The Bullish Case for Japan
The path to investment hell is paved with naive overlay charts. That being said, there is a legitimate relationship between the performance of the Japanese stock market and the direction of the USDJPY (chart 1). In contrast to the period immediately after 2011, and the start of Abenomics, the recent phase has been driven more by dollar strength rather than yen weakness. Moreover, the case for Japanese equity out performance is considerably broader than a simple currency depreciation story that it was in 2012. Of course, the reform elements of the three arrows were mixed. Although from a stock market perspective Japan has seen a convergence in ROE. There are a few key points to note;
First, Japanese companies (in aggregate) have the highest operating leverage to global growth (beta of EPS to global IP) of any major market. When US growth is very strong that tends to support a rise in global final demand, risk perceptions, dollar strength relative to the Japanese yen and rising Japanese EPS (chart 2).
Second, Japanese equities will likely prove more defensive in a rising rate (liquidity withdrawal) environment because they have the lowest financial leverage of any major market. Net debt to EBITDA is negative in Japan (in aggregate) which implies that companies have net cash on balance sheet (chart 3). That is in contrast to “growth” sectors of the US market which have been driven by plentiful liquidity, leverage or hopes and dreams of future cash flows. It is an obvious point, but highly levered entities will be more vulnerable to an increase in the cost of debt. It also suggests that Japanese companies could boost returns on equity via an increase in leverage. To be fair, excess cash of balance sheet might signal an absence of growth opportunities.
Third, a key factor that has weighed on Japan this year has been the weakness in China. According to Credit Suisse, Japan has four times the exposure to China of the United States. As we have noted recently, the rate of change in China’s credit growth has probably near a trough and should start to improve again over the coming months.
Fourth, the strongest case for Japanese equities is the valuation discount both on an outright and relative basis. There has been lots of analysis over the years on Japanese “deflation” and under-performance over the past few decades. However, from our perch the crucial reason for Japan’s under performance was simply the valuation starting point. Well after the bubble had burst in 1993, Japan’s TOPIX Index still traded at over 100 times earnings on a trailing basis. That contrasts to the current valuation which is 15 times forward earnings and a 20% discount to world equities. It is also interesting that the price performance on Japanese equities has actually lagged underlying earnings when indexed back to 2006 prior to the last crisis (chart 4). That is unusual on a global basis. In most markets price is more optimistic relative to underlying earnings.
In conclusion, Japanese equities have material upside in a macro expansion phase given; 1) high operating leverage; 2) low financial leverage; and 3) inexpensive valuations which ought to benefit in a rising rate and liquidity withdrawal environment. Similar to Asia Pacific more broadly, Japan would benefit from improved growth and risk perceptions on China. From a domestic standpoint, additional fiscal stimulus might provide some further support. The final point to note is that the scope for alpha in Japan is high given analyst coverage is extremely low. The leading 3,700 companies have on average only seven analysts covering them. Despite it being the second-largest single country equity market in the world, 40% of Japanese companies have no analyst coverage at all. From a behavioural perspective, that suggests an element of revulsion, capitulation in beliefs or that many investors have simply given up on the market.