Head of Equity Strategy
Summary: Japanese equities have the same reputation as its economy. It feels like it is ageing and providing low growth opportunities for investors. Add to this a lack of well-known companies outside Sony and Toyota. But Berkshire Hathaway has a history of preferring what others do not like and in the case of Japan the tradition continues. Berkshire is keen on increasing its exposure to Japanese equities and in today's equity note we take a look at the different features of the Japanese equity market that might have seeded Berkshire's interest.
Earnings growth and the future drivers
As we wrote in our QuickTake this morning and talked about in today’s podcast, Berkshire Hathaway is issuing more yen bonds to increase funds for increasing its stake in Japanese equities. Berkshire made its first foray into Japanese equities by getting exposure to the sogo shosha, which is a collection of general trading companies, back in the early days of the pandemic and which have improved to be great investments. Berkshire clearly wanted exposure to something that could do well under inflation and a structural positive environment for physical commodities. As part of the yen bond sale, Berkshire wants more Japanese equities which can be seen as Warren Buffett’s aim to find alpha outside US equity market and making sure Berkshire keeps up with the S&P 500 or maybe even getting ahead of it over time.
Japanese equities have been growing earnings by 4.9% annualized since Jan 2005 and with inflation over the same period being 0.5% annualized this is a healthy 4.4% annualized real earnings growth. This figure dwarfs AQR’s estimate of 2.1% as Japan’s 10-year expected long-term real earnings growth based on historical growth and expected GDP growth. Despite Japan is perceived as an ageing society with little growth its companies are managing its operating environment well. Profitability has also improved over the years and US-based activist investors have helped over the years to put pressure on Japanese companies to become more efficient.
With an ageing society the long-term labour input into growth is negative and thus Japan is highly dependent on production and capital productivity. The myth has always been that Japan has low productivity, but if one focus on the working-age population GDP per capita then Japan has followed the most productive OECD countries. This McKinsey report from March 2015 outlines very well the problems and opportunities for Japan in the decades to come. Because Japan will experience the pressure from negative demographics first in the developed world the incentive and pressure on automation will also be the biggest. This could set up Japanese automation and robotics industry for a leading position creating an export engine in the future as demographics will come to haunt the US and Europe in the future causing an ever increasing need for automation offset a shrinking labour pool. Keyence is one of those companies that are leading the automation industry in Japan.
Significant valuation discount, buybacks, and the low interest rate sensitivity
One of the most interesting aspects of the Japanese equity market is its valuation level. Japanese equities are valued on the 12-month forward EV/EBITDA at 6.7x which is a 48% discount to US equities reflecting extraordinary relative pessimism of Japanese companies. The more than a decade bull market in US technology stocks have created an expectations gap between the US and Japan like anything we have ever seen before. This is also evident in the difference in the dividend yield between Japan and the US which has increased from -2%-points to +0.8%-points since 1995. Another positive factor for Japanese equities is the capital productivity improvement by Japanese companies which has made it possible for these companies to increase the payout to shareholders through buybacks. In the past five years, the average buyback yield has averaged 0.9%.
If we follow the classic way of calculating the long-term expected real rate return on Japanese then it is currently 5.4% annualized derived from a dividend yield of 2.4%, 0.9% expected buyback yield, and 2.1% annualized real earnings growth which could prove to be too low if investors underestimate productivity gains and Japanese companies ability to expand overseas freeing them from the constraints of Japan’s low nominal growth economy.
The final interesting factor on Japanese equities is the negative net debt (cash levels exceed debt). This feature means that Japanese companies actually have a positive sensitivity to rising interest rates unlike most other equity markets including the US equity market. With the new BoJ Governor Ueda taking over from Kuroda, the country may adopt a different monetary policy over time which could help strengthen the JPY but also increasing the value of those cash balances in the corporate sector.
Investors have plenty of cheap ETFs to choose from tracking the Japanese equity market and there are even options that hedge the JPY as well if investors do not want the currency risk. For other investors investing in single stocks is more preferred and the list below shows the 10 largest stocks in the Japanese equity market today:
2024: The wasted year
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Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
Commodities poised for rebound. The "Year of the Metal" boosts gold and silver, copper awaits rate cuts. Grains may recover, natural gas stabilises. Gold targets $2,300-$2,500/oz, copper's breakout could signal growth.
