• Recent economic readings for Japan have fared better than consensus expectations. Also, various positive catalysts – Asian export recovery, global semiconductor upcycle and positive progress for trade talks – for rebound in economic condition are emerging.
• Over the past quarter, Japanese equities have been positively driven by a global flight to value, sparked by sustained mixed signals in the market. We believe the value run will likely continue.
• Corporate fundamentals improved notably after Abe came into office in 2013. Margins for corporates are near cycle high while debt levels has sunk steadily. Reforms in corporate governance and improved profitability has also drove up ROE.
• Japanese companies, at the current juncture, are not only more profitable but also use capital more effectively as they (i) raised dividend and payout ratios, (ii) create value through more M&As and (iii) use share buybacks to return capital to investors and support EPS.
• Japanese equities offer potential upside of 18% by end-2021. It also offers the combination of reasonable valuation, robust corporate fundamentals and the potential for better-than-expected economic growth. Overall, we maintain our star rating of 3.5 stars “Attractive” for Japan.
Flight to value fuel surge in Japan equities
Over the past quarter, Japanese equities (as measured by Nikkei 225 Index) have been positively driven by a global tilt towards value. Rising more than 7% since our update in late-June ("Japan: A Value Pick For The Long Term"), Japan was the top-performing market in the third quarter this year.
After plunging in August, Japanese equities rallied strongly upon news of a resumption in trade talks, while also buoyed by a rotation to low-valuation markets from global investors. We believe the rally is representative of a global flight to value, sparked by sustained mixed signals in the news flow and heightened volatility in global markets.
This is also evidence in the reversal of value-momentum performance differential across global equities. The measure, which compares the factor of value against the factor of momentum, has started to reverse sharply after August this year, despite lagging significantly over the last three years (Chart 1).
Such reversal hints that global investors are increasingly willing to pay a larger premium for safety, amid a macroeconomic environment where global growth is slowing and risks are rising. The safety premium is evident in the outperformance of bond proxies like consumer staples and utilities this year thus far.
With valuations (both price-to-earnings and price-to-book ratios) of Japan equities still relatively low on a historical basis, we believe a sustained shift towards value will likely continue and be highly beneficial in lifting prices of Japanese equities ahead.
(Related Article - 3Q 2019 market report card – Top performing markets)
Chart 1: The global rotation towards value and safety fuelled surge in Japan equities after August this year
Economic prospect remains dim but catalysts for recovery are emerging
Economic growth is expected to remain muted amid the trade-dispute overhang. As an export-led economy, Japan’s growth is closely tied to global demand. The escalation in trade dispute has accelerated the contraction in global demand, which in turn hamstrung its economic expansion.
To make matter worse however, Japan is also stuck in a geopolitical headlock with its closest neighbour and trading partner South Korea, which arose from their historical differences.
Since our update in late-June, Japan has imposed stringent restrictions on several high-tech exports to South Korea in July and downgraded South Korea’s status as a trusted trading partner in August.
South Korea, on the other time, retaliated through boycotts of Japanese products, such as beer and cars. However, we do note that lately, there has been steps taken by both side to quell the dispute and the possibility of a resolution has risen.
Despite recent negatives, we believe various positive catalysts for rebound in economic condition are emerging – Asian export recovery (trade diversion from the one-off trade shock), global semiconductor upcycle, and US-China trade talk progression (with the likelihood of a resolution in coming weeks).
At the same time, hard economic data released in the second half of this year have been surprising positively, performing better than what economists have previously forecasted (Chart 2).
(Related article: Asia: Export recovery inbound)
Chart 2: Economic readings in Japan have come up better than expected in the second-half of this year
Corporate fundamentals have improved tremendously
Not just on the economic front, the corporate fundamentals across Japan companies have improved tremendously over the last few years. A closer look at chart 3 shows that margins for Japanese corporates remained healthy.
Structural shifts caused by Abenomics (push to improve profitability and corporate governance) in after 2013 and robust economic growth have elevated profit margins.
Despite stagnating over recent quarters due to external headwinds from the trade dispute, profit margin remain resilient and elevated. Additionally, debt levels for Japanese corporates have plunged steadily in recent years and debt burden on profits are low.
Similarly, reforms in corporate governance and improved profitability (discussed above) has drove up the return on equities (ROE) in Japanese corporates. A higher ROE generally suggest better use of capital for a business. While Japanese companies has a lower ROE than its US and European peers, the gap has narrowed notably since mid-2016.
When look across the current economic cycle, Japanese companies, on aggregate, are not only more profitable than before but also use capital more effectively to generate profits. Fundamentally, this put Japanese equities at a more attractive position historically.
Chart 3: Profit margin and ROE jumped after Abe came into office
Companies are cash-rich and more efficient with capital
In the aftermath of the global financial crisis, cash reserves for innumerate Japanese companies skyrocketed (Chart 4). This was driven by a recovery in corporate earnings and initiatives from Japanese corporates to buffer their reserves as a precaution against future crisis.
The amount and rate of cash accumulation by Japanese corporate was significant and also a distinguishing factor when compared against its developed market peers.
It is prudent for corporates to hold a certain amount of cash for business operations and financial reasons. Nonetheless, holding an excess of cash (Japanese corporates in the past) can be unfavourable to shareholders as it means capital are deployed less efficiently and therefore, value creation for shareholders will be eroded.
In recent years, Japanese corporations have made significant efforts to deploy their cash to create value for the firm and shareholders. The reforms in corporate governance, championed by Abe’s administration, has improved capital efficiency and essentially, Japanese companies are spending their capital more effectively which benefits shareholders.
We continue to believe this improved focus on capital efficiency has meaningfully boosted earnings quality of Japanese companies.
Chart 4: Cash reserves for Japanese companies skyrocketed after the GFC
Greater dividend payout expected to continue
A quick look at chart 5 shows that Japanese corporates have significantly increase their dividend payouts. The combination of strong profit margins, ample cash reserves and corporate governance restructuring (by Abe’s administration) has drove companies to pay out more cash as dividends.
Moreover, since the GFC, Japanese corporates have deleveraged heavily (unlike their DM peers) and this leaves them ample cash to distribute as dividends.
This is reinforced by a rebound in dividend payout ratio for Japanese companies (Chart 6). While, the payout ratio has steadily risen it is still below its historical average for the current economic cycle, and this means dividend payout has room to increase.
In our view, the steady growth trend in dividend payouts suggest that Japanese companies have gotten used to the idea of paying out cash as dividends. As such, shareholders are getting a greater share of payouts and we anticipate this trend to continue, thereby boosting the attractiveness for Japanese equities
Chart 5: Companies have been and are expected to pay out more dividend
Chart 6: Payout ratio for Japanese companies has also risen steadily
Creating value through M&A
Another area that Japanese companies have accelerated the usage of their cash reserves is through mergers and acquisitions (M&A). After Abe came to office in 2013, M&A activities and value of transactions have climbed tremendously (chart 7).
Not only did we observed a surge in domestic M&As, overseas M&As (Japanese firms acquiring companies overseas) have accelerated. As reported by the Japanese Ministry of Finance, the US has been the primary destination of such activities.
M&As, when executed right as a corporate strategy, can boost a company’s profitability in the long run through a combination of cost-cutting and revenue-boosting strategies.
Moreover, the Japanese government also supports M&A activities and through several changes in the 2017 tax reform, help boosted M&A activity. As such, we believe M&As are beneficial for Japanese equity’s as a way to boost earnings growth in the longer term.
In our assessment, we believe the uptrend of M&As will likely continue due to (i) Japan’s plight of a rapidly ageing population and shrinking domestic market as well as (ii) Japanese firm’s abundance of cash reserves.
Chart 7: M&A activities have accelerated in recent years
Buybacks to support Japanese equities
Buybacks activities in Japan has risen in the last few year, reaching record levels post-GFC (Chart 8). At the end of 2018, the amount of share buybacks reached topped 6.5 trillion yen, exceeding the record in 2015. 2018’s value of buybacks announced was a far cry from 2009’s value of less than 1 trillion yen.
Over the recent years, Japanese companies have particularly became more comfortable at the idea of buybacks. We are of the view that buybacks in Japan will likely rise moving forward. This is once again driven by the abundance of cash reserves, rising focus on capital efficiency and the pressure from the government and investors on capital allocation.
We note that there might be critics to share buybacks with regards to value creation for shareholders as excess cash could be deployed for capital expenditure or dividend. However, Japanese corporates have not only boosted dividend (as highlighted above) but also increased capital expenditure in recent years.
Therefore, Japanese companies have shown to allocate capital efficiently and buybacks are just an additional way to return capital to shareholders.
In our view, this makes Japanese companies attractive as capital from cash reserve gets return to investors, allowing them to reinvest elsewhere. Additionally, it allows Japanese companies in to enhance EPS growth and ROE.
Chart 8: Share buybacks reached post-GFC high in 2018
Valuation remains reasonable despite recent stock rally
Corporate earnings tend to be procyclical for Japanese firms than DM peers due to its exposure to the global demand and therefore, Japanese equities have a higher earnings volatility. As such, headwinds that drag down global demand can heavily affect earnings of Japanese corporates, while tailwinds which supports global demand will do the opposite.
Looking ahead, we see rising macro tailwinds supporting global demand, which can similarly drive upwards revision in earnings estimates for Japanese corporates. We believe the three primary tailwinds will be the (i) rising possibility of an interim resolution in trade talks, (ii) a rebound in the electronics and semiconductor demand and (iii) improvement in China’s growth data.
Earnings expectations for the current quarter are already low and therefore, any unexpected positive beat in earnings could surprise investors from a contrarian view point. Therefore, we have become more positive on the earnings outlook for Japanese corporates.
While Japanese equities have risen strongly (more than +7%) since our last update in late-June, it currently still trades below our fair valuation of 18.0X allotted to the Nikkei 225 Index. Such undemanding valuation provide ample room for positive re-rating, while limiting the downside price risks from the heightened market volatility.
Simultaneously, we see increased likelihood of key drivers for expansion toward our fair valuation in Japanese equities ahead:
(i) Near-term materialisation of positive catalysts such as an Asian export recovery, global semiconductor cyclical upswing and positive resolution in the US-China trade talk progression.
(ii) An extended global quality (defensive value) tilt – with investors flocking towards assets with low volatility, low beta & resilient profit growth – amid a macro environment characterised by heightened volatility.
(ii) Cash-rich Japanese corporates returning capital to investors either via buybacks or greater dividends payout or both.
Using a fair value PE ratio of 18.0X on our estimated end-2020 and end-2021 earnings-per-share (EPS), we derived fair prices of 25,290 and 27,530 respectively. This translates to a potential upside of 18% by end-2021, which is one of the highest among developed markets under our coverage.
Chart 9: Despite the recent surge in share prices, Japanese equities still trade below fair value
Table 1: Potential upsides of investing in Japan equities from today
| Nikkei 225 Index | FY2018 | FY2019 | FY2020 | FY2021 |
| Price-Earnings Ratio (X) | 17.1 | 16.8 | 16.6 | 15.2 |
| Expected Earnings Growth YoY% | -2.1% | 1.7% | 1.8% | 8.9% |
| Earnings Per Share (EPS) | 1357.8 | 1380.4 | 1404.7 | 1529.5 |
| Projected
Fair Price (Based on Fair PE ratio of 18.0X) |
- | - | - | 27,530 |
| Potential Upside from Today (%) | - | - | - | 18% |
| Source: Bloomberg,
iFAST estimates. Data as of Nov 2019. |
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Japan: A value pick for the long-term
At the current juncture, Japanese equities offer the appealing combination of a reasonable valuation, improving corporate fundamentals and the potential for better-than-expected economic growth.
Within the developed markets peers, we prefer Japan over Europe and US, as it offers one of the highest potential upsides among developed markets under our coverage. Overall, Japan offers better potential earnings, profitability story and more compelling undervaluation.
Hence, we maintain our star rating of 3.5 stars “Attractive” for Japan.
For those who seeks an active approach toward Japan equities, our recommended funds are the JPMorgan Funds - Japan Equity A (dist) SGD and United Japan Small and Mid Cap SGD.
Investors who prefer a passive approach can consider the ETF for Japan, iShares MSCI Japan ETF.
Chart 10: Nikkei 225 Index performance and underlying earnings have been on a consistent uptrend after Abe took office in 2013.
The Research Team is part of iFAST Financial Pte Ltd.
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