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Turning Japanese
Looking back at 2005, it appeared that the sudden mood change for investors in Japan came on the heels of Prime Minister Junichiro Koizumi’s landslide general election victory. The subsequent equity market rally was a reminder of how powerful sentiment is and how strongly it can drive prices.
There have been clear signs that the Japanese economy’s fundamentals were improving dramatically over the last 15 years and, consequently, the market was substantially undervalued in global terms.
Significant financial market reform and the cleaning up of corporate balance sheets had been grinding forward. However, investors did not react until compounding evidence of many smaller changes appeared in macro numbers (including a stronger yen and rising interest rates), and then in typical fashion they rapidly became over-optimistic. The Japanese equity market ended last calendar year as the best performing developed market economy (up 43 per cent in local currency terms).
Can it keep going up?
The 2005 rally was initiated by foreign investors (see below), but it was given further momentum by a series of hostile takeover attempts. This included dotcom Livedoor’s bid for Nippon Broadcasting and Rakuten’s attempt to take over Fuji Television.
The uncharacteristically bold approach of these companies sent shockwaves through a corporate establishment that traditionally favours a more modest approach and gradual accumulation of wealth through hard working and saving. The market mavericks’ use of their enlarged market cap to buy out established companies, including some of Japan’s largest broadcasting companies, also put pressure on companies to reconsider shareholder value and, ultimately, the cost of capital.
Japanese companies have traditionally prioritised market share and employee welfare, as they were sheltered by a stable cross-share holding structure (Zaibatsu). Management were trained to look after their employees and their customers, but not their shareholders.
After 15 years, Japan has extracted itself from a deflation trap. The possibility of further appreciation of the market will depend on corporate Japan’s success in dealing with the most crucial issue at hand, namely the creation of sustainable shareholder value. This is not simply about raising return on equity, but also, in its truest meaning, about management’s respect for the owners of capital. Part of this would be to unlock underlying asset value and then distribute it to shareholders.
Foreign investors in the Japanese market
International investors have been, and continue to be, the main force behind the rally in the Japanese share market and their appetite is not abating. This is particularly noticeable in the large cap segment, with foreign investors continuing to pour capital into the top 30 Japanese companies. As a result, a performance differential can now be observed between the MSCI Japan Index, which covers the largest and most liquid companies, and the broader, domestically used Topix Index. Over a one-year period, this performance gap has expanded to 5 percentage points (typically, there is a 1 per cent differential), highlighting the enthusiasm of foreign investors towards Japan.
What about Japanese investors?
Following a strong economic recovery over the last couple of years, companies are starting to hire new workers and the labour market is becoming more favourable. Indeed, the number of female and aged workers (over 60) increased for the first time in eight years. This will help support domestic consumption and the housing market, both of which have suffered in the last decade. In addition, the expected recovery in residential property prices outside major cities could provide an additional incentive for housing investment.
Additional developments to watch is the reform of the Japanese Post Office and the savings of ordinary Japanese citizens. With the end of deflation, we expect to see domestic investors beginning to take on some equity risk and invest in the local bourse.
IT is it!
While many domestic companies have recovered strongly from a trough after over a decade of deflation, we believe the revitalisation of the export sector and, in particular, the technology sector is crucial for Japan’s long-term economic growth. The manufacturing sector, such as automobile, machinery tools and technology product makers, is indeed the core of Japan’s industrial system. We have seen a strong revival in the automobile and machinery sectors internationally, with Japanese companies capturing higher market share worldwide, but the technology sector and the semiconductor sector in particular are still searching for re-entry into the international league. In our opinion, the success or failure of this effort will dictate whether the country can get back on to a sustainable long-term growth track. The proximity of Japan to Asia and, in particular, China will also continue to be a boost for economic growth.
Conclusion
After 15 years of long and tough reforms, Japan is reasserting itself in the international economy. Having virtually cleared bad loans and restructured financial markets, we are confident Japanese companies will continue to increase their profitability and deliver shareholder returns.
Diane Lin is head of Asian and Japanese equities at Perennial
AUTHOR
Mike Taylor
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