Despite a modest rebound at the beginning of 2019, the lack of upward momentum displayed by the Japanese stock market in 2018 has left valuations low. This could present a better entry point for investors – especially if one considers that a lot of the negative factors, such as slowing Chinese growth, have already been priced in. Here we highlight four reasons to consider Japanese equities.
Reason 1: Historical profitability of Japanese companies
Many Japanese companies are increasingly profitable, mainly as a result of structural change. Indeed, this has led to historically high operating profit margins in 20181 – the highest level in decades. The breakeven ratio, the point at which sales equal costs, has come down significantly; a large proportion of this has been driven by a drastic cost-cutting exercise undertaken by Japanese companies since the Global Financial Crisis in 2008. Variable costs have come down by roughly 2%, and even fixed costs have declined by 1% compared to 10 years ago.2 A weaker yen should also prove supportive for companies’ bottom-lines, both for exporters and domestic companies.
Reason 2: Lower valuations historically and relative to other countries
Stock market valuations look attractive when compared to history and relative to other countries. Japanese stocks are at a 12-month forward price-to-earnings (P/E) ratio of around 12x (based on the Tokyo Stock Price Index or TOPIX), the low end of the range following the Global Financial Crisis in 2008. In contrast, the 12-month forward P/E ratio in the US is coming to back to more than 15x (S&P 500).3 Although still lower than levels in Europe and the US, the gap on the return on equity (ROE) between Japan and other countries has shrunk over the past few years. There are ample reasons to believe that Japanese companies will look to continue improving their ROE, especially with corporate profit margins at historical highs, although this is to some extent offset by lower asset turnover. There is also a lot of pressure on companies to increase returns to shareholders based on improved corporate governance standards.
Reason 3: Corporate governance improvements
Corporate governance and shareholder returns of Japanese corporations are improving as the 2015 Corporate Governance Code of Conduct and a revised Stewardship Code of Conduct for institutional investors take effect. The adoption of more reasonable governance policies should lead to better working capital policies. For example, among the new governance standards is a recommendation that at least a third of board members should be independent. Companies were previously only required to have a minimum of three independent board members, but it was recognised that for large corporate boards, such as those with 20 members or more, this was not sufficient. The code was therefore revised to recommend that at least a third of board members should be independent.
Company management teams are also being gradually incentivised to increase returns to shareholders, evidenced for example by a growing dividend payout ratio. The total payout ratio by Japanese corporations is still only 39%: 29% in the form of dividends and roughly 10% in share buybacks. This is well below their European and US counterparts.
In order to better align management interests with those of shareholders, the proportion of share compensation schemes is increasing, although this is still a relatively small portion of overall compensation packages. Other corporate governance changes include opposition votes against board members increasing and takeover defence measures decreasing. While it will take time for a complete shift in mindset to take effect, we are nonetheless already seeing improving standards in corporate governance.
Reason 4: Inflation outlook
While we are still a long way off from the Bank of Japan’s 2% inflation target, we are finally beginning to see some reflation. In terms of the unemployment rate, we appear close to an inflection point: the natural rate of unemployment is thought to be around 2%, which we are close to with a current unemployment rate of 2.4%.4 Should that rate drop, we could begin to see wage growth start in earnest. Previously, growth in the number of lower wage part-time workers has dampened overall wage growth, but the number of full-time workers entering the workforce is now growing as quickly as that of part-time workers.
Abenomics, the monetary and fiscal policies put into place by Prime Minister Shinzo Abe when he came to power, has brought about a rise in the number of female workers. Greater labour participation among women, as well as the elderly, has meant limited pressure on per-worker wages, but total employment income has increased as a result. The Japanese labour force is strengthening, but the participation of the elderly may not be sustainable over the long term. The large cohort of baby boomers which has been supporting the labour market of late should gradually drop off. This will likely have a significant impact on the tightness of the labour market. The government is clearly aware of the ageing population and is implementing changes to try and help mitigate the effects of shrinking demographics, including making strides towards attracting foreign workers and tourists, notably through relaxing visa rules. The average wage per worker has been accelerating, denoting an improvement in upward wage pressure, which should have a beneficial impact on inflation.
- Q2 2018. Source: Japanese Ministry of Finance
- Sources: Japanese Ministry of Finance, Capital Group as at 30 September 2018. Q4 1962 – Q3 2018 (4-quarter aggregate). Corporate Statistics by Ministry of Finance, non-financial and non-insurance companies with capital stock of more than 1 billion yen (5,091 companies for Q3 2018). CY: calendar year.
- Sources: Thomson Reuters Datastream, Bloomberg, Capital Group, as at 31 January 2019.
- Source: Ministry of Health, Labour and Welfare, as at 31 December 2018.