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

For the unconstrained global investor, Australia is a prospective hunting ground for profit. Any comprehensive analysis of the main trade and capital trends at work in the world find their conflux in Australia’s capital markets. Predicated on China’s fixed asset investment boom over the past quarter century, Australia’s economy has been substantially driven by demand for its ores and minerals. It relates uneasily, it seems at times, on account of deep cultural differences, to the rest of Asia, in particular Indonesia.

Australia is an affluent, urbanised society. It is, above all, a consumerised population that is, in economic jargon, fully financially included. It has an independent central bank and currency.

On account of these features, backed by disciplined capital markets and secure laws, Australia’s equities, government bonds and currency have been a destination for macro investors of all stripes, including hedge funds.

We measure recent opportunities by looking at 12 month rolling returns of its currency, benchmark bond and main equity index.

12M Rolling Returns - Australian Equity, Bond & Currency

Source: Morningstar/Bloomberg

When the currency is weakening, returns from key asset classes are crimped, as can be seen in the below chart.

12M Rolling Returns - Astralian Equity, Bond & Currency

Source: Morningstar/Bloomberg

The tricky thing with macro investing, prosecuted via Australian instruments, is the various counter influences at work. We list these as follows:

– Shorting the AUD is intrinsically expensive on account of the yield differential between AUD and its obvious corollaries. For example, the yield differential between AUD and USD, based on 1Y rates has averaged 304bps over the past 5 years.

– Outright investments in the sovereign bond market have delivered returns in AUD based on the general fall in rates accompanied by some flattening of the curve. However, for a non-domestic investor, these gains have been crimped by AUD weakness. Longer range, strategic investments in the bonds require the adoption of significant currency risk. Against them are lined up the yield hunters and persistently positive capital flows of new immigrants from China and elsewhere.

– Many macro commentators have long predicted the demise of the economy as they surmised that that falling commodity prices would spur some form of recession that could include a property down cycle. This has tempted some funds to go short Australian equities and the banking sector, in particular, has been targeted. To their frustration, the Australian equity market has remained peachy, supported by Australia’s superannuation schemes (government mandated pensions), with the banks especially valued for their income stream.

– To cap these, the various identified trends have been subject to reversal. In particular the currency which fell 20.1% between July 2014 and April 2015 has strengthened by 6.7% from 2nd April 2015 to the time of writing.

Cerno Capital’s core strategy ran a short Australian dollar position profitably until it was closed on 16th February 2015. We currently hold no specific exposures to Australia directly.

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).

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.

 

 

 

When investors fail to secure sufficient compensation for bearing illiquidity, they almost always come to regret it. The summer reaction of certain asset classes to the Fed’s suggestion that it was considering reducing the pace of its bond purchases exposed vulnerabilities for the future. list of domains . The US-centred bond market sell-off in June caused notable stress in emerging markets. This stress was most visible in ETFs that invest in emerging market debt where some banks and intermediaries were unable to meet immediate redemptions from their clients.

Emerging Market Local Currency debt is a good illustration of  just how tight pricing has become. Local currency bonds typically offer a positive spread over developed markets and this spread is a function of a number of factors including credit risk and illiquidity premium. Market participants often underestimate the illiquidity premium component in earning their yields. The traditional appeal of Local Currency bonds is their traditionally higher yields, price increases with improved credit quality, diversification in a global portfolio and the potential for currency appreciation. The illiquidity of these instruments and return for this illiquidity that investors must demand has been all but forgotten.

We expect to see more attractive levels for emerging markets over the coming quarters for three reasons. First, emerging markets will face strong headwinds as this period of quantitative easing slowly comes to an end. A further re-pricing of the US risk free rate is unlikely to be a smooth and ordered process for emerging markets and the liquidity premium is likely to rise. Second, valuations for emerging market stocks and bonds do not appear to be especially attractive at these levels by historical standards. Finally, although there has been some capitulation in the asset class we do not appear to have had a proper capitulation from slower money. This final capitulation would ordinarily suggest a bottom may have been reached. The optimal expression for us is to hedge by being long the USD against an EM currency basket consisting of five emerging countries selected for having the lowest ranking on current accounts and purchasing power parity.

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