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.
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.
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.