The ongoing battle with assessing opportunities in Japan has always been about balancing the pros and cons at both a market level and individual company level.
As a whole, the market seems to be pricing in an overly optimistic outlook, even after the January correction.
While valuations are not excessive, they seem to be pricing in a scenario whereby earnings flatten out and possibly rebound in the near term.
The market price/earnings ratio (PE) is where it was five years ago and looks neither cheap nor expensive.
However, the external economic environment is weaker today than it was then so the market should be trading a reasonable discount to history.
It is likely that the market will lag global indices over the next twelve to eighteen months from the growing list of macro uncertainties and structural challenges facing the country.
The earnings outlook similarly appears grim. Earnings have declined 17 per cent in the last six months and while the earnings estimates for the Tokyo Stock Price Index indicate an earnings per share (EPS) growth of 2.24 per cent for the next twelve months, it is still well below the 9.22 per cent growth expectations for the MSCI World Index.
Frustratingly, when it comes to evaluating the Japanese equity markets, it seems like the negatives far outweigh the positives.
The good
The political environment seems to be the biggest source of optimism in Japan.
With Prime Minister Shinzo Abe poised to control both houses of parliament, he may be able to introduce badly needed reforms around pensions and immigration as well as delaying or cancelling the consumption tax increase due to be introduced in April 2016.
Given the relatively fragile state of the Japanese consumer, the consumption tax hike from 8 per cent to 10 per cent would put a dent in consumer confidence and the economy as a whole.
After many years of hoarding cash and generating poor returns on equity, Japanese companies have been catching up to global peers in the past two years.
In that time, the return on equity from these companies have improved from 6 per cent to 8 per cent which is commendable but still far below their US and European peers at 16 per cent and 11 per cent respectively.
Unemployment rates are also at record lows despite wage growth being absent.
The bad
As an economy driven by the domestic consumer and global export markets, the Japanese economy remains sluggish and likely to grow at less than 1 per cent in 2016.
Economic growth will be impacted by the cutback in spending by the larger and older subset of the consumer economy, which may be further dampened by the impending 2 per cent consumption tax hike.
Similarly, the recent collapse in economic growth in emerging markets, especially China, and the decelerating growth trajectories of major developed economies will hurt Japan.
While corporate Japan gained momentum under the government’s directive to improve their corporate governance practices, lifting return on equity (ROE), improving disclosure and adding independent directors, many companies may start hoarding cash as they face earnings pressure.
This might cause a reversal in the increases to ROE and cause stock prices to drop.
Japanese companies have also become increasingly dependent on the Chinese economy as an export market and to grow their local presence in China.
This means that companies are not only exposed to the slowing Chinese economy but are also exposed to the corporate governance challenges that come with doing business there.
The ugly
Japan still has various structural challenges that will continue to weigh on the economy for the foreseeable future.
Its rapidly ageing population will place pressure on the economy as a whole as the ratio of workers versus retirees decreases and the strain on the pension system increases.
Meaningful immigration and pension reform will be critical to addressing this.
Immigration reforms will not pass without some difficulty with the bulk of the active voting population opposed to immigration.
Discussion at the Daiwa Investment Conference raised the possibility of introducing a guest worker visa program to allow guest workers to enter Japan on working visas and work in remedial lines of employment such as housekeepers and maids to allow Japanese women to join or rejoin the workforce to offset the impact of the ageing male workforce.
The competitive advantage that Japanese companies had, particularly in the auto and electronics sectors, has dissipated.
While the competitive global stage has been partially responsible for this, so too has these companies’ sluggishness in product development and innovation.
Sony, for example, has had its position as a leading franchise in consumer electronics decimated by Apple and Samsung because it failed to invest in new product development.
As such, equity investors are finding it increasingly difficult to identify ‘true global leaders’ in the Japanese market.
Japanese companies generally have low levels of profitability and against global peers, don’t stack up. A number of contributing factors include:
- Putting employees and customers ahead of shareholders, often employing large workforces and keep them employed until retirement
- Sacrificing price and margins to retain market share during increased periods of competition, which has a dilutive impact on returns
- Older management teams can impact on the appetite to innovate and compete
- Failing to innovate to maintain their ‘innovative edge’
As an equity investor, it is difficult to get enthused about the Japanese equity market and we expect it to underperform in the next twelve months.
It is best to continue to watch the market closely and capitalise on opportunities to capture better quality Japanese names at more attractive valuations.
Ned Bell is the chief investment officer of Bell Asset Management.
