There is a sea change in corporate behaviour in Japan that is leading to a focus on capital efficiency, return on equity and higher dividends, as well as share buybacks.
Valuations and earnings growth are favourable compared with other markets at a time when foreign investors are underweight and have been selling the market. Deflation has de facto ended, with rising wages, rising rents and better domestic consumption. Everything is in place for Japan to be one of the best performing major equity markets.
The Nikkei 225 has rallied by 112% in total return terms since December 2012, when prime minister Shinzo Abe came to power. Owing to very strong earnings growth – 20% in 2014 – valuations are attractive. Japan is the only major developed market with lower price-to-earnings ratios (P/Es) now than in 2012.
Japan’s forward P/E trades at 13.6x versus 17.3x for the US and 16.4x for Europe. On a price-to-book basis, Japan trades at 1.4x, which is the cheapest of all the major regions.
Return on equity (RoE) is rising, with corporate governance improvements driving profitability as shareholder returns increase. The focus on returning cash to shareholders and driving up RoE is now widespread across the boardrooms of Japan.
High earnings growth and low valuations make Japan stand out and look attractive relative to other regions. We expect earnings per share growth of more than 20% this year, RoE will move above 10% as a consequence and we expect it to reach mid-teens before the end of the decade.
The introduction last year of the Stewardship Code and the launch of the JPX-Nikkei 400 index has helped to create a focus on improved corporate governance.
This trend has been in place for some time, but it is getting more attention as Japanese companies continue to buy back shares and increase dividends. Aggregate shareholder returns, dividends and buybacks are forecast to be ¥18.6 trillion in 2016, more than double the amount in 2012.
There is evidence that companies with better disclosure and corporate governance are outperforming the wider equity index. The new corporate governance code is expected to be adopted by companies in June.
Next leg of Japanese recovery
As the year progresses, we expect to see more evidence of companies setting targets, adding independent directors and an increased level of payout ratios and buybacks. The move by ISS to introduce a 5% RoE threshold into its Japanese voting guidelines was a significant move.
In this context, the JPX-Nikkei Index 400 index is a very effective way of playing the recovery in Japan with exposure to those companies benefiting from the improvement in corporate governance. Companies with significant cash on their balance sheets are expected to outperform, as this cash is returned to shareholders.
Domestic investors were the main buyers of the market in 2014, and this trend has carried on in 2015.
Indeed, foreigners have already sold more in 2015 than they purchased in all of 2014. The major domestic buyers are the Bank of Japan as part of its quantitative easing programme, which has meant a tripling in its annual ETF purchases to ¥3 trillion.
The government pension fund, GPIF, increased its domestic equity weighting from 12% to 25%, with a +/- 9% band. It is estimated that this will add to equity purchases of ¥1.7-3.5 trillion per annum.
We also expect retail flows from NISA accounts, equivalent to ISAs in the UK. These accounts have only been available in Japan for just over a year so it is too early to gauge the magnitude of the effect, but there is considerable potential firepower available from retail investors in the future.
Real income growth was negative in 2014, but there is every prospect of a turnaround in 2015. The shunto wage negotiation process takes place over the spring period and the major unions are already suggesting a wage demand increase of 3-4%, which is well ahead of the 2.8% for 2014.
The current tight state of the labour market, combined with government moral suasion will all help to put upward pressure on wages. With core inflation estimated to be around 0.5%, the scope of real income growth looks impressive and a helpful boost to consumer spending.
Measured inflation is expected to pick up more slowly, as the series used by the government has always been more sticky.
Japanese equity remains the largest single country allocation in Cerno Capital’s multi-asset funds.