Head of Equity Strategy
Summary: Japanese equities are rallying the past two weeks fueled by Prime Minister Suga's resignation and hopes of his pro-business party LDP to get re-elected in the upcoming general election. Japan has undergone several market reforms lifting women's labour participation rate and increased immigration, but Japan must do more if Japanese equities are to outperform global equities. The return on equity remains too low burdened by the Keiretsu system and without higher return on capital we do not see an end to Japan's underperformance.
Nikkei 225 futures are up 12.2% in only 11 trading sessions with the latest push higher coming on the back of Prime Minister Yoshihide Suga’s unexpected resignation. The market is cheering on the news as Suga was criticized for his handling of the pandemic and seen as an obstacle for the LDP (Liberal Democratic Party) to win the general election scheduled to be held on or before 28 November 2021. Especially, the current vaccine minister Taro Kono is seen as a market reformer and someone that could extend the market reforms of the Japanese society which started back in 2012 under former Prime Minister Shinzō Abe which has extended the women labour participation rate from 41.9% in 2012 to 44.3% in 2019. During the years of the Abe government, Japan loosened its immigration policy leading to years of subsequent net positive immigration offsetting some of the economic growth pressures coming from negative natural change in the population (births minus deaths).
The Japanese rollercoaster
With Suga gone and Japanese equities rallying it worth asking the question whether this is the start of a longer period of Japanese equity outperformance or just another false start. But before we go into details of the Japanese equity we must first outline the historical performance. From January 1970 to November 1988, Japanese equities enjoyed a spectacular rally outperforming the MSCI World Index by 10.6% annualized. But as the world thought Japan was about to conquer everyone with their efficient model it all crumbled and catapulted Japan into deflationary swirl that has been difficult to escape ever since. By late 1998 the implosion of Japanese equities had run its course underperforming the MSCI World by 80% throwing out most of its relative gains made during the 1970-1988 period.
From 1998 to 2008, Japanese equities waxed and waned against the MSCI World and proved to suddenly becoming a relative safe-haven during the Great Financial Crisis due to the strong JPY. Since December 2008, Japanese started its second secular decline relative to global equities losing 46% or 4.8% annualized. During this period of 13 years the initial period after Abe was elected new Prime Minister in 2012 saw a brief period of excitement over Japanese equities and growth with MSCI Japan outperforming the MSCI World by 14% in only six months. But the magic disappeared and investors turned to US growth and technology companies showing consistently high growth rates and a new profitability profile of the new digital age.
As the relative performance chart shows, Japanese equities have had many false starts and the late 2012 to early 2013 period under the Abenomics introduction was the latest period of excitement. The question is now whether Japanese equities could turn the tide and enjoy the love of investors.
Japanese equities are historically cheap
The MSCI Japan has almost recouped its lost earnings per share (EPS) over the past years since it peaked out in Q1 2018. In Q2 2021, EPS was almost back to the peak and we expect Q3 to show a new all-time for EPS, and this is also the main reason why Nikkei 225 futures have almost doubled from the lows in 2020.
While EPS has grown 14.7% annualized since 2011 the global investor has not been impressed pushing the valuation of Japanese equities lower. Today, the MSCI Japan Index is valued at 9.1x on EV/EBITDA compared to 15.1x for the MSCI World. This spread is a staggering 40.1% discount, a record low since 1995, showing that investors have not been this pessimistic on Japanese equities in almost three decades. How can investors be so pessimistic?
The ROE problem
Shareholders in Japanese companies have for many years suffered under the Keiretsu system which is a system that creates immense stability and high degree of employment and was instrumental in Japan’s growth miracle after WWII. But the Keiretsu is also an obstacle for innovation and concentrates wealth and power among a few mega conglomerates. This has led to Japan losing out to the US across many technologies such as cyber security, software application, social media, semiconductors, and biotechnology.
The problem is crystalised when we look at the return on equity (ROE) among Japanese companies which is currently at 9% and peaked in November 2018 at 10.7%. The average return on equity since 1995 has been 5.2% which is significantly below the cost of equity and thus the main driver of lower relative total return to the MSCI World and US equities. For comparison the Nasdaq 100 companies are currently operating at 26.9% ROE and S&P 500 has a ROE of 17.2% significantly above Japanese companies. As long as this difference persists then Japanese equities will continue to underperform US equities and the MSCI World. A valuation repricing of Japanese can temporarily create outperformance but long-lasting outperformance requires a higher ROE which requires profound reforms of the Japanese corporate culture.
Our view remains that the best the Japanese equity market can deliver to global investors is its wide-ranging companies within robotics and automation, which also happens to be our next equity theme basket.
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