The lost decades in Japan are a well-known dictum. From the 1989 highs, the country has gone through a sustained period of weak economic growth, with intermittent recessions and benign inflation that saw GDP growth practically unchanged in nominal terms. Furthermore, both equities and residential property are still below their 1989 highs.
This has created a fascinating situation, with an extended period of stress and many false starts. As a result of this ongoing trauma, government leverage has increased significantly (now among the world’s most indebted at over 200 per cent of GDP), with large-scale deleveraging elsewhere in the economy.
The question long left unanswered is whether Japan is ready to turn the corner. If it does turn around, as many think it is ready to, Japanese equities could be an attractive long-term position offering diversification benefits and the potential for gain. However, following economic stagnation and a deleveraging hangover, one must also address the poor profitability that has been a defining feature for the best part of two decades.
To open the lid on profitability, one must acknowledge what has gone wrong and why. One of the most cited problems has been corporate governance, which has resulted in poor dividend policies, obscure compensation schemes, a lack of appropriate risk taking, a very low percentage of independent directors and high cross-shareholdings making M&A activity problematic. Companies have also failed to target appropriate profitability metrics, leading to high cash holdings and a general perception that they fail to act in the best interests of shareholders.
So, what is going on and could we expect a change?
With so many underlying issues, investors have been yearning for a catalyst. In 2012, along came Abenomics and the so-called “Third Arrow”, as Prime Minister Shinzo Abe introduced several measures that went about trying to stimulate economic growth and address some of the profitability issues that have plagued Japanese companies. As a part of this response, Japan’s corporate governance code eventually came into effect on 1 June 2015.
Sceptics have been quick to question whether the government could influence the fundamental structure that held back corporate Japan for so long. For example, we knew in Japan that very high cash holdings were associated with a low percentage of independent directors, but it wasn’t clear whether government regulation would meaningfully shift that cash into shareholders pockets.
With a few years of evidence now under our belts, we are in a far better position to make these assessments and there are some clear positive developments. One of the most encouraging has been profitability targeting by corporate management, which has increased rather dramatically.
As intended, independent directorship has also increased significantly, with the corporate governance code acting as an effective method for change. This is undoubtedly encouraging, but it is worthwhile remembering that it will only be helpful if it helps derive outcomes such as increased payouts to shareholders.
In respect to payouts, we are seeing newfound success, with dividends in absolute terms increasing across the board and payout ratios experiencing significant growth. Buybacks have also grown in popularity (which only became a legal practice in 1994), as the number of companies initiating their first buyback program continues to increase. These sorts of developments look likely to be both structural and profoundly important for investors.
There are other influences which must be considered too. For starters, favourable currency trends have played their part, with the ¥/US$ rate moving from around 76 in 2011 to 115 as at July 2017. Industry concentration also still remains low and whilst some evidence of consolidation is apparent in pockets, the level of M&A is not widespread enough to cause structural shifts in profitability. Leverage will be another key issue going forward, where we are seeing early green-shoots of corporate leverage ticking up across the board for the first time in decades. This would only help the backdrop and provides further evidence of slow-moving change.
Assessing the Developments
With positive developments evident in the Japanese corporate sector, one must also contemplate how much is priced in and whether the opportunity is complementary in a portfolio context. From a fundamental risk perspective, there is still some volatility in the cash flows and indications that profitability may be nearing a cyclical high. However, this is offset by strong balance sheets and a structural tailwind of improving corporate governance. With scope for added leverage, this could influence profitability improvements that would further narrow the gap to global peers.
Overall, we view Japan as a “Medium” conviction opportunity, reflecting developments that are both captivating and compelling.
Emma Morgan is a portfolio manager at Morningstar Investment Management Europe