A new capitalism: Seeking value in Japanese equities

Japanese corporate reform is no longer a story. It is a fact-based observation. Thanks to self-help, Japan may well be the best market globally for earnings growth in the decade ahead. Margin growth, capital reduction from higher dividends and buybacks along with accelerated M&A trends all bode well for shareholder returns.

A coordinated, state-sponsored campaign to transform corporate Japan – unleashed by Abenomics – has driven a decade of solid returns for Japanese equities. In the ten years through to 27 April 2022, the TOPIX generated a compound annual growth return (CAGR) of 11% in local currency terms. 

“There is now overwhelming evidence that Japanese companies have become more shareholder friendly, opening the door for investors to benefit from the release of latent potential embedded in the Japanese equity market.”
 

All of this return was generated by earnings and dividends, with none of that return coming from valuation expansion. Whilst the S&P500 Index returned 13.5%, 30% of this return came from an expansion in valuation. The CAGR from other key, global markets such as EuroSTOXX 50 and FTSE All Share¹ were in the mid-single digits.

Abenomics transformed the Japanese corporate landscape, paving the way for a decade of impressive self-improvement. Prime minister Fumio Kishida’s new policy agenda – ‘a new form of capitalism’ –  looks to build upon recent improvements in the corporate sector to deliver broad based and sustained economic growth.

For the first time since the collapse of the bubble economy, the institutional infrastructure is finally in place to support this accelerated pace of reform. The prospects for yet another decade of strong earnings and share-price performance seem bright.

There is now overwhelming evidence that Japanese companies have become more shareholder friendly, opening the door for investors to benefit from the release of significant latent potential embedded in the Japanese equity market.

“The institutional infrastructure surrounding Japanese companies has now evolved to the point where it is actively supporting the type of corporate change that is required to deliver another decade of double digit earnings growth,” explains Carl Vine, co-head of Asian investment. “Companies now have an expanded toolbox for self-help.”

Loaded balance sheets

Balance sheets in Japan are awash with excess assets. Around 40% of Japanese companies have at least 20% of their equity value sat in cash. Hundreds of businesses in Japan still have more net cash than their market cap, Vine highlights. There is also excess real estate, cross shareholdings and inefficient working capital to take into account. “Balance sheets are loaded with latent value,” he adds.

Yet further potential exists in Japanese income statements. Despite a decade of double digit earnings growth, Japanese profit margins are still around half those in the US, suggesting further scope for structural improvement. “Low margins in Japan reflect a combination of sub-optimal commercial strategies and excessive industry fragmentation. Both of these are improving at speed,” says Vine. 

‘New capitalism’

Labour productivity and wage growth are key focuses of PM Kishida. As a near-term objective, he is encouraging companies to raise wages and is offering tax incentives to do so. Longer-term he wants his government to invest significantly in a variety of schemes to improve labour productivity.  He believes that higher productivity can deliver higher wages and higher profits simultaneously, with both contributing to higher economic growth.

Kishida has also promised the most aggressive shift in Japanese household balance sheets in history, Vine notes. This is an important part of the puzzle when it comes to growing household incomes. Today Japanese households have one thousand-trillion yen sat in deposits, earnings zero. That is a significant opportunity loss for household income.

Stars Aligning

“Not only do we now have proof that corporate behaviour is changing, we can point to how this has already delivered impressive earnings growth. We can also point to improvements the institutional framework and how they are continuing to encourage further improvements in corporate performance,” he says. “In addition, we have now got a prime minister that is very supportive of ongoing corporate change and a set of domestic policies coming down the pipe which are supportive for domestic economic growth and for equity ownership in Japan.”

Drivers of change

“Changes in the nature of corporate governance in Japan means that voting capital now has a value. This was not true before,” Vine explains. “Thanks to improvements in stewardship and governance, more and more companies today are embarking on journeys of self-improvement. Increasingly, they are looking to shareholders for guidance.”

Demographics is also an important driver of change, according to Vine. Japan’s ageing population is reflected in the country’s boardrooms. Over 300 CEOs in Japan are over the age of 70².“That is not to say that older CEOs are doing a bad job,” says Vine. “Indeed some of the best CEOs in the country are in this age cohort. However, as the prime minister himself points out, Sony was started by a 26 year old, and Honda was started by a 35 year old. It will be a younger generation that leads Japan forth into the new industries of innovation.”

¹ M&G, Bloomberg, Period 10 years to April 27, 2022
² TSE1, M&G Bloomberg, January 2020.

The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.