- Earnings growth looks set to hit 12 per cent
- Private buyouts on the rise
Few commentators would have bet on Japan being a stand-out equity performer on any level at the start of the year, as the country grappled with the long tail of the pandemic and impact of Russia’s war in Ukraine.
Add in ongoing tensions with a resurgent China and many investors would have been forgiven for giving the country’s equities a wide berth. What many may have missed is that a decent bout of inflation is exactly what Japan’s economy needed to throw off its torpor. A tougher operating environment in China for Western players also helped shift funds into Japanese IPOs and equity raises.
With the blended Tokyo Stock Price Index (Topix) exchange up by an impressive 22 per cent in the past 12 months, and Japanese companies enjoying one of their best earnings quarters in 30 years, talk of a return to growth after decades of stagnation does not seem so farfetched.
Analysts at Goldman Sachs credit the performance of equities to three key factors. Firstly, the Bank of Japan has stayed dovish as inflation year on year has fallen back to 3 per cent, compared with 3.7 per cent at this point in 2022, and its negative interest rate policy is so far unchanged – the current rate is -0.10 per cent. The trigger for a raise will be solid evidence that wage growth is now ahead of inflation, which would justify a more aggressive policy.
The second criteria for being positive on equities is wage growth, and there is some evidence that Japanese wages are starting to grow again after stagnating alarmingly since the 1990s. In 1989, the average Japanese person earned the same as an American – nowadays it is barely equal with the British. The government’s own survey suggests that pay deals at many firms are running at 3.2 per cent – the highest headline growth since 1993. Nomura also forecasts 3.9 per cent growth in the years to March 2024 and 2025.
In short, the Japanese consumer will soon have higher disposable income which, given the interest rate environment, will either find its way into the stock market via the updated Nippon individual savings account (Nisa), or be felt in increased consumption – itself a positive for many listed companies.
Thirdly, corporate Japan has reaped the benefit of significant capital spending investments in 2022 and the yen’s weakness against the US dollar. The result has been a recent quarter of earnings growth that could see Japanese listed companies register 12 per cent profit increases for the year. Inevitably this has made itself felt in total exports. In the third quarter, Japan exported $60bn (£48bn) of goods, compared with $57bn in the second quarter.
Escaping the value trap
One question that may trouble investors is whether the Japanese stock market is still too much of a value trap for companies to continue to justify their listing? A recent study commissioned by Topix showed that around 50 per cent of the companies on the index traded below book value and with a return on equity of less than 8 per cent.
On the one hand, this should be ripe territory for activist investors to shake companies up and return more to shareholders, but on the other many firms are simply leaving the market rather than putting up with the hassle of a low public valuation, and management buyouts are growing.
As a recent example, one of Japan’s largest over-the-counter drugmakers, Taisho Pharmaceuticals (JP:4581), accepted a $5bn offer in a management buyout that will see the founding Uehara family retain firm control and end the company’s 60 years on the exchange.
According to Bloomberg reporting, management buyouts, in general, are on the rise in Japan, with another large drug retailer, Tsuruha Holdings (JP:3391), reportedly looking at a $4bn offer from private equity after winning a boardroom battle against an activist investor. If the deal goes through, it illustrates how being a minority investor in Japan can still be an uncomfortable experience.
The prevailing attitude to smaller shareholders in Japan can be summarised as “accept what you are given”, amid accusations that management and majority shareholders have an interest in stifling a genuinely open auction that would generate a higher valuation.
There are two structural problems that may be accelerating this process. Firstly, the very necessary financial reforms in the 1990s meant that crossholdings in companies, which often amounted to formalising cosy cartels and ensured a pliant shareholder base, were deemed less acceptable and have fallen steadily ever since. Goldman Sachs reckons that now only 10 per cent of companies on the market of a similar size have declared cross-holdings in each other, compared with 70 per cent in the 1980s.
The second structural point is that there are arguably too many listed companies on the market as many Japanese start-ups tend to list quickly, rather than going through stages of funding rounds, which means profitability is prioritised instead of growth very early on in a company’s life cycle. This has a knock-on effect for a company’s long-term valuation.
To illustrate the point, according to research by CB Insights, of 1,170 unicorns (start-ups that achieve a valuation of $1bn, or more) the majority, 644, are in the US. China comes second with 302, India third with 108 and Japan last with just six.
If investors are to avoid the market’s value traps, then some kind of clear-out is needed. To its credit, the Tokyo Stock Exchange will adopt a 'name and shame' approach, publishing a monthly list of companies not meeting guidelines on financial reporting and governance. This will start from January, but still relies on a culture of avoiding public shaming rather than anything more concrete.
The impression remains that if you want to wade through the Japanese market to capture some of the potential growth on offer, you may need to leave it to the professionals.
