8 min read 13 Apr 23
The value of investments will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally 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.
We believe Japanese equities represent a compelling long-term investment opportunity. In our view, they offer the potential for attractive returns over the coming years. While there are some short-term tactical considerations that might keep some investors on the side-lines, these should be considered in the context of the overall opportunity set for the asset class.
Over the next five to ten years, we think Japanese equities could plausibly generate an annual percentage compound total return in the mid-teens (Figure 1).
Figure 1: The Japan Opportunity: drivers of potential returns from Japanese equities
The main driver of potential returns is likely to be earnings, which we believe could grow at an annual compound rate of 8%, a level corporate Japan has indeed delivered over the past decade.
Dividends could also add to the potential return. The stockmarket’s starting dividend yield is a little under 3% currently. Dividends have also been growing faster than earnings over the past decade. This has been possible because the payout ratio has been increasing, albeit from a very low level, and company balance sheets are strong. An increase in the payout ratio could increase dividend growth by more than 1% pa, in our view.
And finally, when you include the contribution of share buybacks (the stockmarket has been buying back around 3% of itself every year), we think it is easy to see how you could plausibly get a mid-teen total return.
This is before any change in valuation ie, multiple expansion. It is worth noting that the starting point for valuations in Japan is low – low versus the rest of the world and low versus Japan’s own history. And if an adjustment is made for excess cash and assets, the multiple is even lower. So, if valuations were to expand, in addition to the factors above, we could potentially end up with a very attractive return over a multi-year period.
Another factor to consider is that despite being the third largest economy in the world, the Japanese equity market is poorly covered by the investment community, in our view. The lack of coverage makes the market inefficient and creates a rich source of opportunities for stockpickers like ourselves. For selective, active investors, the prospective equity returns could be even higher.
The dividend yield of the Japanese equity market is observable, and the ability of companies to increase their payout ratios and buyback shares is evidenced by their strong balance sheets and clear trends. Therefore, the big question about the potential return from Japanese equities centres around how companies are going to grow earnings by 8% compound. This might not be such a leap of faith as it appears.
A decade ago former Prime Minister Shinzo Abe launched his “three arrows” programme of economic and corporate reform known as “Abenomics”. As part of these policies, companies were encouraged to go forth and make profits.
Abenomics created a tremendous buzz and, over the next couple of years, foreign investors went on a quarter-of-a-trillion yen buying spree on Japanese equities. They then spent the next eight years selling their shares, disappointed with the apparent lack of progress on corporate reform.
Foreign investors should be kicking themselves. What happened over the past 10 years is that the market recorded a compound annual growth rate (CAGR) in earnings of around 12 to 13% (in local currency terms). This is very respectable compared to other markets. Even the mighty S&P 500 Index, did not achieve this level of earnings growth (Figure 2).
Figure 2: Delivering the results
Past performance is not a guide to future performance
Valuation vs Fundamentals: contributions to total returns of major equity markets over 10 years.
In light of this track record, we would argue that forecasting attractive earnings growth and returns for the next 10 years should not be the same leap of faith it was 10 years ago.
Japan has delivered, in our opinion. What is impressive, is that this has been achieved against a backdrop of challenging domestic economic conditions – low GDP growth and little or no inflation.
There has been a coordinated, state-sponsored campaign to drive corporate improvement (Figure 3). In some ways it is a bit like Singapore 20 years ago. It has been a massive institutional project, to upgrade the legal framework in which companies operate.
Figure 3. Campaign to drive corporate improvement
Whilst there was a perception Abenomics was taking too long for some investors, the pace of change was not unreasonable, in our view. It takes a long time to go from post-war industrial policy to the mantra of “go forth and make money”.
A good example of a business that was an early adopter of change is incumbent telecommunications company NTT. NTT has seen only a modest increase in revenues over the past 10 years. However, over that period investors have enjoyed an internal rate of return (IRR) of 19% in yen terms. This was not due to multiple expansion – it still trades on a similar multiple to the one it did at the start of the period (11x). It was down to increased profit margins, share buybacks and dividend growth.
To labour our point, double-digit earnings growth across the market was achieved without the complete institutional framework in place. In our view, the framework is now fit for purpose. This is why we believe there is still a lot more earnings growth to come. There is an abundance of low-hanging fruit to be picked, in our opinion – cross-shareholdings to be sold; too much cash on balance sheets; headquarter buildings that can be sold and leased back; and scope for productivity/margin improvement. (Margins are low in Japan and productivity poor because the corporate sector is massively fragmented.)
Whilst we believe the long-term prospects for Japanese equities are excellent, we recognise that there are some short-term challenges.
The Bank of Japan’s (BOJ) policy of targeting government bond yields in a narrow range around 0%, the so-called yield curve control (YCC), was unsustainable, in our view. We believe the BOJ’s decision, in December 2022, to widen the YCC range is a good sign and an acknowledgement of an improvement in Japan’s economy, where wages and prices are finally beginning to rise.
However, some investors will worry about the impact of the policy change on the strength of the yen and the negative impact it might have on earnings, particularly for exporters. We believe this is an overreaction.
We don’t have a view on the yen – it may or may not strengthen in 2023, but over the long term we believe the stockmarket will be driven by earnings, not the level of the yen. Over the long term there has been no consistent correlation between the yen and the TOPIX Index (Figure 4).
Figure 4. Relationship between stockmarket and Japanese yen (JPY)
Past performance is not a guide to future performance
That’s not to say there haven’t been periods when the correlation between the yen and the index level has got close to one. But there have also been periods when the correlation has gone negative. On average, we believe there is not much of a relationship between the yen and TOPIX.
Despite exporters growing their earnings very meaningfully in 2022, (benefiting from a weaker currency), they underperformed the broader market. We think this is because investors were worried about the global economy. In contrast, banks outperformed meaningfully, even before the BOJ tightened monetary policy (Figure 5).
Figure 5. Market reaction to BOJ policy change
Past performance is not a guide to future performance.
In summary, to punish exporters as the yen strengthens when investors did not give them the benefit of a weaker yen in 2022 seems unfair to us. If the yen does strengthen in 2023, we think exporters could still outperform, supported by a stronger global economy and because valuations are currently attractive, in our view.
Japan is forecast to be one of the fastest growing major economies in 2023. Although to be fair, this is partly due to a “base effect”, as the country was still locked down for COVID-19 at the start of 2022. In addition, wages and inflation are both increasing meaningfully, something that has not happened in 25 years. These conditions could be a powerful driver of corporate earnings, in our view.
For example, one of the biggest companies in Japan, Fast Retailing, recently announced plans to increase pay for employees by up to 40%. This maybe an extreme example, but we think wage growth of 4% in 2023 is possible. Higher prices mean that nominal GDP growth is going to be very different in the next 10 years, than it was in the previous 10 years.
Another potential driver of wage increases is the beginning of the end of seniority-based pay. A critical shortage of labour in some sectors means pay needs to be based on merit not length of service. While this is not happening at all companies yet, the companies leading this revolution are creating a more competitive market for labour and higher wages.
As a result of these corporate and macroeconomic trends, we are positive on the prospects for Japanese equities. The asset class has an enviable track record over the past 10 years. This is despite a full institutional framework having only been in place until relatively recently.
Now that the framework is in place, we think companies will have ample self-help opportunities to further improve profitability. The prospect of faster nominal GDP growth, will be an added tailwind to corporate performance, in our view.