Lifting the kimono on a misunderstood Japan

“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 ([email protected]).“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 ([email protected]).

Print Article

About the Author:

Nicholas is a co-founder of Cerno Capital and lead manages several of the firm’s client portfolios. His investment career began at Cazenove & Co in 1990. In 1995, he joined CLSA rising to Head of Asian Sales, where he was responsible for the institutional business in the UK and Europe. He is a member of the Board of Governors of Downe House School and a Trustee of the Downe House Foundation. He is also a Trustee of the Cecil Estate Family Trust and Chairman of The Ashendene Trust, a UK charity. Nicholas is an Economics graduate of Bristol University and an Associate of the Chartered Institute for Securities & Investment.