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Betting on Japan, Inc.’s recovery
By Advisor Perspectives
Japanese stocks have outperformed their peers the past few years, and we don’t think their run is over. Policies to improve profitability, capital use and productivity should provide a stronger foundation for further gains.
The run started when the Liberal Democratic Party, led by Prime Minister Shinzo Abe, returned to power in December 2012. Abenomics brought a weaker yen, providing a tailwind to Japanese-based global corporations. It also boosted import prices, helping break the deflationary trend in Japan. As a result, the profitability of Japanese firms, as measured by return on equity (ROE), has recovered to near historical highs (Display).
At this point, there are questions as to how much energy Japanese equities have left: whether it’s mixed macro data, worries about China, or uncertain policy direction. Meanwhile, Japanese equities are trading nearly on par with those of other developed markets based on the price-to-forward-earnings ratio, indicating limited potential for further multiple expansion at current earnings levels.
So, is it time to trim our overweight to Japanese equities? We don’t think so.
Further Gains Require Structural Economic Changes
However, we think the next round of outperformance will come from Japan closing its substantial ROE gap versus its global peers. By closing this gap, our research suggests, Japanese companies could generate more than 30% excess earnings growth over the medium term. But narrowing the gap requires fundamental changes in the way businesses operate.
Why should this happen now?
The current Japanese ROE gap relative to the US is primarily driven by lower operating margins, but we see signs of improvement that could set the stage for progress.
Tightness in labor markets. Over the past three years, overall labor participation has improved from 59.4% to 60.0%, but labor is likely to be in shorter supply as it becomes challenging to further increase participation. As labor markets tighten, businesses will need to find ways to better use their workforces.
Potential increases in capital investment. One way to improve productivity would be with greater capital investment, and government policy seems to be encouraging it. Meanwhile, thin manufacturing capital investment has left aging equipment. The yen’s decline has also fostered signs that Japanese firms may be bringing manufacturing capacity back onshore. As a result, increased capital spending could help improve productivity over the long term, and create a source of domestic demand in the short term.
Government encouragement of improved earnings power. Government reform efforts include the introduction of the JPX-Nikkei 400 Index, featuring companies with high returns on equity, high operating profits and at least two outside directors. Index companies must adopt international financial reporting standards and report earnings in English.
The Government Pension Investment Fund has increased its domestic equity allocation, which will use the JPX-Nikkei 400 for passive investment. And the Bank of Japan will include the index in its quantitative easing purchases.
Reform measures also include a stewardship code and a corporate governance code, which asks firms to set return-on-capital targets, appoint at least two independent directors, and explain the economic rationale for cross-shareholding. A reduction in the corporate tax rate could als