For investors in Japanese stocks, nearly three decades were lost. In the late 1980s, expectations for the country’s companies were running extremely high, and stocks were bid up to nosebleed earnings multiples. In the subsequent decades, results fell far short of those lofty expectations, and valuations fell to reflect reality. As a result, the Japanese stock market delivered a return of virtually zero.
While the Japanese stock market has delivered underwhelming returns, the region hasn’t been devoid of opportunity. In fact, it has been an unusually rewarding market for value-oriented stock pickers – and in our view, it still is.
Valuation spreads in Japan, historically a good predictor of stock-picking opportunities, are at their widest levels since 2000. And unlike the late 1980s, the market as a whole doesn’t look so bad, either. Expectations appear neither too high nor too low. Whether Japanese companies beat these middling expectations is anybody’s guess. We don’t have a crystal ball, but there are some reasons for cautious optimism.
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One such reason is the gradual improvements we are seeing in capital efficiency. It has been low historically – an enduring issue that has been detrimental to both shareholders and the wider Japanese economy. Over the past 20 years, Japanese companies have earned returns on equity of about 5 per cent, compared with about 12 per cent for businesses in other developed markets. The causes include investing in low-return projects, holding other companies’ stock and hoarding cash.
Why did these behaviours become so ingrained? It’s complicated. Hoarding cash is appealing on some levels for management teams. And having a chunk of your shares owned by a friendly peer company offers protection against activists and takeovers. While these habits may be negative for shareholders, they may reassure other stakeholders, such as employees and local communities. It’s natural and right for companies to consider their effects on other stakeholders, yet even from an overall stakeholder perspective, these behaviours can have some negative side effects.
Capital should go to where it is most useful, and the most enduring companies are those that allocate capital in creative ways. Companies with cash and exciting opportunities should invest it, while those with cash but no opportunities should pay it out so that investors can direct that capital to companies that do need it. The more cash gets stuck on companies’ balance sheets, the harder it becomes to fund innovation. Given its shrinking population, the only way for Japan to grow will be through the productivity gains that innovative companies help to drive.
When Prime Minister Shinzo Abe speaks of reviving “animal spirits,” this is one of the things he has in mind. Under his leadership, the Japanese government has introduced a sweeping revitalization strategy, including a corporate governance code that took effect in 2015. Among other things, the code encourages corporations to wind down their “cross shareholdings” – large stakes held in other companies. According to research by Jefferies, 40 per cent of Japanese firms are majority owned by these “allegiant” shareholders. Helping that along is another provision of the code – that boards should include independent directors. Before the reform push, most Japanese firms had zero. Following the introduction of the code, 85 per cent of companies now have at least two.
Better corporate governance and better engagement with shareholders should encourage management teams to make better capital allocation decisions. There remains plenty of scope for improvement – 60 per cent of Japanese companies hold net cash on their balance sheets, for instance, compared with just 25 per cent of companies in the MSCI World Index. Although it is early days, we have been encouraged by the improvements in capital allocation we have seen.
Japan’s trading companies, or sogo shosha, offer a good illustration of how these changes have started to take hold. The country has a large population, but few natural resources, so the trading companies emerged – in a business model somewhat unique to Japan – to source resources the country could not provide. Today, the largest is Mitsubishi Group, and its operations span a dizzying array of businesses: everything from natural gas to salmon fisheries to convenience stores.
In the past, the trading companies did not hoard cash, but they did spend freely on investments, sometimes paying too much and sometimes on assets with low return potential. All that investment sapped the cash available to shareholders. This appears to be changing. The companies are generating better cash flow and investing it more carefully, freeing up more cash for shareholder returns.
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In Mitsubishi’s case, the shift is stark. Ten years ago, the company paid out less than 20 per cent of its profit and offered the same yield as 10-year Japanese government bonds. Today, 10-year bond-yields are anchored at zero, while Mitsubishi’s dividend yield is 3.5 per cent. This represents 30 per cent of its profit – and management has committed to maintaining or raising the dividend in the future.
Behaviours ingrained for decades don’t change overnight, but there are some signs that reforms in Japan are creating a more dynamic environment. Our hope is that the country continues down this path. In our view, this is one of the many reasons that Japan remains a stock-picker’s market.
Graeme Forster, PhD, CFA, is a portfolio manager at Orbis Investments and is responsible for the Orbis International Equity and Orbis Optimal Strategies.