By Sarah Williams
Japan’s corporate financial year has ended. When earnings results are announced in a few weeks’ time, they will be shown to exceed the previous peak in 2008 for the first time since the global financial crisis
The recovery process has taken much longer in Japan than other developed economies and was significantly interrupted by the earthquake in 2011 and subsequent closure of Japan’s nuclear facilities. The strong earnings recovery, coupled with heightened and well-covered expectations of change in corporate governance practices, has led to outperformance by the Japanese market (even when measured in US dollar or sterling terms) and focused even more attention on Japanese equities. However it is still true that the country has hundreds of companies that now have zero analyst coverage. The best opportunities may still lie totally undiscovered to an extent that can drive further market gains.
It is still common to read that the jury remains out on the success of Abenomics or that the third arrow in particular isn’t working. Some commentators even suggest that Abenomics isn’t working at all. What is undeniable is that Abenomics has created an environment in which corporate Japan can reach a new level of profitability. Japanese companies can benefit fully from the cost-cutting measures that were the only way to survive against the backdrop of deflation and an ever-strengthening yen.
Looking at a breakdown of the overall profit recovery we might expect that export sectors such as autos and machinery have returned to making record profits. While the yen was strong they worked hard to lower their breakeven exchange rate and are now reaping the benefits from a weaker currency. However the recovery in Japanese earnings is much broader than just the exporters with many domestic sectors such as construction, retailers, food companies and telecoms doing well. Financial sector earnings have also recovered strongly whether we look at insurance, banks, brokers or real estate.
Earnings have recovered to pre-crisis levels but the Topix has not. It reached just over 1,800 in February 2007 and still remains around 10% below that level. Hence, taking this longer-term perspective, the market has become cheaper for the same level of profits. Or we could say that all of the market’s return since Abenomics began can be explained by the earnings recovery and, in fact, the equity risk premium has risen somewhat. We cannot see any evidence of valuation expansion based on any expectation of the success of Abenomics’ stated aims of the end of deflation and a change in Japan’s long-term growth outlook. So where might we look for factors to drive the Topix up to and beyond pre-crisis levels?
The publication of new Japanese Corporate Governance and Stewardship codes has focused attention on Japan’s return on equity (ROE). Assuming that profits have recovered we expect that the market’s ROE should also have recovered to pre-crisis levels of around 9%. While we should be wary of criticising any company for achieving a low ROE in the years just after the earthquake, this still means that Japan’s 9% ROE remains somewhat adrift of the global average of 12% or the US level of close to 15%. For 12% ROE the global price-to-book ratio is just over 2 times compared to Japan’s 1.4 times. The US trades at 2.8 times price to book for its 15% ROE. The opportunity is clear.
Since the beginning of Abenomics all of the Topix’s return can be explained by profit growth. Taking a further step back and comparing the market to the pre-crisis and pre-earthquake levels it has become cheaper. The market doesn’t seem to be pricing in any expectation that Japan will escape deflation or that corporate Japan will significantly change its balance sheet structure or dramatically improve shareholder returns. By the time we know whether corporate Japan is going to embrace any of the factors which specifically enhance ROE it may be that old-fashioned earnings growth will already have taken the Topix to new post-crisis highs.
The risks may lie in making an investment case for buying companies with inferior earnings growth, lower ROE or poor shareholder returns purely on the expectation of a change in corporate governance practices at the expense of companies who have always striven to make the best returns possible and reward shareholders, however negative the environment. Yet the best opportunities may lie in the mid and small cap segments of the market where analyst coverage has been long since abandoned.
Sarah Williams is manager of the Threadneedle Japan fund.
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