15 Jun 2018
By Margaret MacCarthy Bacon, Investment Specialist
Optimism about Japan’s economic growth has become increasingly common among investment analysts, particularly since the Japanese economy is experiencing its longest period of steady economic growth since the mid-1980s. Indeed, the Bank of Japan (BoJ) expects to see solid business investment and household spending in 2018 and has raised its gross domestic product (GDP) forecast for fiscal 2018.
Since the 2012 introduction of Prime Minister Shinzo Abe’s three-pronged economic intervention program (nicknamed “Abenomics”), which focuses on fiscal expansion, monetary easing, and structural reform, the Nikkei index (Nikkei 225) has more than doubled in value. This has helped promote some positive momentum, especially for certain sectors, companies, and pockets of the economy.
However, areas of concern remain in Japan, notably the country’s aging population, high debt levels, excess cash on corporate balance sheets, uneven corporate governance, and a strong yen. Let’s look at some of these headwinds and the steps the country is taking to address them. We’ll then touch briefly on our current assessment of Japan from an equity investment standpoint.
Aging demographics. Japan’s aging population presents a headwind for economic growth and a challenge for business owners, policymakers, and investors alike. In March, the unemployment rate in Japan reached a 24-year low of 2.4%. On the positive side, the government has stepped up and enacted policies to increase labor participation rates by women and immigrants, a distinct break with the past. Women in the labor force have increased from 48% in 2012 to more than 50% currently, and foreign workers have increased by more than 40% since 2013. (Data: World Bank; Health, Labor, and Welfare Ministry — Japan).
High debt levels. As a percentage of GDP, debt levels in Japan are greater than 240%, substantially higher than the 177% found in Greece (data: Council on Foreign Relations). Nonetheless, most of the debt is owned by the BoJ and other domestic financial institutions, so the risk of defaulting is much lower than a case such as Greece, where the debt is generally held by outside entities. Consider that if the debts were not repaid, the government would simply have to recapitalize the domestic financial institutions. In a sense, Japan would be defaulting on itself. Viewed in this light, we think a default doesn’t make much sense as a likely outcome. Meanwhile, an upcoming consumption tax, set to take effect in October 2019, is meant to help decrease the debt.
Increased wages. The low employment rate noted above has raised concerns about wage inflation, which can have a negative effect on earnings. In a development that could potentially help offset this earnings pressure, the corporate tax rate in Japan was lowered from 37% in 2012 to 29.74% in April 2018. The government also enacted a tax policy that reduces corporate taxes to 25% for companies that raise wages by 3%.
Excess cash on balance sheets. Japanese companies have more than $940 billion in cash on their balance sheets, which is much higher than what we find in other developed markets (data: Goldman Sachs, via Barron’s). This detracts from return on equity (ROE). It’s worth keeping in mind, however, that the issue is not going unnoticed by the Japanese securities industry. For instance, the JPX-Nikkei Index 400, created in 2014, was meant to encourage Japanese companies to focus more on ROE. To be included in the index, companies need to rank in the top 400 on the Tokyo Stock Exchange based on ROE, operating profit, and market cap. What’s more, the effects of Abe’s reforms are already visible; ROE was at approximately 5% in 2012 and has since increased to approximately 8.4%. We believe there is room for improvement and expect more companies to focus on returning more capital to shareholders in the form of dividends and share buybacks.
Uneven corporate governance. Governance reform is a prominent issue, with companies in the Nikkei 225 exhibiting the lowest median proportion of independent directors as well as the lowest median proportion of female directors among developed-market peers, according to Bloomberg reports. On June 1 of this year, Japan's corporate governance code was revised to focus on the reduction of cross-shareholdings, greater board diversity, broader adoption of formal nomination committees, and a requirement that companies provide "clear and logical" explanations to shareholders on the allocation of management resources. We think these are important steps that could help Japanese companies become more globally competitive.
A stronger yen. A strong yen presents a disadvantage for Japanese exporters because it makes their goods more expensive and decreases the value of their overseas earnings when converted back into yen. On the plus side, however, a strong yen can strengthen a Japanese company’s purchasing power overseas. Japanese corporations can attempt to offset decreasing sales at home by increasing sales through foreign acquisitions.
Bullish at the company level, but selective
As managers of concentrated, active portfolios, we focus on the abilities of individual companies to compete in an environment of challenging macro conditions.
We believe independent, rigorous, fundamental research can uncover compelling opportunities. We are currently examining several Japanese companies that have exhibited the following traits after being put through our quantitative and qualitative screens:
- capable management teams
- strong balance sheets and good csh flow
- strong competitive ositions
- stable earnings
- improved focus on shareholder returns
- 50% potential upside within our 3–5 year investment horizon.
A broad opportunity set
We believe investment opportunities in Japan have some breadth to them, spanning various sectors and industries. Here are three company-level examples that help shed light on this diversity:
In the consumer sector, we own shares of a manufacturer and seller of furniture and home fashion accessories. The company is vertically integrated and able to control all major components of its business, from manufacturing to distribution to retailing. We believe this helps differentiate the firm from competitors.
In industrials, we are holding a company that specializes in making very small ball bearings. The technologies required to manufacture these components are extremely complex, so barriers to entry are high. We believe demand for bearings will grow due in part to increased use in automobiles and consumer electronics. There has also been visible pick-up in demand for bearings used in drones and other small robots.
In telecommunications, we own a telephone company whose earnings in recent years have been driven by deregulation and strong results at its regional operating companies. Its margins have improved as of late, due to cuts in subsidies and marketing expenses.
On balance, a positive view
Despite the notable headwinds that confront the Japanese economy, we strongly believe there is reason for optimism. On the whole, we think momentum in Japan is positive. In addition to constructive policy steps and an improving economy, we believe there are well-run firms that display promising fundamentals. Nonetheless, it’s important to keep headwinds in mind, and we remain highly selective when making decisions about portfolio exposure to Japanese equities.