Anyone familiar with the Japanese economy is all too aware of the stock market’s vertiginous climb from the early bullet-train era of the 1960s to the market’s peak in December 1989 and subsequent stomach-churning fall to the post-peak lows of 2009, by which time 82 per cent of the market’s value had been wiped off. It was not just a lost decade but two lost decades for Japanese equity market investors.
Abenomics the catalyst for recovery:
But since the March 2009 post-bubble low the indices have staged a gradual recovery, with additional impetus since Prime Minister Shinzo Abe took power in 2012. A glance at the numbers since then shows that Mr Abe’s economic policies – known as ‘Abenomics – seem to have been working. On 26 December 2012, the Nikkei 225 index stood at a shade over 10,230; when Nash met with Thai institutional investors in Bangkok in October the market stood at over 21,000 and has since moved even higher.
Trying to make sense of all this and to determine where the Japanese market is today and where it might head, Nash met with Thai investors. They are increasingly focused on outward investment, allocating larger proportions of their funds each year to overseas markets. Although their allocations are still very low on a comparative scale with the developed market investors – restrained by domestic liabilities they must fund as well as tight regulation – they nevertheless have a keen interest.
As one might imagine given their phase of development, Thai investors do not have the resources to stock pick, particularly in Japan with around 4,000 stocks in the market and a language barrier that few foreigners breach.
“The fund route into Japan is clearly the way forward for us,” said one investor attending the discussion. “Without funds, we might only invest in a handful of well-known names and, even then, it would require a lot of work to ensure that these are sound decisions.” Another added: “I guess the work for typical institutional investors, for life insurance companies, or for asset management companies, is asset allocation, so the fund format is ideal for that. We tend to buy and hold unless we see the market turn dramatically, of course. In terms of what we hope for Japan, we need to see some real growth in profits and earnings per share and dividends. But this should not be driven by the weakening yen, rising exports story, but by domestic efficiency improvements and rising consumption at home.”
Nash likes to start her presentations on her fund with what she terms her ‘scorecard for Abenomics’. Addressing the room, she notes: “Here in Thailand you are perhaps more positive about Abe’s achievements than in many places we visit. Me, too, we feel they have achieved a lot since taking office.”
She notes that since Abe came to power the Nikkei is up dramatically and earnings per share were up 123% by end August this year. Dividends have nearly doubled, unemployment has fallen more than a third and office rents have risen while vacancy rates have dropped markedly. Annualised housing starts have risen by about 10% and the labour market is tightening, with Nash and co-manager Scott McGlashan expecting real wage growth to come through. Meanwhile, the market’s price-earnings multiple has dropped from 16.5 times to 14.1 times, at the same time as return on equity (ROE) is up almost 20%.
A long and turbulent journey
To those outside Asia and less familiar with it, many would assume that Thailand is quite near Japan. But those who fly between the two countries on a regular basis know that, depending on the winds and their direction at certain times of the year, the flight can be up to 7-1/2 hours one way and as little as 5-1/2 hours the other way. And regular travellers on this route also know that the flights can be bumpy. Then on ‘terra firma’, visitors are always aware that the ground can literally shift beneath their feet.
Long, hard, bumpy, uncertain. Those words perhaps tell the tale of the Japanese equity market indices since the heady heights of the 1989 market peak. On December 29, 1989 the Nikkei Stock Average closed at 38910. That was almost six times higher than the 6569 close on December 28, 1979.
But despite intense optimism that the market would head further north towards 45,000, or beyond, in 1990 the Nikkei 225 began to fall, and fall before hitting a low for 1990 of 21913 on December 3, almost 44% below its peak.
Passengers on the Japanese equity market flight then had to reach for their oxygen as the index continued to nose-dive, plummeting ever further to the post peak low of 7685.36 in April 2003. It bounced nearly 140% to 18297 by mid-2007, only for that to prove another false dawn as it soon stalled, slumping to 7110.27 by March 2009.
Then ensued a long journey of mid-air turbulence, as the Nikkei bumped along close to the new bottom from 2009 until the current Prime Minister was elected in late 2012 on a platform of his new economic and fiscal mantra, commonly known as Abenomics.
But when…oh when…will inflation kick in?
Nash argues that all this should make a compelling story for the Japanese market. “But,” she notes, “and this is a big ‘but’, crucially, Abe has not yet delivered on inflation. The public goal of the Bank of Japan (BoJ) has for a long time been 2% inflation. We are still some way off that today although we feel that the turning point is very close now.”
Nevertheless, Nash explains that it is important to understand that confidence is rising for other factors. “In the workplace, a lot of new people are coming into the labour market, for example, many part-timers, of which many are housewives coming to work for the first time, especially in the services sector, such as shops, restaurants and so on. This means that while real wages are not yet rising, other than in a few areas, household income is up due to more people working from those households. “The result? Rising consumer confidence and nascent domestic economic growth, evidenced by car sales picking up. And this domestic growth is vital as we do not expect the yen to drop further, nor to rise much either.”
Nash notes, for example, that in the convenience store sector wages have grown about 25% in the past few years, especially as Japan’s ageing population continue their move towards urban centres, where they can access top-class transportation, housing, social, technological and medical infrastructure.
“This is helping create a very tight labour market in sectors such as convenience stores and restaurants, all of which are booming,” Nash explains. “And immigration can only alleviate the problem at the margins – unlike the US or Europe, Japan has a strong antipathy to immigration.”
Renewed vigour in the labour market
Nash has theories as to why more people, young students and housewives and retired people are coming to the labour market, albeit mostly part-time. “Take the retirement sector, for example. There is definitely anxiety in Japan about retirement income, but it is not necessarily well founded, actually people in Japan are still relatively well off, even after 15 to 20 years of lost economic performance, which as an aside was actually worse than it might have been because things in Japan never really felt that bad, as anyone who has been a regular visitor for the past 20 or so years would appreciate.”
Nash also notes that elderly people beyond the retirement age are generally healthy and fit, benefiting from a lifetime of careful eating and regular exercise, as is the typical Japanese way. “There are delivery truck drivers in their 80s here,” she observes, “that is a bit of an extreme example, but it highlights how fit and energetic retired people are in general. With a long life expectancy ahead of them on retirement, many want to fill the years earning some money and engaging with other people in a positive way. And there is a higher proportion of women working in Japan than in the US today.”
Inflation… it must be around the corner… well, maybe
Nash believes that all these factors will add up to rising inflation, the elusive end game for the Bank of Japan since the arrival of zero interest rates in 2001. “Inflation means that the vast cash mountains that Japanese individuals are sitting on – most people have 50% of their assets in cash, entirely appropriate for a deflationary era – will start to devalue in real terms. This means that cash will be recycled into other assets or simply into consumable items as expectations of prices rises increase.”
The equity market and funds might also benefit, as dividends today far outweigh bank rates and even if inflation rises this will likely remain the case for the foreseeable future. For example, Toyota currently offers a dividend yield of close to 3% while car sales will be an early beneficiary of inflation.
Corporate profitability at record levels
Japan is also currently at record levels of corporate profitability. “Interestingly,” Nash reports, “while the profitability surges the valuation multiple has fallen so the market is not fully valuing this profit growth. The reason is that people attribute all this profit growth to the roughly 28% fall in the yen since 2012, while we believe that the growth is driven by other factors such as corporate restructuring, dramatic cost reductions, rising efficiency in both capex allocation and operations.”
The result, according to the fund managers’ analysis, is that sales could in general fall about 35% before companies start to go into losses in general. “In fact, this trend towards widespread restructuring actually goes back to about 2000.
“Today, Japanese companies are now as efficient as they have ever been, and they have done that in an environment where there has not been much sales growth at home. So, if we get some sales growth plus a modicum of inflation the growth in profits could still be quite explosive. That is something we do not think the market is factoring in.”
The labour market remains tightly regulated in terms of the inability of forms to rapidly trim labour. However, companies have adapted, for example, a move towards a performance-based pay system rather than just pay by seniority. And companies have then been imaginative by offering jobs in other locations, leading to natural attrition as many people prefer not to move.
“All this had to happen and has left corporate Japan lean and efficient but without damage to the social structure,” says Nash. “Unemployment has also dropped sharply, and real wage growth is just around the corner.”
Corporate restructuring proliferates
Cross-shareholdings have also evolved as corporate restructuring has become widespread. “Boards cared little for the return on their cross-shareholdings and due to the way dividends were taxed they almost preferred to have no dividends on these holdings. But then came the first major financial crisis in 1993, when banks realised that they needed to start the process of offloading these holdings in order to bolster their weakened capital.”
Fast forward to 2017 and after much difficulty and often emotional turmoil behind closed doors, much of that stock is now in the hands of investors who want a return instead of perhaps a cosy game of golf and a nice dinner and night out.
“As there are many cheap companies here in terms of multiples and many with strong balance sheets the next step,” explains Nash, “was that around five years ago corporate Japan began to become worried about either becoming a takeover target or wanted to themselves become a buyer of other companies. And that spawned the rise in dividends that we have witnessed in the past five to 10 years.”
Dividends began to rise in 2003, at the nadir of the market indices in Japan, since when there has been almost consistent double-digit growth in dividends, interrupted only by the global financial crisis and 2011 natural disasters.
“This year the market is expecting roughly 8% dividend growth, but more likely it will end up being double-digit growth.”
Nash also highlights the growth of stock buybacks, noting that companies in Japan use buybacks opportunistically – if they have spare cash and they feel the share price is undervalued, they will buy back shares. “In the US it is much more an automatic thing, boards there just keep doing regular buybacks if they can.”
The current gap between the virtually zero yields on JGBs, bank deposits and other relatively risk-free assets compared with dividend yields of around 2% is the largest it has been for a very long time.
“This is tempting to individual investors, especially when the government has also been trying to encourage more people to buy equities, for example with the NISA (a tax-free savings plan). And they are planning more such initiatives to appeal to a wider audience at home.”
Will capex be the next recovery story?
An interesting debate today is whether Japan will again return to a new era of capital expenditure. “Cash as a percentage of assets has risen sharply in recent years and I do think we are passing the phase of cutting and reducing assets,” opines Nash. “As cash is relatively high and payout ratios low to modest, corporate Japan can spend on new assets, R&D and so forth while also raising dividends.” But Nash also notes that the corporate psyche in Japan is one of caution. “They have been through so much in recent decades,” she says, “and also fear that every time they raise themselves up there is another crisis around the corner, whether it is the 2007/8 global financial crisis or the great earthquake and tsunami of 2011, and so on. Add to this political uncertainty that has suddenly and unexpectedly come to a head this autumn – the recent snap elections – and we know that capex is not going to leap forward, it will be more of a gradual easing off the brake.”
Aligned to this discussion is a debate over the impact of the new Corporate Governance Code and the Stewardship Code in Japan some three years ago. “We think the government saw all the cash lying around on balance sheets and wanted to encourage as much of that as possible back into the economy, so that corporate Japan is re-investing in the country’s future, whether through buybacks, dividends, capex or whatever means.” The government is therefore challenging boards to focus on enhancing returns on equity and pushing for independent directors to monitor performance.
All these factors combined spurred Nash and co-manager McGlashan to launch the JOHCM Japan Dividend Growth Fund. It is a large capitalisation fund focusing on the top 200 Topix stocks and designed to capture as much of the dividend growth as possible.
“We screen the list for two core lists, those with an above average yield and those with above average dividend growth. After that, Scott and I narrow down the selection by analysing these companies, focusing particularly on management strategy, measures of balance sheet efficiency and free cash flow generation.” Nash notes that Scott began investing in the Tokyo market in 1982 and she herself began in 1987. “That is more years than we care to remember!”, she jests.
The personal approach
Most importantly, Nash and McGlashan are focused on the companies themselves. “There are metrics that decide which companies we focus on, but the vital element is to meet those companies and determine which direction their business and their balance sheets are heading, so it comes down to a very hands-on approach.” Being based in London is an advantage. “Going to Japan is one thing, but getting to see the top people is never so easy for any investor,” Nash explains.
But when those leading companies visit London it is generally the President or a very high-level executive who travels, so the duo have enjoyed many one-on-one meetings there with top decision-makers, for example, the presidents of NTT, Nippon Steel, Mitsui & Co, Hitachi. “Strangely enough, we might never get to see such influential leaders if we were based in Tokyo,” she adds. “Last year, between the two of us, we met 220 companies, of which about three quarters we met in London.” Because of the stock filtering process, the Japan Dividend Growth fund is a highly concentrated portfolio of between 30 and 40 names, of which at least half are in the Topix 100. With a 40-name limit, it means that the managers must sell a stock in order to bring another better-performing share into the portfolio.
“This keeps us very focused and forces us to sometimes make tough decisions,” Nash states. She also notes that the balance between dividend growth and dividend yield stocks varies, but in recent times has been roughly equal, perhaps slightly favouring yield.
Value everywhere… but will it be valued?
More than half of the 40 stocks are trading below market P/E multiples, with some in single digits. “P/E multiples in Japan used to be in the 70s in 1987 when I began investing here and today they stand on average below the US market. There is value everywhere in Japan these days, which helps us run the portfolio without any sector weightings.”
Nash also highlights that within her investment universe there are some stocks which are priced for bankruptcy. “This is just kind of a favourite theme of ours,” she explains. “We hunt for companies which are profitable and with net cash but trading below book value, in other words in other markets they would appear priced for bankruptcy.” An example in recent history was Fujifilm, which had net cash on its balance sheet but which traded at just 0.9 times the company’s book value.
“This was partly the Kodak effect,” she reports. “Kodak went bankrupt, but Fujifilm survived because it was very focused on the future. It had invested in innovative technologies and had diversified into pharmaceuticals,” Nash explains. “The president of Fujifilm later wrote a book on how it survived while Kodak passed away. It is a core lesson for us as fund managers and a main focus to spot such undervaluation.”
With value ubiquitous it seems, why has the fund underperformed a big run-up in the Japanese market in the past 18 months? “Not all in our garden is rosy,” Nash concedes. “The fund is currently trading on an underlying yield on the portfolio of 2.6% and with dividend growth of about 15%, translating to a dividend of about 2% after fund expenses. That is good, but the price performance of the fund has been disappointing since early 2016. Our mission now is to turn that under-performance around.”
Nash accepts the notion that the fund focused too much on value, whereas value has not been the priority for investors it seems, especially as since 2008 more and more buyers have switched from bonds to equities.
“These investors actually do not seek out dividends. They seek out companies that forecast the strongest earnings streams,” she explains. “They have been prepared to pay high multiples to book value for high and high forecast ROE rather than hunting out value.”
Value will prevail
But Nash believes that value investing is on the point of returning to Japan, as central banks around the world gradually tighten their grip on easy money. “We are starting to see value outperform again as accommodative central bank policy globally contracts,” she claims.
Nash turns to that bellwether Japanese name Toyota to illustrate how widespread value is in Japan. “This is an excellent example of how ridiculously cheap Japan can be,” she claims. Toyota Industries is a textile company that spawned the Toyota Motor behemoth and still owns a stake in the vehicle group. “Having reinvented itself a few times, it is now the biggest maker of forklift trucks in the world,” Nash explains. “Stocks of its main German competitors have performed very well – the leading names trade at around three times book value – but Toyota Industries has underperformed and recently traded at less than book value. Moreover, it was valued at less than the shares it holds in Toyota Motor, implying that investors could buy the world’s biggest maker of forklift trucks for a negative value. Additionally, they make compressors for automotive air-conditioning, another good business.”
The weight of evidence, therefore, leads Nash to conclude that value must out. “This is a great company and they have been growing the dividend,” she says. “I think we are reaching the point now where many valuations are so ridiculous. We are certainly adapting, fine-tuning our strategies all the time, but we firmly believe in the value play
in Japan.” Given Japan’s many false dawns since December 1989, perhaps now is the time for normalisation. Time will tell…