By Andrew McCagg, Senior Client Portfolio Manager Nomura Asset Management U.K.
Historically, Japan has been a difficult market for many overseas investors to fully comprehend, with several misconceptions about the Japanese corporate sector likely weighing on decisions to initiate or increase allocations. “Why should I invest in a market with little to no economic growth?” is still one of the most frequently asked questions about Japan, even though the Japanese equity market has become a healthy one driven by corporate fundamentals and earnings since valuations normalized post Global Financial Crisis (Chart 1), and a sizable gap between corporate and economic performance has grown over the last 30 years. In fact, recurring profits have nearly tripled since the 1990’s, while Japan’s nominal and real GDPs have essentially been flat (Chart 2).
A low Return on Equity for the market overall has been another common reason given by investors for not being able to fully buy into Japan. While it is true that a large percentage of the Japanese companies listed on the TOPIX index have low ROEs, that doesn’t mean there isn’t an abundance of investment opportunities in the Japanese equity market. Only 21% of TOPIX constituents have an ROE above 15% compared to 58% of stocks listed on the S&P 500, but because the TOPIX is a much broader index, there are actually 378 companies with an ROE above 15% listed on the TOPIX compared to 275 issues for the S&P 500 (Chart 3). Additionally, the companies with high ROEs in Japan are trading at much more attractive valuations than those in the US (Chart 4), providing investors with a sizable universe of cheap quality stocks.
More importantly, perhaps, Japan’s capital markets are modernizing, and even companies with lower ROEs may present attractive investment opportunities as corporate governance reforms and increased engagement activity continue to facilitate positive changes in corporate attitudes and improved capital efficiencies. Shareholder returns, which we believe is a key indicator of this change, have already doubled from 10 trillion JPY to over 20 trillion JPY since 2013, but there is still plenty of room for further growth. Nomura Asset Management will look to help accelerate these changes and shareholder return trends through active engagement that leverages our position as a leading presence in the Japanese equity market.
In addition to the above, there are many shorter-term reasons to take a closer look at Japanese equities now. The Japanese market is trading at its most attractive valuations relative to global equities in 50 years, and the real effective exchange rate shows the Japanese yen is even cheaper than in 1985 before the Plaza Accord. Inflation in Japan has risen to the 3% range, but the BOJ has maintained a unique position amongst central banks of developed markets where monetary policy will likely remain accommodative until at least early next year. A potential global economic slowdown will obviously impact Japanese equities, but the expected recovery in domestic consumption and the full fledged re-opening of Japan are expected to help offset any expected downturns in the global macro environment. In the end, we believe there are many Japanese companies that are underappreciated global market leaders in key industries of the future.