Japan’s companies are among some of the most cash-rich globally. Equally, some of the most attractive developed market valuations are found in Japan. Investors willing to look beyond the economic headlines will discover a market of stocks that is attractive on many fronts.
For many, Japan is typically a low-growth economy with a rapidly ageing population, both of which keep the lid on domestic consumer spending. The country’s ability to attract investors thus has been low since its stock market hit an all-time high in 1989. Yet, Japan has always been a corporate — not an economic — revival story. There is a very compelling corporate reform revival story that is ongoing.
Another critical point is that Japanese corporations have remained resilient despite the pandemic. Gradual but steady corporate restructuring over the last decade has resulted in higher operational efficiency and improved trend profitability — something relatively well known but is yet to be fully recognised by international investors. We expect the benign impact of the reforms to continue, justifying a strategic allocation to Japanese equities in portfolios.
Japan’s corporates demonstrate earnings resilience
We think that Japanese corporations have shown significant earnings resilience in recent years — with Topix EPS outperforming S&P and MSCI Europe EPS over 10 years, no small feat given the scale of financial engineering going on in US corporations. Examples of proactive policies that have boosted earnings and restructurings, where excess capacity has been taken out in steel and auto companies, and a focus on pricing, for instance, in beer and beverages.
Many companies exceeded the earnings expectations in 1Q2022 (among them, Nippon Steel, MMC, Mazda, Honda and Credit Saison). They delivered growth under challenging conditions like China lockdowns and raw material price hikes. Production is yet to normalise in the auto value chain, given the negative impact in 1Q2022. Furthermore, Japan’s Covid-19-related economic reopening is still unfolding versus the rest of the world in areas such as rail transport and domestic consumption. All this points to Japanese companies being much more immune to a global slowdown than investors are currently pricing in.
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At a 12x price-to-earnings ratio, Japanese equities are cheap both versus its history and other developed markets; Europe is on a similar valuation multiple to Japan but has neither the earnings resilience of Japan nor the longer-term structural tailwinds. With significant corporate governance reforms and a gradual shift in mindset toward profitability, margins have been expanding and return on equities (ROEs) have been improving. Abenomics (named after former premier Shinzo Abe, referring to the economic policies implemented by the Japanese government since December 2012) kick-started the market reform process. Still, we believe that the current Prime Minister, Fumio Kishida, will continue to back corporate reforms. These structural changes have another five to 10 years to play out.
After an initial frenzy in 2013 to 2015, international investors have largely shied away, and Japanese equities remain chronically under-owned in foreign portfolios. This differs from what one might expect when considering the earnings per share trajectory over the last decade. Furthermore, Japan is the only major market in positive territory year-to-date (in local currency terms). We expect international investors to return to the fray as they relocate away from their US equities’ overweights.
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Why invest in Japan’s value
Growth stocks in Japan never entirely traded at the extreme levels we saw in the US, but we still observed relative valuations of growth versus value reach multi-decade highs. There has been a pull-back year-to-date in the multiple that investors are willing to pay for growth and a positive re-rating for value companies, especially in certain sectors.
The P/B valuation multiple differentials between growth and value stocks have thus closed slightly but remain at high levels. However, after years of neglecting cheap companies, we think this trend persists as investors refocus on areas of the market where mispricing is prevalent.
Our recent analysis of how much historical earnings growth has been delivered by companies in the MSCI Japan Value index versus the MSCI Growth Index too revealed an interesting result. Over the last five years, value companies have seen their earnings grow faster than growth companies. This suggests that the very reason to invest in the growth segment of the market turns out to be a bit of a fallacy.
Our sweet spot has always been to invest in companies where trend earnings are not properly reflected in prevailing share prices. We believe this will continue to deliver strong outperformance through a market cycle. It is also worth noting that based on an analysis by Bank of America (BofA), value has outperformed the market in six out of eight recessions since the 1980s.
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Opportunity to reap double digit returns
Japan remains a very cheap equity market versus global peers, and we expect the gap to narrow. In addition to continued earnings per share growth, dividend growth, and ultimately higher return on equity, multiple re-rating would be a cherry on top for investors.
Ultimately there is a lot of opportunity for double-digit returns for investors in Japan over the coming years, predominantly from i) more efficient balance sheets and capital allocation, ii) improved margins from high pricing, cost efficiencies and culling of underperforming products, iii) corporate governance reform being more friendly to shareholders, and iv) potentially a stickier inflationary environment.
Investors who remain sceptical about Japan risk missing out on long-term gains.
Ivailo Dikov is a portfolio manager at Eastspring Investments
