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Darius McDermott: Japan’s slow build to growth

31 August 2023

Since Abenomics emerged a decade ago, the Japanese corporate landscape has undergone significant change.

By Darius McDermott,

Chelsea Financial Services

Unloved, under-owned and underappreciated – that’s the narrative supporters of Japanese equities would relate to investors in 2023. However, there are plenty of pessimists who would argue the region has yet to recover from the bubble bursting back in December 1989.

The reality is the past decade has been about a quiet transformation, dating back to when Shinzo Abe became prime minister in 2012. Abe assumed leadership of a country burdened by stagnant economic growth, unfavourable population dynamics and a mountain of debt – but quickly set about making change with his ‘three arrows’ approach of Abenomics.

This was the catalyst for long-term change as the state-sponsored campaign sought to improve both corporate governance and capital management. For example, helping companies to become more shareholder friendly.

It has been successful. I was somewhat surprised to read that the average earnings per share (EPS) of the Japanese Topix has grown as much as the S&P 500 in the past decade. Unfortunately, this has gone under the radar, resulting in low valuations and a lack of ownership within the region.

This apathy towards Japan means only 50% of listed companies now have sell-side coverage at all versus 99% of the S&P 500. That looks like an opportunity for active managers.

What is different this time?

The changes are both structural and cyclical in nature. I’ll start with the move by current prime minister Fumio Kishida to persuade Japanese citizens to buy domestic stocks by introducing a new tax exemption scheme, which is designed to help accelerate a switch from savings to investment.

To put this into context, Japanese investors have traditionally put half their wealth into cash and bank deposits; while only 15% of their assets are held in stocks and investment trust funds.

In order to lift the share of equities, Kishida is overhauling the tax-exemption scheme for investment, also known as the Nippon Individual Savings Account. From January 2024, the tax-free annual investment limit will effectively double and, more crucially, become permanent.

Pictet Japanese Equity Selection fund manager Sam Perry says this is part of a move which could prove transformative for Japanese stocks as domestic savers have some $15trn dollars.

He says: “It could also boost Japan’s appeal among foreign equity investors, turning previously conservatively managed businesses into the dynamic, lean, shareholder-friendly companies that are investment staples for global portfolios worldwide.”

This feeds nicely onto the latest attempts for corporate change, with the Tokyo Stock Exchange’s (TSE) call earlier this year for companies to focus on achieving sustainable growth and enhancing corporate value.

As part of its proposals, the TSE would, “require that management and the board of directors properly identify the company’s cost of capital and capital efficiency,” especially for companies that have consistently traded below a price-to-book (P/B) ratio of one (for clarity that is over 50% of companies in the Topix).

The move is designed to put further pressure on Japanese management teams to address issues of capital inefficiency. One of the main reasons for these low P/B ratios is cash in reserve. According to Nikkei, reserves of listed companies, excluding financial institutions, had accumulated to about 100trn yen by the end of 2022.

This is likely to be a further catalyst to an existing trend as Japanese companies have already made notable progress in returning cash to shareholders. Combining dividends and buybacks, Japanese equities were yielding 3.7% toward the end of last year.

Unlike other parts of the world, mild inflation is welcome in Japan following years of deflation and low growth, particularly as it gives companies the confidence to invest longer term. It currently stands at 3.3%, but for the first time in decades, wage growth is sustaining the momentum of inflation in Japan. At the end of July, the Bank of Japan tweaked its bond yield policy control, allowing interest rates to rise more freely as a result.

Double digit returns from here?

M&G Japan fund manager Carl Vine says: “Consumers are more willing to reluctantly accept price hikes and companies are far more proactive about the price setting mechanisms in their business. There are clearly some structural green shoots on this front.”

JP Morgan believes Japanese companies will also benefit from a number of major global secular growth trends, such as automation, digitisation and online e-commerce, particularly as wage inflation becomes more common.

Vine believes Japan could plausibly generate mid-teen compound total returns in the next five to 10 years. He says prior double-digit earnings growth across the market (in the past 10 years) were achieved without the complete institutional framework, which he feels Japan now has.

Perry expects Japanese equities to deliver an annual return of more than 10% in the next five years, outperforming US equities and almost matching returns from emerging equities in dollar terms, with lower volatility. Adding returns could be even higher if reforms have their desired effect.

Since Abenomics emerged a decade ago, the Japanese corporate landscape has undergone significant change. When I think of the region, I keep thinking of the story of the tortoise and the hare. Japan has taken the decision to take things slowly in the past decade or so and may well start to reap the benefits as a result.

Investors may want to consider the Baillie Gifford Japanese Income Growth fund as a way to tap into the move to return more cash to shareholders through dividends; while solid options like M&G Japan, Pictet Japanese Equity Selection and T. Rowe Price Japanese Equity all have experienced managers with strong, long-term track records.

Darius McDermott is managing director at Chelsea Financial Services and FundCalibre. The views expressed above should not be taken as investment advice.

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