.0

11.1

Source: Bloomberg, Cerno Capital

With an ROE of only 8.2% for the Japanese equity market, compared to 15% and 11% for the US and the European markets respectively, returns for equity shareholders in Japan are lagging behind and have done so for the past twenty years as the graph below demonstrates.

Graph 1: Historical Returns on Equity – US, Europe, Japan

Historical Returns on Equity – US, Europe, Japan

Source: Bloomberg, Cerno Capital

ROE is a function of companies’ profit margins, leverage used as well as asset turnover. Asset turnover measures with what efficiency assets are being deployed. We can infer that Japanese companies’ focus has not been on increasing shareholder value, but rather that they haven’t been in control of their costs and capital has been allocated inefficiently; the focus has been on pleasing employees, suppliers and customers. The latter two very much so due to the significant cross shareholding between firms which is typical for the Japanese equity market. This has led to a lack of risk taking of corporates and short termism, i.e. focusing on quarterly earnings rather than having a long term strategic plan in place that will deliver sustainable shareholder returns over time. It has also made companies reluctant to engage in business restructuring and to divest unprofitable parts of their businesses. These inefficient investments along with the enormous cash holdings have depressed firms’ ROEs.

Abe’s structural reform aims to refocus corporates’ attention to the shareholder. He is looking to prompt companies to allocate capital more efficiently and target returns on equity above their cost of capital, or to return cash to investors in form of higher dividends and share buybacks.

Dividend yields have been low in Japan, even compared to the US.

Table 2: Dividend Yields as of 6 October 2014 – Japan, US, Europe

 

TOPIX

Nikkei 225

S&P500

MSCI EUROPE

Dividend Yield

1.8

1.5

1.9

3.6

Source: Bloomberg, Cerno Capital

One regulation already implemented aims to change the cross holding ownership. The below graph shows that for the first time the ownership of firms and banks is below that of the equity ownership of investment management firms, individuals and foreign investors.

Graph 2: Transition of Shareholder Composition in Japan %

Transition of Share holder Composition in Japan

Source: TSE Shareowner Survey 2013, Cerno Capital

However, not all measures can be implemented via regulations. Corporate governance and stewardship codes are only principle based guidelines, which companies can subscribe to, or not.

To encourage companies to adhere to these principles, the Japanese Exchange Group (JPX, world’s third largest bourse operating the Tokyo Exchange amongst others) and Nikkei have jointly created a new index, called the JPX Nikkei 400 Index, which launched at the beginning of this year. This new index explicitly selects companies which focus on the efficient use of capital, specifically referring to ROE, as well as those promoting good corporate governance.

The index excludes companies that have been listed for less than three years, have liabilities in excess of assets during any of the past three fiscal years, those which had an operating deficit in all of the past three fiscal years and those which are designated for delisting.

Eligible companies are scored and ranked according to the following criteria:

  1. 3 year average ROE
  2. 3 year cumulative operating profit
  3. Market capitalisation on the base date for selection

Point one and two are each given a weighting of 40% and market cap is only weighted with 20%. In contrast, the TOPIX is a market cap weighted index and the Nikkei 225 a price weighted index.

To encourage adoption of corporate governance standards, scoring based on qualitative factors is also applied and focuses on the following three items:

  1. Appointment of independent directors (with the requirement of at least 2)
  2. Adoption or scheduled adoption of International Financial Reporting Standards (IFRS)
  3. Disclosure of English earnings information via TDnet (company announcement distributions service in English)

One would expect the above three from companies listed in the US or Europe as minimum standards, however to the majority of Japanese companies, these are rather uncommon features to date. The scoring of these criteria is determined so that around 10 names are different from those if only quantitative criteria were applied.

The overall 400 highest scoring companies are selected for the index, subject to buffering rules to minimise turnover.

Constituents are reviewed once a year in August. This year’s first review saw 31 in and 31 out, with Sony being one of the companies dropped. This is consequential in a shame culture, such as Japan’s, and the index was already dubbed the ‘Shame Index’.

Public endorsement for the adoption of this index was given by Japan’s Government Pension Investment Fund (GPIF) which currently manages around US$1.2trillion. Historically, the GPIF is very conservatively positioned but is expected to slowly shift more money towards a higher equity allocation. It has identified the JPX Nikkei 400 as one of its equity benchmark indices. Given the size of the GPIF and its influence on other pension funds, this should be regarded as significant support for Abe’s structural reform program.

What does this mean for investors? First of all, we can expect that better ratings and higher share prices as a result of inclusion will induce companies to modify their behaviour and spark competition to grow ROEs and an alignment with global governance standards. This in effect should contribute to asset price inflation, with the hope that is matched by wage growth to contribute to Abe’s 2% inflation target.

Critics argue that this index is little more than another smart beta offering and investors buying high ROE stocks will be disproportionately exposed to cyclical companies at the top of their cycles. They argue that by simply buying the index, not enough attention is given to the consideration of value versus quality.

Clearly, companies included in the index will tend to have higher ROEs. This is demonstrated in the below table 3 which lists the average of the most recent (August 2014) inclusions and exclusions of the index. However, we otherwise do not concede to this argument. We consider the growth in ROE to be the most critical factor and expect that via improvements in capital efficiency, Japanese ROEs will continue to improve and align with other developed markets. As they are starting from a low base, a plausible strategy is to invest in both index constituents as well as those expected to join the index.

Table 3: JPX Nikkei 400 – Inclusions & Exclusions August 2014

 

ROE

3 Year Av. ROE

5 Year ROE Growth

Inclusions (Av.)

15.4

9.3

25.1

Exclusions (Av.)

3.4

6.8

-4.9

Table 4 below illustrates that the combined ROE of the new index, the JPX Nikkei 400, is only marginally higher than that of the TOPIX and Nikkei 225 and well below that of the S&P500 and the MSCI Europe.

Table 4: Valuations as of 6October 2014 – Japan, US, Europe

 

JPX Nikkei 400

TOPIX

Nikkei 225

S&P500

MSCI EUROPE

Return on Equity

9.3

8.2

8.0

15.0

11.1

Dividend Yield

1.8

1.8

1.5

1.9

3.6

P/B

1.4

1.3

1.6

2.8

1.9

Source: Bloomberg, Cerno Capital

To date, two ETF providers have launched an ETF on the JPX Nikkei 400 for European domiciled investors. One of these is an improved investment for clients of Cerno Capital.

We have substantial balances at work in Japan and the advent of JPX Nikkei 400 trackers provide the opportunity to structure low cost exposure around the main themes at work in that market.

If you would like to find out more about how we access the Japan opportunity, please contact Hannah Sharman (hannah@cernocapital.com).

“It is not unnatural that, perhaps, in this matter of being misunderstood, Japan has more reason to complain than any other nation in modern times”. These words were written in 1900 in a book titled Misunderstood Japan.

After stellar returns for investors last year, the Japanese stock market has been much less exciting this year. The numbers on the external accounts have been poor and this has prompted questions about the Japanese recovery. We have retained our allocation to Japanese equities which remains our largest single country allocation. We believe that the deflationary pall has lifted and that improved capital efficiency of companies will deliver higher profits and so significant returns to shareholders. The move out of deflation and to higher profits is only just beginning, meaning that the rerating of valuations in the market is at a relatively early stage.

Figure 1. Share buyback Programs

Share buy back chartSource: Goldman Sachs. As at 8th September 2014.

One of the key features of improved corporate profitability is shown by the introduction of the JPX Nikkei 400 index. This is an index of the most profitable companies. Sony and Panasonic have been excluded, a shaming omission perhaps. This plays into the ‘shame culture’ in Japan and those companies not ‘part of the club’ are expected to take action to change this. Another key feature of the trend towards improved profitability is that corporates are paying out more in dividends and using cash on their balance sheets to buy back shares. Figure 1 above shows this trend clearly. Currently, Japanese corporates have Yen70tr net cash on their balance sheets, this is approximately 25% of the total stock market capitalisation. Buy backs of this kind will, of course, further increase return on equity (ROE) and profitability.

Figure 2. Table showing global equity valuations

EPS Growth P/E Ratio P/B Ratio EV/EBITDA ROE DVD Yield P/CF
Name FY15E FY16E FY15E FY16E FY15E FY15E FY15E FY15E FY15E
Japan 16% 14% 14.0 12.3 1.3 7.7 9.3 2.2 8.5
US 8% 8% 17.2 16.0 2.7 9.8 16.0 1.9 10.8
Europe 6% 12% 15.4 13.8 1.8 7.6 11.3 3.3 12.4
Asia ex. Japan 9% 13% 13.1 12.2 1.6 7.1 12.4 3.1 10.7

Source: Goldman Sachs. As at 12th September 2014.

It is interesting that despite the recent slow-down in economic growth, earnings growth in Japanese has continued to be strong. Table 2 above shows how Japanese company valuations compare very favourably with other global equity markets. ROE is currently rising and on the way to 11%. It was recently predicted at a lunch held in our office by Hugh Sloane of Sloane Robinson that Japanese profits will surprise on the upside and that an ROE of 15% is very achievable, furthermore in 5 years’ time Japanese ROE will be above that of the US. The point that US corporate profitability is at an all time high and Japanese profitably is rising from a low base is well made. The chart below, figure 3, shows how all major profit drivers are moving in the right direction. Du Pont analysis shows that so far the only underlying measure that has significantly turned up is net profit margins; asset turnover and leverage are only just starting to move. It would be unlikely not to get further improvement in asset turnover once deflation has formally ended, as it removes any incentive to hoard cash.

Figure 3. Evidence of improved profitability

Evidence of improved profitability chartSource: Mizuho Securities. As at April 2014.

The other major leg in the argument is that that the monetary expansion that has doubled the size of the monetary base is bringing about an asset reflation. Property rental prices are now starting to rise, see figure 4. There are negative real interest rates currently in Japan, this is confirmed by the break even yields on inflation linked bonds. Wage growth is still sluggish, but total compensation is up for the first time in decades. The Bank of Japan is explicitly targeting a 2% inflation rate, which is a significant change from past policy.

Figure 4. Evidence of rising rents

Evidence of reflation chartSource: Barclays Research. As at 1st September 2014

The risks to all the above are that Abenomics may fail to stop deflation. While we see this as an unlikely outcome, the poor economic numbers following the sales tax increase may continue and the trend in other developed markets currently is for less inflation not more. The marginal buyer of the stock market has been the foreigner, the hope is that with the end of deflation, domestic investors will turn bullish, change their preference for liquidity and will incrementally buy more equities. This is much less likely without an end to deflation.

Japan continues to be misunderstood. When we think about the opportunity in Japan, some knowledge of Japanese history and character is useful. The Japanese domestic investment sector is of great significance. It continues to slumber for now and when it is awakened it will likely have a pronounced effect on equity market direction and tone. We suggest the opportunity is barely plumbed and target at least 40% of our equity market exposure towards Japan presently. If you would like to find out more about how we access the Japan opportunity, please contact Hannah Sharman (hannah@cernocapital.com).“It is not unnatural that, perhaps, in this matter of being misunderstood, Japan has more reason to complain than any other nation in modern times”. These words were written in 1900 in a book titled Misunderstood Japan.

After stellar returns for investors last year, the Japanese stock market has been much less exciting this year. The numbers on the external accounts have been poor and this has prompted questions about the Japanese recovery. We have retained and our allocation to Japanese equities which remains our largest single country allocation. We believe that the deflationary pall has lifted and that improved capital efficiency of companies will deliver higher profits and so significant returns to shareholders. The move out of deflation and to higher profits is only just beginning, meaning that the rerating of valuations in the market is at a relatively early stage.

Figure 1. Share buyback Programs

Share buy back chartSource: Goldman Sachs. As at 8th September 2014.

One of the key features of improved corporate profitability is shown by the introduction of the JPX Nikkei 400 index. This is an index of the most profitable companies. Sony and Panasonic have been excluded, a shaming omission perhaps. This plays into the ‘shame culture’ in Japan and those companies not ‘part of the club’ are expected to take action to change this. Another key feature of the trend towards improved profitability is that corporates are paying out more in dividends and using cash on their balance sheets to buy back shares. Figure 1 above shows this trend clearly. Currently, Japanese corporates have Yen70tr net cash on their balance sheets, this is approximately 25% of the total stock market capitalisation. Buy backs of this kind will, of course, further increase return on equity (ROE) and profitability.

Figure 2. Table showing global equity valuations

EPS Growth P/E Ratio P/B Ratio EV/EBITDA ROE DVD Yield P/CF
Name FY15E FY16E FY15E FY16E FY15E FY15E FY15E FY15E FY15E
Japan 16% 14% 14.0 12.3 1.3 7.7 9.3 2.2 8.5
US 8% 8% 17.2 16.0 2.7 9.8 16.0 1.9 10.8
Europe 6% 12% 15.4 13.8 1.8 7.6 11.3 3.3 12.4
Asia ex. Japan 9% 13% 13.1 12.2 1.6 7.1 12.4 3.1 10.7

Source: Goldman Sachs. As at 12th September 2014.

It is interesting that despite the recent slow-down in economic growth, earnings growth in Japanese has continued to be strong. Table 2 above shows how Japanese company valuations compare very favourably with other global equity markets. ROE is currently rising and on the way to 11%. It was recently predicted at a lunch held in our office by Hugh Sloane of Sloane Robinson that Japanese profits will surprise on the upside and that an ROE of 15% is very achievable, furthermore in 5 years’ time Japanese ROE will be above that of the US. The point that US corporate profitability is at an all time high and Japanese profitably is rising from a low base is well made. The chart below, figure 3, shows how all major profit drivers are moving in the right direction. Du Pont analysis shows that so far the only underlying measure that has significantly turned up is net profit margins; asset turnover and leverage are only just starting to move. It would be unlikely not to get further improvement in asset turnover once deflation has formally ended, as it removes any incentive to hoard cash.

Figure 3. Evidence of improved profitability

Evidence of improved profitability chartSource: Mizuho Securities. As at April 2014.

The other major leg in the argument is that that the monetary expansion that has doubled the size of the monetary base is bringing about an asset reflation. Property rental prices are now starting to rise, see figure 4. There are negative real interest rates currently in Japan, this is confirmed by the break even yields on inflation linked bonds. Wage growth is still sluggish, but total compensation is up for the first time in decades. The Bank of Japan is explicitly targeting a 2% inflation rate, which is a significant change from past policy.

Figure 4. Evidence of rising rents

Evidence of reflation chartSource: Barclays Research. As at 1st September 2014

The risks to all the above are that Abenomics may fail to stop deflation. While we see this as an unlikely outcome, the poor economic numbers following the sales tax increase may continue and the trend in other developed markets currently is for less inflation not more. The marginal buyer of the stock market has been the foreigner, the hope is that with the end of deflation, domestic investors will turn bullish, change their preference for liquidity and will incrementally buy more equities. This is much less likely without an end to deflation.

Japan continues to be misunderstood. When we think about the opportunity in Japan, some knowledge of Japanese history and character is useful. The Japanese domestic investment sector is of great significance. It continues to slumber for now and when it is awakened it will likely have a pronounced effect on equity market direction and tone. We suggest the opportunity is barely plumbed and target at least 40% of our equity market exposure towards Japan presently. If you would like to find out more about how we access the Japan opportunity, please contact Hannah Sharman (hannah@cernocapital.com).

As ever, Apple’s product launches are greatly anticipated and 9th September was no exception. At that launch the iPhone 6, iPhone 6 Plus, Apple Watch, and an intriguing new payment platform, Apple Pay were revealed to the world.

Thanks to its tightly integrated iOS ecosystem, Apple’s hardware tends to feel less commodity-like compared to its peers and, as a consequence of Apple’s integration in users’ lives, the explicit and implicit costs of switching mount.

Its iPhones, iPads, iMacs, and the newest addition to the family, the Apple Watch, complement each other well by synchronising everything from apps to media (music, films and TV shows) to personal data (contacts, calendars, photos, etc.) through its iCloud and iTunes platforms. Apple’s ever growing application universe is a clear money-spinner.

Given the typically short product replacement cycle of 2-4 years for personal electronics, building a loyal customer base is thereby essential to the success of the business over the long-term in this maturing and highly competitive market.

It is generally thought that this loyalty lies on the sleek design, interface, simplification and sheer “wow” of their products. However, whilst the techies will froth on the screen size and resolution, the more meaningful business development is Apple’s grip on users’ lives. FT’s Lex column harpooned this fact in their column of 5th September stating that “most of those who shell out for the next iPhone will not be buying a phone, they are paying a toll”.

This is a toll to a near private garden. The iOS system is relatively simple when operated from within. However, access from a different operating system (say Android) can often be fraught with difficulty. Much of the data, especially licensed media, is either non-transferable or give people a very hard time when they try. For Apple users, hardware upgrades is as much a means to maintain access to the system as enjoying increasingly smaller benefits in feature specifications.

If confirmation were sought of this, it has arrived in the form of Apple Pay. Apple Pay utilises NFC (near-field communication) technology to enable contactless credit card payments in physical stores and allows ‘one-click’ online purchases (no card details to fill in) via the new iPhone and the Watch. While it may not contribute materially to near-term revenues, it offers a potentially valuable service that will further cement customers to the iOS system, if proved successful. Once the phone or the watch becomes your wallet, it will become more challenging to persuade users to depart.

In a stroke, Apple Pay is poised to take advantage of US$12 billion of daily transactions value in the US. Already, it gained strong financial institution and retail endorsements with negotiations held in typical Apple secrecy. Early backers include eleven of the biggest US card issuers including Visa, Mastercard, American Express and several major banks, collectively representing 83% of the market. Retailers such as McDonald’s and Walgreens are also on board. Further, they will be paying Apple 15 cents for every US$100 purchase for this privilege, an impressive feat of Apple’s bargaining power in persuading the key players in the payment industry to give up a slice of their revenue, something neither Google Wallet nor CurrentC (developed by MCX – Merchant Current Exchange) has managed to achieve.

As mobile devices handles increasingly sensitive personal information such as health/fitness records and payment details, data privacy and security is paramount to the integrity of the business, especially in light of the recent iCloud hacking debacle. In attempt to address these concerns, credit card details will not be stored nor shared on the device or in Apple’s servers. Instead, a transaction is authorised via one-time payment numbers, dynamic security codes, touch ID, and Apple forfeits a potentially lucrative opportunity to monetise user data by not tracking user purchases.

Whilst the technology is nothing new, Apple has timed its launch well. A major change set to occur in the payment landscape will require the majority of some nine million merchants to deploy new hardware in their stores within the next year, in compliance with the EMV (Europay, MasterCard & Visa) standard, and to reduce fraud levels rampant in the traditional magnetic strip system. Banks have made concerted efforts to push merchants to upgrade their POS (point of sale) systems to the ‘Chip & Pin’, widespread in Europe but virtually non-existent in the US (which still uses the traditional system). From 2015 onwards, issuers like Visa and MasterCard will no longer cover the cost of credit card fraud for retailers still on the old system. The new terminals should allow both PIN and NFC transactions, and streamlining of the online payment could also help speed up the uptake of Apple Pay.

iTunes revolutionised the music industry back in the mid-2000s. For the time being, card issuers and merchants believe that Apple Pay is a benign partner, forecasting an increase in transaction volumes to offset the fees they surrender to Apple. The transition process will take time, it remains to be seen whether this system, with its 800 million credit cards already on file (via iTunes Store), will disrupt to the payment industry on a similar scale.As ever, Apple’s product launches are greatly anticipated and 9th September was no exception. At that launch the iPhone 6, iPhone 6 Plus, Apple Watch, and an intriguing new payment platform, Apple Pay were revealed to the world.

Thanks to its tightly integrated iOS ecosystem, Apple’s hardware tends to feel less commodity-like compared to its peers and, as a consequence of Apple’s integration in users’ lives, the explicit and implicit costs of switching mount.

Its iPhones, iPads, iMacs, and the newest addition to the family, the Apple Watch, complement each other well by synchronising everything from apps to media (music, films and TV shows) to personal data (contacts, calendars, photos, etc.) through its iCloud and iTunes platforms. Apple’s ever growing application universe is a clear money-spinner.

Given the typically short product replacement cycle of 2-4 years for personal electronics, building a loyal customer base is thereby essential to the success of the business over the long-term in this maturing and highly competitive market.

It is generally thought that this loyalty lies on the sleek design, interface, simplification and sheer “wow” of their products. However, whilst the techies will froth on the screen size and resolution, the more meaningful business development is Apple’s grip on users’ lives. FT’s Lex column harpooned this fact in their column of 5th September stating that “most of those who shell out for the next iPhone will not be buying a phone, they are paying a toll”.

This is a toll to a near private garden. The iOS system is relatively simple when operated from within. However, access from a different operating system (say Android) can often be fraught with difficulty. Much of the data, especially licensed media, is either non-transferable or give people a very hard time when they try. For Apple users, hardware upgrades is as much a means to maintain access to the system as enjoying increasingly smaller benefits in feature specifications.

If confirmation were sought of this, it has arrived in the form of Apple Pay. Apple Pay utilises NFC (near-field communication) technology to enable contactless credit card payments in physical stores and allows ‘one-click’ online purchases (no card details to fill in) via the new iPhone and the Watch. While it may not contribute materially to near-term revenues, it offers a potentially valuable service that will further cement customers to the iOS system, if proved successful. Once the phone or the watch becomes your wallet, it will become more challenging to persuade users to depart.

In a stroke, Apple Pay is poised to take advantage of US$12 billion of daily transactions value in the US. Already, it gained strong financial institution and retail endorsements with negotiations held in typical Apple secrecy. Early backers include eleven of the biggest US card issuers including Visa, Mastercard, American Express and several major banks, collectively representing 83% of the market. Retailers such as McDonald’s and Walgreens are also on board. Further, they will be paying Apple 15 cents for every US$100 purchase for this privilege, an impressive feat of Apple’s bargaining power in persuading the key players in the payment industry to give up a slice of their revenue, something neither Google Wallet nor CurrentC (developed by MCX – Merchant Current Exchange) has managed to achieve.

As mobile devices handles increasingly sensitive personal information such as health/fitness records and payment details, data privacy and security is paramount to the integrity of the business, especially in light of the recent iCloud hacking debacle. In attempt to address these concerns, credit card details will not be stored nor shared on the device or in Apple’s servers. Instead, a transaction is authorised via one-time payment numbers, dynamic security codes, touch ID, and Apple forfeits a potentially lucrative opportunity to monetise user data by not tracking user purchases.

Whilst the technology is nothing new, Apple has timed its launch well. A major change set to occur in the payment landscape will require the majority of some nine million merchants to deploy new hardware in their stores within the next year, in compliance with the EMV (Europay, MasterCard & Visa) standard, and to reduce fraud levels rampant in the traditional magnetic strip system. Banks have made concerted efforts to push merchants to upgrade their POS (point of sale) systems to the ‘Chip & Pin’, widespread in Europe but virtually non-existent in the US (which still uses the traditional system). From 2015 onwards, issuers like Visa and MasterCard will no longer cover the cost of credit card fraud for retailers still on the old system. The new terminals should allow both PIN and NFC transactions, and streamlining of the online payment could also help speed up the uptake of Apple Pay.

iTunes revolutionised the music industry back in the mid-2000s. For the time being, card issuers and merchants believe that Apple Pay is a benign partner, forecasting an increase in transaction volumes to offset the fees they surrender to Apple. The transition process will take time, it remains to be seen whether this system, with its 800 million credit cards already on file (via iTunes Store), will disrupt to the payment industry on a similar scale.

Japan has been the stand out equity market of 2013, rising 50% in Yen terms during 2013. We explain the reasons for our continued interest in this equity market despite these gains having already been recorded.

• Valuations on the Japanese market remain attractive. Although the market is up approximately 50% YTD, earnings per share have increased by 36%, so in price earnings terms the market is not much more expensive than at the beginning of the year. The PE ratio has actually declined from 18.0x to 16.8x. When looking at asset values the price to book ratio in Japan is 1.27, which has risen from 0.9x a year ago. This compares very favourably to the US equity market that trades at 2.6x price to book.

• As the world continues to heal after the stresses of 2008, we can expect a normalisation of US interest rates to equate to higher US bond yields. We expect this will drive the US dollar higher against the Japanese Yen over the medium term. A weaker Yen is likely to be bullish for the Japanese stock market, with its high degree of earnings from exports overseas.

• Japan is one of the few economies in the world that would welcome higher inflation and indeed inflation is a mark of success of their policies. While the rest of the world has to deal with the headwinds of higher inflation and probably interest rates, Japan will benefit from the reflationary effects of unlocking savings after years of falling prices.

• Japan has little choice but to stick with its current plans. The fiscal position in Japan has deteriorated to a point at which something needs to be done. Gross and net debt is currently 210% and 140% respectively, significantly worse than its OECD partners. Up until now Japan has not had to rely on foreigners to buy it debt, it appears that this may now be changing.

• In 2000 China had an economy one-fifth the size of Japan, now China’s economy is more than 60% bigger than Japan’s. The fear of being further eclipsed by China is giving Japan a reason to act now. The rivalry between the two nations is well documented and many in Japan think this is their last chance to act in order to be able to hold their own against their now larger and powerful neighbour.

 

 

 

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