Observing Japan

On governance, the cost of monetary policy, scars and growth.

Introduction.

Every decade or so this analyst observes renewed enthusiasm for Japanese equities. The narrative generally starts with "I know Japan has disappointed in the past, but this time is different."

2023 did not disappoint. Most of the major finance papers argued the case for Japan. These reports are trying to make sense of a set of surprising events that few, if any, had pencilled into their marketing plans. They include an emotionally satisfying +37% price return and the spectacular inflows that followed.

The narrative supporting this enthusiasm turns on the cracking returns experienced, support from names such as Warren Buffet, vague gestures towards improving corporate governance and the return of inflation after a decade’s long absence.

I am always sceptical of simple narratives that brush aside complexity and nuanced debate. I do not claim to have "the answer". Rather, I will attempt to highlight more nuanced aspects of the debate worth considering.

The 1st cut.

The head-turning 37%+ returns that galvanised investors are in fact local currency return. Dollar investors would have done a only little better owning the S&P 500:

A 19.8% dollar return over the last year is nothing to be sneezed at given the rise in the global cost of capital. However, equity investors tend to underestimate the impact of currency, perhaps because the allure of their earnings forecasts allows them to ignore the ravages of currency devaluation on portfolios. 

I cannot comment on Warren Buffet's expertise in picking Japanese stocks, nor that of the legion of analysts now attending packed Tokyo conference venues. I do know the market very well and will point out one's ability to extract alpha form this market requires specialist knowledge and a solid sell-discipline.

Seasoned equity investors know that good governance turns on rather more than the size of a dividend cheque. They understand that globally competitive companies should be allowed to invest and grow, that middle of the road companies can improve shareholder outcomes by innovating, restructuring or returning excess capital and that uncompetitive companies should be disassembled.

Finally, the enthusiasm for inflation rising in Japan should be tempered by the reality of the rising global cost of capital and the need for real earnings growth to offset the ravages of the former in a self-sustaining way.

Related to considerations around the cost of equity, the Bank of Japan's program of equity purchases has left deep scars on the cross-section of equity risk-premia that investors need to consider. 

We need to talk about governance.

Good governance focuses on building durable businesses that optimise the outcomes of all stakeholders - not only shareholder pay-outs.

Unfortunately, all stakeholders are not equal. It is important that investors recognise that the batting order tends to shift over time. For example - In the 80's and 90's the shareholder nominally ranked high as trade liberalisation allowed management to optimise profits at the expense of employees, suppliers and the environment.

Today the batting order has shifted to favour customers, employees, supply chain and society (including considerations such as tax, community and the environment). A discussion of this shift is beyond the scope of this paper.

It is however important we acknowledge this shift to avoid biased conclusions.

Rather than take the ongoing reform of Japan INCs governance on face value, it is useful to consider what has been delivered. Once we understand the facts, we will better understand the investment opportunity and be able to place the narrative's claim in context.

Exploring the facts.

The appropriateness of a company’s pay-out to shareholders depends on its profitability, growth & investment prospects and its ability to match or exceed its cost of capital. Judging a company’s growth & investment prospects is a difficult matter. We could use analyst forecasts as a proxy, but this is a noisy signal.

We can however analyse the competitiveness of Japan INC (as defined in Appendix A) using objective measures of profitability and capital efficiency – that is, how much profits a company generates per unit of capital deployed compared to its peers. Appendix A outlines how I constructed and segmented the dataset used in this analysis using methods like those developed in the literature analysing the excess returns of “quality” stocks.

Specifically, competitiveness is measured by ranking a company’s Return on Capital (RoC) and Gross Profit Margin (GP%) relative to its global peers. These rankings are used to classify each company as either world class, competitive, also run or mediocre:

• Segment 1: World class companies have a RoC and GP% that in either the first or second quartiles.

• Segment 2: Competitive companies have a RoC in the first or second quartiles and GP% in the third or fourth quartiles.

• Segment 3: Also run companies have a RoC in the third or fourth quartiles and GP% in the first or second quartiles.

• Segment 4: Mediocre companies have a RoC and GP% that in either the third or fourth quartiles.

The relative competitiveness of Japan INC is summarised as follows:

Using this market segmentation, we see that 38.7% of Japan Inc is world class, a further 29.7% are competitive, 11.7% are also run and 19.9% mediocre. Given the preponderance of competitive companies, we should consider how this translates into shareholder pay-outs:

Pay-out ratios, measured as dividends plus buybacks divided by  free cashflow, are grouped by decile. E.g., a -90% ratio means a stock pays out 90% of its free cashflow.

From this dataset we learn that:

• About 24% of the sample pays out more than 70% of free cashflow through dividends and buybacks,

• 30% of the sample pay-out more than 50%, and

• 28% of the sample pay-out an amount despite having negative free cashflow.

There is clear contradiction here: whilst Japan Inc has an apparently world-class  competitive position, their pay-out levels leave much to be desired. We can shed some light on this by considering the debt levels of each of the four market segments:

The levels of gearing for Japan Inc is low. For example, most companies with a Return of Capital in quartiles one and two have debt-to-capital levels that range from 0% to 25% - the average is 20.7% across both segments. The greater reliance on equity funding suggests a relatively higher cost of capital than their global peers, with direct implications for valuations.

Increasing debt benefits shareholders if a company can generate more profits than its cost of capital in a sustainable way. The relatively low gearing levels we observe amongst profitable companies may therefore reflect either a) scepticism about the sustainability of profits or b) the residue of a deflationary mindset.

The consensus view is that low levels of gearing amongst competitive business is consistent with the latter argument. However, an entrenched belief that companies should be self-funding is not a necessarily and sufficient outcome of a deflationary shock. Observe, for example, the maintenance of relatively high levels of gearing amongst US companies during the last two decades.

We are now better placed to consider what constitutes appropriate governance and what role, if any, a higher pay-out ratio may play in each segment:

Segment 1

Stocks in this market segment are both relatively capital efficient and have competitive profit margins. It follows that shareholders will benefit most from efforts that grow free cash flow in a durable way and a reduced reliance on equity funding.

It is therefore interesting that the percentage of world class companies that pay-out more than 70% of free cashflow is about the same as that of the sample.

However, 45.7% of segment 1 companies have a negative free cashflow and a positive pay-out. Whilst investors tend to laud over the positive signal inherent in this practice, it is questionable at a time when the global cost of capital has increased significantly - especially when a company is engaged in a multi-year investment program.

Segment 2

Stocks in this market segment are relatively capital efficient but have uncompetitive profit margins. Shareholders in these stocks will benefit most from efforts that grow free cash flow or improve profitability – such as investing in plant & equipment, research & development or restructuring underperforming assets.

Segment 3

Stocks in this market segment are relatively capital inefficient but have competitive profit margins. In general, shareholders in these stocks will benefit most from asset sales and increased pay-out ratios.

For this market segment a significant commitment to shareholders should be expected. However, we find that the pay-out ratios of profitable companies are not significantly different compared to that of the overall sample.

Segment 4

19.9% Of the stocks in the dataset have relatively low returns and profit margins. For these stocks the available remedies include asset sales, delisting or a sale of the business and shareholder pay-outs are of secondary importance.

A plot of the differences - Each segment's Pay-out ratio less the Sample Pay-out ratio.

Initial Conclusions.

The data shows that:

1. A meaningful fraction of Japan INC's universe is globally competitive, and

2. The pay-out rates of competitive companies are not exceptional due to an excessive reliance on equity financing.

This example illustrates that relying on a single measure of governance - the size of a company's pay-out cheque - oversimplifies a nuanced conversation between the board and its stakeholders that should explore suitable funding structures (debt vs equity), sensible restructuring, asset disposals or privatisation. These are all important tools that, deployed with care and diligence, can do more to enhance the competitiveness and governance of Japan INC.

To this end there are encouraging signs that capital markets are reallocating underperforming capital. During 2022 more than a thousand Japanese companies were acquired by domestic and foreign investment entities. In total, there were 4304 deals involving Japanese companies in 2022 - the highest number in decades.

Despite the flurry of deals, a lot of work still needs to be done. It is worth remembering that Japanese management teams are past masters at pointless restructuring - the kind that looks good on paper but delivers no lasting benefit - and that it takes time and skill to extract value from a transaction.

The motivating factor.

That "Japanese equity" has been a bride in waiting has been known for some time. So are the long running governance reforms. None of this was unknown in 2019, 2018 and in 2012 when Shinzo Abe started advancing the reform agenda.

We therefore need to look a bit harder to uncover the catalyst for recent capital flows and the surge in deal making. At least two candidates present themselves, with a third lurking in the shadows.

First, during the last couple of years, the shine has come off Chinese equities. China has been the regional, indeed global, favoured child of the investment cognoscenti. The chart below tells the whole story, better than any Wall Street, or Hollywood, script writer can:

The other is the sharp devaluation of the Yen in response to the Bank of Japan's (BoJ) policy of quantitively easing. I will not discuss the latter in detail as others have already done so.

For the sake of this discussion, it is important to note that a monetary authority cannot set both the interest rate and the exchange rate for any length of time. The BoJ has opted for the former in the form of a negative short rate and by capping the 10-year government bond rate at 0.5%. The Yen duly depreciated:

The effect of this is a spectacular increase in Japan Inc’s export focused earnings. Because the capital base generating these earnings is not adjusted to reflect prevailing monetary conditions, Japan Inc’s Return on Capital is elevated relative to their peers.

This monetary policy driven growth was a once off. The odds of further sustained devaluation of the Yen at this juncture are not high.

At what cost?

Corporate capital comes at a cost which, for better and worse, is set by the Fed Funds rate. The latter has increased significantly in recent years, causing the global cost of capital to rise substantially.

It can take a long time to put the inflation genie back in its bottle once it has escaped, especially if monetary authorities stood on the side-lines for too long. An added complexity is that the broader population of investors have either forgotten what inflation is or have never experienced it. Until now.

The uncomfortable fact is that the price of the Yen will be reconsidered if either the Fed's approximately 500bp of rate hikes starts to constrain growth, inflation or both.

Assets prices are driven by marginal pricing. The fact that the BOJ - acting as a price insensitive buyer - has managed to (somewhat) constrain the rise of the 10-year rate at 61bp is reflected in the 30-year rate's rise to 162bp. This is a very steep yield curve and owners of local equity assets ought to consider the consequences of any change in the status quo.

Scar tissue.

The BoJ’s large equity purchase program has left a deep scar on equity prices. These have been studied by academics and their conclusions make for a sobering read.

The two effects that should most concern active investors are firms increased stock illiquidity and the "longer price delays and larger deviations from a random walk". This means that the market's price setting mechanism has become less efficient, and its effects are most visible amongst two types of firms:

1. Firms that are small, young or with low levels of institutional ownership, and

2. Firms subject to strong buying pressure.

Whilst this program has not been abandoned, the frequency with which it is implemented has declined. More importantly, there is no exit strategy from this program, including the fate of the equity holdings.

Investors should therefore consider adding additional liquidity risk premia to their TAA models when assessing Japanese equity investments, perhaps with a higher loading for the small- and mid-cap universe.

It's about growth, really.

These concerns may be moot if importing inflation into Japan gives rise to a sustained period of endogenous growth.

So far there is little evidence of real wage growth in Japan, in fact we have the opposite.

Capex related investment by Japanese corporates have been on a tear, but then Japan INC has never been parsimonious when it comes to investing - witness their history of poor pay-out rates and, until recently, relatively uncompetitive returns. We will only know once the tide is out who has prudently invested the monetary windfall the market has gamely priced.

Finally, it is unclear whether a sustained period of real wage increases will depress Japan INCs margins. Mostly because many domestic industries are still dominated by local companies. This may change after a sustained period of inward focused M&A.

Conclusion.

The MSCI Japan is priced at a relatively modest 14.1 p/e. However, expectations for both near-term and medium-term earnings growth have been marked up rapidly in recent months with the latter hovering at 11%.Price is now driving expectations with longer term expectations becoming unmoored:

This opportunity needs to be considered against prevailing cash rates, the unfolding drama in the fixed income market and the immutable power of patient investing.

Appendix A.

The example presented segments the Japanese stock universe in two parts relative to the median market cap and excludes financial and real estate companies.

This approach controls for important structural differences:

1. The competitiveness of small- & mid- cap stocks tend to differ from large cap stocks in a structural way, and

2. The profitability of financial names are primarily a function of monetary policy and prudential regulation, with management action of secondary importance.

3. Real estate companies - both private and public - have benefited significantly from the post-Lehman deflationary shock. This resulted in highly leveraged companies with asset rich balance sheets for whom the bell tolled in 2020. For this reason, combined with the credit problems of their regional peers, it seems prudent to consider this sector separately in a future analysis.

Each company is ranked relative to their global peers based on Return of Capital and Gross Profit Margin. These metrics are chosen because they are less biased by balance sheet structure and accounting considerations; that is, leverage and fixed cost amortisation can vary significantly by geography.

I exclude small and mid-cap stocks from the analysis due their relatively small size - the range is $37m to $150m - and poor liquidity.  

This leaves a sample of 1510 names. For ease of exposition each ranked fundamental metric - i.e., Return on Capital and the Gross Profit Margin - is grouped by quartile. The resultant matrix gives us some insight into the names that are world glass (1st quartile), competitive (2nd quartile), all so run (third quartile) and mediocre (fourth quartile).

References.

1. Japan Has a Long History of Disappointing Investors. Why This Rally Might Be Different - by the WSJ.

2. The Excess Returns of “Quality” Stocks: A Behavioural Anomaly – by Bouchaud et el.

3. The Bank of Japan’s equity purchases and stock illiquidity -  by Kalak et. el.

4. Japan & the Stable Disequilibrium by Nick Ferres of Vantage Point Asset Management.