5 min read 30 Apr 19
Summary: As the Heisei era comes to an end, the era of Reiwa will soon start in an unusual fashion. Japan will be steeped in a mood of jubilation for its new emperor, rather than mourning for the passing of the old. Perhaps this is another sign that Japan is entering into a new period of history; putting behind its decades of economic malaise, looking to once again be a leading force in the developed world.
Loosely translated, the name given to the Japan’s new imperial dynasty, ‘Reiwa,’ means ‘beautiful harmony.’ Yet, the dispersion between growth and value stocks – the widest since the tech bubble – suggests investors have been single minded in their investment choices. A Value strategy proved to be a profitable strategy in the Japanese stock market during the first half of the Heisei era, how the world has changed since those times. Since 2016, growth stocks have attracted a distinct premium, with investors preferring to focus on the structural themes of Japanese robotics , Semi-conductors and growing Asian consumer demand.
Investors stubbornly refuse to believe that ‘Japan Inc.’ overall can grow its profitability following decades of corporate inefficiency, ignoring growing evidence to the contrary. A look at the underlying margins of these value-orientated large cap companies reveals that method of thinking could be outdated. From their recent lows of 2008, operating margins of larger companies (ex-financials) have registered steady progress for almost 10 years. In many instances, median earnings growth for value stocks has proved superior to that of growth stocks. The top quintile stock performers over the last three years (growth stocks) produced median earnings-per-share (EPS) growth of 6.8%. This compares with the bottom quintile stock price performers (typically value stocks) which produced higher growth of 7.5% over the same time period.
It would appear that the link between earnings growth and share price growth has broken down. Currently, share prices are not even at 60% of their peak levels seen during the first year of the Heisei era in 1989. Yet, corporate profits are now over twice the levels seen in 1989 (see chart below).
For those investors who believe that Japan can make real progress on the corporate profitability front, there are bargains to be had. Better corporate governance is contributing towards an improved bottom line. On the whole, return on equity has increased significantly; both dividend pay-outs and share buybacks are nearing all-time highs. We are starting to see a greater willingness by company management to engage with investors.
However, many investors still remain unconvinced, pointing to the inefficiencies of the previous decades where the preferred way of running a company was to accumulate as much cash on the balance sheet as possible. The result is that, while corporate Japan has carried out these positive changes and has mostly caught up with other developed markets in terms of shareholder returns and operating margins, half of Japanese companies are still trading below tangible book value compared to around 20% of European companies and less than 10% of US companies. As long-term investors, we believe this presents significant opportunities for investors globally.
One such example is the household name Hitachi. Besides its well-known electronics business, the group also holds subsidiaries in a vast range of other business segments. With a focus on increasing profitability, the company has embarked on a strategy of divesting from unprofitable peripheral business units to focus on more profitable, core business areas. It has already sold peripheral businesses in areas such as finance, logistics and power tools, and continues to streamline it business unit operations to focus on ones that can deliver cost synergies and grow profitability.
As investors in the company, we welcome the drive by the firm to become a market leader in social infrastructure and energy. We have benefited from management’s actions, witnessing a steady rise in the company’s operating margin as a result of this restructuring. The firm has also scaled back from some unprofitable overseas projects, including nuclear plans in the UK. This has strengthened the company’s balance sheet and enabled it to engage in meaningful acquisitions to further strengthen its positions in its core businesses. This is but one example of how a traditional company in Japan is changing to enhance its attractiveness to investors. As active fund managers it is our role to seek out companies such as these that are able to provide alpha for our investors, and we continue to believe that the Japanese market offers a wealth of such opportunities.
 Source: Datastream, April 2019. Index: TOPIX
 Source: CLSA, Bloomberg, March 2019. Indices: Japan (TOPIX), Germany (CDAX), France (CAC All Tradable), UK (FTSE All Share), US (Smp;P 1500)
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