By Michael Stanes, Investment Director at Heartwood Investment Management
Japanese equities have surged ahead since the start of this year despite lacklustre growth. Economic trends are starting to gather momentum more recently, but what is enthusing investors more is the perception that Japan is changing.
As careful as one has to be in using this trite phrase…developments in Japan appear to be different this time. We are optimistic that perception may actually be morphing into real change. But rather than being driven by top-down government reforms, an objective supposedly to be filled by the 'third arrow' of Abenomics, changes are afoot at the corporate level due to an increasing focus on shareholder rights.
Japan's first corporate governance code came into effect on 1st June with the intention of improving transparency and accountability to shareholders, such as the appointment of independent outside directors. Potentially, it represents a watershed moment because although the code is voluntary, companies are expected to be 'shamed' into following best practice through the tool of moral suasion.
The pressure to conform is being seen in other areas too as the accepted norms are reshaped. The recent launch of the JPX-Nikkei 400, dubbed 'the shareholder friendly index' due to its strong focus on return on capital, is already encouraging Japanese corporates to strive towards being part of the 'good company club'. There have also been more examples of shareholder activism to improve shareholder returns. Japan's largest institutional investor Nippon Life has stated that it would consider exercising voting rights for companies that fall short of expected standards, including delivering an average of 5% return on equity over five successive years.
All of these developments form part of a broader effort to unlock shareholder value. Corporate Japan is in relatively rude health, owing to years of balance sheet repair and deleveraging. The debt to equity ratio of non-financial Japanese corporates stands at a 20-year low [Source: Barclays] and that downward trend has continued over the past year, in contrast with the US. Cash balances have increased significantly where the average Japanese company sits on 20% of its market value, largely due to capital expenditure restraint and improving profitability -Japanese companies are the most profitable in 30 years.
And shareholders are starting to be rewarded. Dividend pay-outs and share buyback activity exceeded expectations in May. Share buybacks reached nearly ¥1 trillion, a record for a single month. Combining dividends and buybacks, Japanese companies continue to yield considerably less than US companies. However, US companies are paying out over 100% of their earnings in the form of dividends and buybacks. The average Japanese company pay-out ratio is just 50%.
With his popularity highly correlated to the performance of Japanese equities, Abe also appears to be latching onto the agenda of shareholder rights. It is increasingly directing the 'third arrow' of his economic policies, where he has a better chance of demonstrable success.
All of these trends raise our confidence that the positive equity momentum can be sustained, in a market where foreign investors continue to remain underweight, although they are beginning to get interested. Reassuringly, economic trends are also starting to turn gradually, including a recovery in manufacturing, an improving labour market and higher levels of bank lending. Markets are overlooking the fact that structural reforms are proceeding at a frustratingly slow pace, but instead are focussing on companies' efforts to create shareholder value. Of course, there is a danger that this momentum could be vulnerable in the short term, but the longer-term shift appears to be one of a strengthening Japanese equity market.
In terms of our own position in Japanese equities, we held a zero weight position for more than 18 months until July 2014. We are now committed to an active overweight in Japanese equity, currently on a 50/50 hedged basis. We also believe that the Japanese yen is beginning to reach interesting levels – the real effective exchange rate is at its lowest since the early 1980s – prompting the Bank of Japan's Governor Kuroda to take the unusual step of expressing concern that the valuation of the yen is too low.