More than three and a half years into Japan’s efforts to revitalize its economy, the debate still rages—do depressed valuations represent a bargain for shrewd investors, or are these companies cheap for good reason? The consensus view, given the relatively low returns on equity in these investments, has been the latter. As a result, TOPIX has traded at a discount compared to other developed indexes.
A Temporary Setback?
Source: Bloomberg L.P., 6/30/2006 to 6/30/2016
*Returns shown are dollar denominated.
Past performance does not guarantee future results.
Stock market dynamics in Japan are changing, however. Global investors have shown interest in the recent past and could again if the Yen weakens. The chart shows that the total return for the TOPIX bottomed against the S&P 500 Total Return in late 2014 and rebounded in 2015 when the currency softened. It has faced setbacks in 2016 as the Yen has appreciated, but we believe significant upside remains overlooked.
Our confidence was reinforced by victories for the ruling party in the July elections. We view the results as validation that the country is committed to Prime Minister Shinzo Abe’s blueprint for growth.
As the timeline shows, the past several years have seen significant developments in Japan’s effort to ignite its economy. The Bank of Japan has followed its QE-like program of buying government bonds to increase the monetary base and fuel inflation for more than three years—increasing its commitment in late 2014. The efforts have resulted in an additional $250 billion of cash annually looking for a home. As was the case when the U.S. Federal Reserve used its QE program to increase liquidity by buying bonds, some of the money has found its way into equities. However, the flood of excess currency has been less effective in spurring inflation to reach the country’s goal of 2%.
With inflation a crucial link in reinvigorating the economy, we believe the next step to spark rising prices will be additional stimulus through infrastructure projects or direct payments to lower income workers. In either case, the windfall could lead to inflation as more dollars chase goods, and the domino effect of increased spending and economic growth could follow.
Demographics are often cited as a structural headwind for Japan’s economy. Yet, while they create challenges for consumption growth, we believe they are a potential underappreciated asset for a nation trying to raise prices. Residents 65 and older are the fastest growing group during the last six decades. That translates to fewer new entrants into the employment pool. The lack of replacement workers is already emerging. As you can see in the chart, the number of job offers per applicant for part- and full-time positions is greater than one. The upshot is that fierce competition for qualified workers should translate to higher wages. While domestic consumption is likely to fall as workers age, more than one-third of Japan’s gross domestic product is tied to government spending and exports—neither of which are expected to decrease.
Job Offers on the Table
Source, Bloomberg L.P., 1/31/2003 to 5/31/2016, seasonally adjusted
We expect stimulus spending and wage inflation will generate growth and build on progress. As we’ve noted in the past, Japanese companies are transitioning to a shareholder friendly stance. For example, the Nikkei 400 Index, designed to be a prestigious subset of the main Nikkei, requires constituent firms to adopt certain shareholder friendly policies such as greater transparency and improved corporate governance. In addition, firms must achieve certain levels of return on equity, which solves one of the reasons global investors have shunned Japan. What many observers fail to mention is the fact that equity returns are, for many companies, diluted by large cash holdings on the balance sheet. Because so many firms were impacted by imploding banks in the 1990s, Japanese companies tend to hold much more cash than their American counterparts. That may be changing, with Nikkei 400 membership as one impetus and a mergers and acquisitions landscape likely to pick up.
One of Japan’s most reclusive companies, Fanuc Corporation (6954 JP), a manufacturer of automation systems, equipment, and robots, announced just last year that it is considering ways to increase shareholder returns. This was an amazing announcement since the company did not have an investor relations department nor hold any regular analyst meetings. The company holds cash and equivalents in excess of annual revenue. The stock price jumped by double digits that day. More recently, Tokyo Electron (8035 JP), a manufacturer of semiconductor equipment, joined the bandwagon to boost shareholder returns. Following its failed merger with Applied Materials (AMAT), it raised its projected dividend payout and completed its share buyback plan, repurchasing nearly 9% of its outstanding shares. These are just two examples of corporate behavioral changes benefiting shareholders that are slowly beginning to spread over the rest of corporate Japan.
We believe additional actions by the Japanese government will provide a brighter future for corporate balance sheets. The government’s pro-growth stance led it to cut corporate tax rates to about 35% and Abe plans to continue to lower the levy to less than 30 percent over the next five years. The government also postponed raising its Value-Added Tax (VAT) by more than two years out of fear that it would crush any budding economic growth.
Lower taxes should translate into higher earnings and may also spill over into higher wages for employees. As shareholders and workers benefit from the eased tax burden, we believe they will spend more and the economy will continue to expand. This virtuous cycle could provide an extended period during which investors should benefit.
With regard to our own exposure, Japanese allocation in the Heartland International Value Fund is slightly below the benchmark, the Russell Global® ex-U.S. Small Cap Index, at 21.6% for the Index versus 20.8% for the Fund, as of 3/31/2017. Japan is our largest single country exposure. We remain optimistic about Japan as a whole, and the prospects of the specific companies we’ve chosen for investment.