Japan: New way of thinking acts as an additional share price driver

To date, the stock market in Japan has been supported by an expansionary monetary policy and a weak yen. Now these two share price drivers are joined by a third force: the growing acceptance of shareholder value thinking at the senior management level. 

The leading Japanese stock market Index Nikkei 225 has almost tripled in the current bull cycle, which started in March 2009. This may sound good, but it is not all that impressive compared with the S&P 500.  

Nevertheless, the Nikkei 225 is working to close the gap. Since November 2012, the Tokyo Stock Exchange has been the world leader compared to other big stock markets. This development is accompanied by the election of Shinzo Abe as prime minister in December 2012. Under the name “Abenomics” he pursues a program that includes as core elements a very expansionary monetary policy and a weak local currency.  

Among other things, the Bank of Japan pumps 80 trillion yen ($670 billion) annually into the bond market and the yen, which is headed for the fourth annual loss in a row for the first time in history, has depreciated against the dollar by 62 percent since September 2012. 

 

Inflation target has not been achieved yet  

Compared with the strong price gains on the stock market, the real economic effects have been far less convincing until now. In the first quarter, the economy has grown by 3.9 percent, but for the full year a significantly lower growth rate is expected. Also in recent years, the Japanese economy has recovered less than the economy in the United States. Most importantly, the measures were not successful in achieving the main goal of combating deflation.  

In April, the core inflation rate was just 0.4 percent. An essential component in order to speak of a real crack-up boom is therefore thus far lacking. As a consequence, the Bank of Japan in April had to postpone the time horizon for achieving its inflation target of 2 percent to the first half of the fiscal year 2016. This explains why 60 percent of the respondents in a survey conducted by AIMA Japan and Eurekahedge Japan expect additional monetary stimulus measures. This, of course, in return is followed by hopes for further stock price gains. 

The big question is for how long such a strategy can work – especially since the recovery comes with the price of a further growing public debt, which is already extremely high. Another critical question is whether, in the case of a further falling yen, the positive effects will continue to outweigh the negative ones.  

Patrick Artus, economist at Natixis, is looking at the interrelated effects with skepticism. “The depreciation of the yen is weakening the Japanese economy due to the negative effect of higher import prices on real income, which outweighs the improvement in exports,” he says. And Artus adds that this would only by corrected by a significant change to income distribution in Japan.  

The weakening of the economy pushes the Japanese authorities to conduct an expansionary monetary policy, which weakens the yen even further, resulting in a divergent dynamic. Moreover, this expansionary monetary policy is needed to keep long-term interest rates low despite the imported inflation resulting from the currency’s depreciation.  

A rise in long-term interest rates would be disastrous for Japanese banks, given their huge bond portfolios, which forces the Bank of Japan to keep long-term interest rates very low. It should also be remembered that many companies have moved their production abroad. In addition, a weak yen raises the price of the cost of energy imports, on which the country relies. 

 

Companies should rethink their position  

Also, companies do not behave according to textbook theories. Instead of spending their cash holdings, they hoard money. The liquidity holdings are at 210 trillion yen ($1.7 trillion), which constitutes wasted capital in a low interest rate environment. To really turn things around, other means are probably needed than those used until now.  

According to the AIMA Japan and Eurekahedge-Survey, 70 percent of Japan-focused investors said they favor structural measures, such as labor market reforms, liberalization of immigration policy and promoting a higher participation rate of women in the workforce. 

Abe has already pulled another arrow out of the quiver. This refers to the obligation that companies take corporate governance and shareholder value more seriously. This also applies for the return on equity of Japanese companies, which on average lags behind western companies.  

To implement such changes in a country like Japan, that is of the mindset that traditions still count for a lot, is difficult. But since new regulations, like a Corporate Governance Code, will help to enforce the change, a success this time seems more likely. 

Initial successes can already be observed, according to Kwok Chern-Yeh, head of Investment Management at Aberdeen Asset Management. “The percentage of companies with at least one outsider in the Board of Directors increased from 45 percent in 2008 to more than 70 percent last year.”  

Furthermore, Japanese share buybacks in fiscal year 2014 rose 85 percent year-on-year to 3.3 trillion yen ($26.9 billion). In the face of a relatively low payout ratio of less than 35 percent, there is also still a lot of room to increase dividend payments. Progress has been made in recent years at the level of profit margins. They have increased from a record low of 1.6 percent in May 2009 to a record high of 5.8 percent in December 2012. 

 

Encrusted structures  

The aforementioned Corporate Governance Code comprises five general principles: 1) securing the rights and equal treatment of shareholders; 2) ensuring appropriate cooperation with stakeholders other than shareholders; 3) ensuring appropriate information disclosure and transparency; 4) defining the responsibilities of the board; and 5) establishing a dialogue with shareholders. The directive aims to promote a healthy entrepreneurship and a sustainable growth and well as increasing the value of companies in the medium to long term.  

“One of the main reasons for our positive view on Japanese equities is the positive corporate governance development with greater focus on shareholder returns by Japanese companies,” says Gérald Moser, head of Equity at Credit Suisse. 

How much needs to be done to break up Japan’s encrusted corporate structures is also demonstrated by figures released by Deutsche Bank showing that the country has over 37,000 listed cross-company holdings, representing about 18 percent of the market held by listed companies. 

This is a big disadvantage, since, according to Deutsche Bank, firms that are part of Japan’s web of company cross-ownership post lower returns on equities, receive inferior valuations and show lower medium-term stock performance relative to non-cross holders. 

If Japanese companies can be pushed to improve corporate governance and to create added value in the interest of the shareholders, a sustainable stock price boost can be expected.  

Alex Treves, head of Japanese equities at Fidelity Worldwide Investment, is also confident. “In particular, the focus on a higher return on equity is justifying rising equity valuations.” 

Additionally, all that the valuation does not speak against higher stock prices. The price-earnings ratio based on the estimated earnings for the next 12 months is 16.1 according to Société Générale. That is a little bit higher than the 10 year average of 15.6, but other leading stock markets are not lower valued, and compared to the low local bond yields, Japanese stocks can even be considered cheap.  

With a fully intact long-term upward trend, the charts of the Japanese stock market indices also look promising. That means, everything is in place for further rising stock prices, should the local companies really decide to cut off old habits and open up to more corporate governance and shareholder value. 

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A visitor walks past a stock board at the Tokyo Stock Exchange. – Photo: Bloomberg
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