Japanese equities have been volatile of late, falling sharply in August and September amid a global market sell-off before recovering in recent weeks. These swings have taken place at a time when investors have concerns about Japan’s growth prospects, with the economy threatened by the slowdown in neighboring China.
This short-term volatility is stealing attention from a larger story, as there are powerful arguments supporting a sustained improvement over the medium to long term. Structural economic reform, improving corporate governance and rising equity holdings by pension funds create an environment well suited to institutional investors with a long time horizon. It is now time to reassess the opportunities in Japanese equities.
With low inflation and suppressed growth, Prime Minister Shinzo Abe and his economic policies have come under fire recently for not delivering on the promise of reenergizing the Japanese economy. The adverse headline data, however, mask a solid performance among a number of sectors as the weak yen, kept low by the Bank of Japan’s loose monetary policy, has boosted corporate profitability. According to Deloitte’s third-quarter global economic outlook, 30 percent of large public companies in Japan reported record profits for the latest fiscal year, with aggregate annual profits rising 6.7 percent to a record high.
Exporters and those with strong overseas subsidiaries are the first beneficiaries of the cheap currency, while the tourism sector is profiting from visitors’ additional buying power. Japan registered 12.9 international visitors from January to August, putting the country on track to attract nearly 20 million tourists for the year — an impressive number for a country that only crossed the 10 million threshold in 2013. Tourist numbers stand to increase further as the 2019 Rugby World Cup and 2020 Summer Olympics further boost Japan’s appeal as a destination. Tourism has lifted the bottom line for large retailers, with players such as Seven & i, Takashimaya and Ryohin Keikaku Co., owner of the MUJI store chain, all revealing substantial growth in their latest interim results.
The recent earnings growth is for the most part concentrated in large caps, including exporters and large banks. Smaller companies, which tend not to have as much international exposure, are more tied to the domestic economy, which has remained subdued.
Structural reform, the third arrow of Abenomics, after fiscal stimulus and monetary easing, is gradually gaining ground in Japan and reshaping long-established business norms. Among the most relevant measures for institutional investors is the Stewardship Code, which stands to improve governance standards and restore the bargaining power of major shareholders vis-à-vis management. In addition to the code, the JPX-Nikkei Index 400, which tracks companies with high returns on equity and good governance, has also been launched and adopted as a benchmark by the Government Pension Investment Fund (GPIF).
Publicly adopted by some 200 institutions to date, the Stewardship Code encourages institutional investors to make public their voting history in portfolio companies and engage more actively with management. With a number of investment managers already using this as a springboard to outline their policies regarding board appointments and return on equity targets, there are grounds for optimism for the medium- to long-term future of corporate governance. This should go some way toward assuaging doubts about management oversight that have perennially deterred foreign investors from allocating to Japan. Structural changes still need to be made, however, as far as the labor market is concerned. Efforts to overturn the traditions of lifetime employment within one firm and wages based on seniority have translated into only modest reforms to date; it will take several years for significant change to occur.
A further consideration, intricately linked to the shift in governance, is the attitude of Japanese firms toward their balance sheets. Historically cash rich, these companies are gradually moving away from a legacy of low investment and aversion to share buybacks. Momentum has gathered recently behind buybacks, which rose 41 percent in the April–June quarter from a year earlier, to ¥2.1 trillion ($17.1 billion), according to Nomura Securities Co. Earlier this month Toyota Motor Corp. announced plans to buy back a record ¥798 billion of stock in the financial year ending March 31, 2016. At a time of robust profits and relatively low debt, this is an especially good time to place money back in shareholders’ pockets.
On the demand side, change is also afoot — finally. The GPIF’s landmark move into domestic stocks, which now make up 25 percent of its mammoth $1.2 trillion portfolio, set the scene for renewed inflows into equities. This provides support for prices and encourages subsequent waves of stock purchases by both public and private pension funds. With price-to-book ratios looking unusually low compared with the U.S., entry to the market could be relatively cheap, and a number of fund managers have upgraded to an overweight rating to reflect this.
In terms of portfolio construction, Japanese equities have also demonstrated a low correlation to other markets, which may encourage diversification. In spite of emerging-markets concerns and China’s slowdown, powerful internal drivers combine to support a positive outlook with potential upside. Unexpectedly robust earnings, competitive exports and a tourism boom, supported by expansive BoJ policy, point to numerous pockets of value. Evolving corporate governance standards contribute to this by empowering major shareholders, while a rising tide of share buybacks, directly relevant to investors even in the short term, is increasingly placing cash reserves back in shareholders’ hands and pushing up prices. All of this translates into an encouraging investment case that institutional investors should not ignore.
Julien Barral is a senior associate for equity asset allocation at investment consultancy bfinance in London.
