When Japan has hit the headlines this year, it’s largely been for short-term factors. A change of prime minster, the postponement of the Tokyo Olympics and a relatively successful handling of the Covid-19 crisis are all noteworthy. But there’s a longer-term story for equity investors that has been temporarily eclipsed by these events.
As far as the current pandemic goes, we think the second quarter will prove to have been the trough in terms of company earnings. Market expectations are for earnings to pick up from Q3 onwards, but this is already largely reflected in valuations.
Instead, we think there are longer-term structural reasons to be positive about Japanese equities. Specifically, we see numerous companies with the potential to improve their return on equity (RoE).
RoE is a profitability measure. It reveals how much profit a company earned in comparison to the shareholders’ capital retained in the business. A higher RoE typically translates into higher returns for investors. It is a very useful measure for comparing companies to their peers operating in the same industry.
Japanese companies have already made strides when it comes to improving their RoE. The chart below shows the spread of RoE for Japanese companies in 2013 (blue bars) and in 2019 (green bars).
As we can see, there has been a shift over time towards the right hand side of the chart, with more companies in those higher RoE buckets in 2019 than in 2013. But there’s still a long way to go for many companies.
We think there are several structural shifts that can help propel further RoE improvements: better corporate governance, a focus on shareholder returns, and improved productivity. Progress in these areas in Japan remains intact, despite the pandemic and the change in prime minister.
Improved corporate governance leads to better management decision-making
Broadly speaking, effective corporate governance is about putting in place the right policies and criteria to enable the long-term success of a business. Japan has long been criticised for relatively weak corporate governance that has allowed poor capital allocation to persist within companies. This is changing.
We can identify numerous companies across a swathe of different industries who are taking steps to deal with underperforming parts of their operations. This could mean restructuring that area in order to improve performance, or it could mean exiting it entirely.
Focusing efforts on the most successful parts of a business, and either improving or exiting underperforming areas, is a key step towards achieving higher RoE.
Increased focus on shareholder returns
Changing corporate governance trends are also seeing company management pay greater focus to shareholder returns, in the form of dividends or share buybacks. The fact that Japanese companies are generally in good financial health compared to their counterparts in the US and Europe should help this trend to continue. This return of excess capital to shareholders is an important element in the structural improvement in RoE that we expect.
The chart below shows how, coming into this year, Japanese companies buying back their own shares were less financially stretched than US or European companies doing the same. These lower levels of debt compared to profits are allowing Japanese companies greater financial flexibility when it comes to maintaining shareholder returns, even as the pandemic dents earnings.
Our view is that share buybacks may become less prevalent due to the pandemic, but shareholder remuneration remains an important theme. On our analysis, company profits are likely to be c.20% lower this year than last, but dividends look set to fall by only 5-10%.
Higher capital spending supports productivity improvements
The solid financial health of Japanese companies also stands them in good stead when it comes to spending on productivity improvements.
The chart below shows how companies’ intention to invest has increased over the past decade. Importantly, this includes spending on IT investment aimed at improving productivity, which we expect to remain relatively robust even if broader capital expenditure expands at a slower pace as a result of the pandemic.
Importance of being discerning
Although we expect the trend towards higher RoE to drive overall market valuations, in our individual stock decisions it is crucial to differentiate between leading and lagging companies. The best investment opportunities will be in those companies who not only have the scope to improve their RoE, but who are actually taking the steps to do so. Our extensive programme of individual company meetings and discussion with their management teams is a key element in our ability to differentiate between companies.
Some companies are already well on their way to improving their returns, but this may already be reflected in share prices. Others may be lagging behind. For us, the sweet spot will be those companies where we can see realistic scope for improvement and where this is not yet priced in to the shares.
We also note that Warren Buffett – renowned value investor and CEO of Berkshire Hathaway – bought several stakes recently in a number of Japanese trading companies. This may be simply a tactical move to benefit from a cyclical recovery and the relatively attractive yields offered by Japanese firms. Nonetheless, it has highlighted the potential opportunities that Japan offers for investors and demonstrates that Buffett sees undervalued opportunities in Japan, as do we.