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Investment outlook

Japanese equities: opportunity for value creation on the road to recovery

Peter Boardman
Portfolio Manager, Equity Analyst
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Executive summary

Quicker path to recovery

With new coronavirus cases in Japan declining sharply from the peak, the country lifted its state of emergency in May – a promising victory in its battle against the virus. Deaths due to coronavirus in Japan are just 0.8 per 100,000 people, while U.S. and U.K. fatalities are 47.5x and 81x higher, respectively. Currently, Japan ranks 103rd in the world in terms of deaths per 100,000 people.

The labor market in Japan has remained remarkably stable, largely due to very strict labor laws, making it relatively difficult to lay off employees. In May, the unemployment rate rose to 2.9%, however it is still lower than in Germany at 6.2% and the U.S. at 11.1%.

Asia’s faster post-pandemic return to growth bodes well for Japan, which has traditionally been viewed as a global growth play as much of the country’s profits are generated overseas. China, the second-largest foreign market for Japan, posted second-quarter GDP of 3.2%, with PMI (Purchasing Managers’ Index) also recovering relatively quickly as supply chain disruptions have abated. Current consensus GDP forecasts bear a similar story, as forecasts show Japan as the least-worst of major developed economies with -4.9% year-over-year GDP growth compared with -5.5% for the U.S., -8.8% for the UK and -6.2% for Germany.

Figure 1: Deaths per 100,000 people 

Additionally, lower leverage for Japanese companies, particularly when compared with European and American counterparts, should assist in fortifying the resilience of these companies as they weather the current economic slowdown and uncertainty around the timing of a recovery.

Figure 2: Leverage across Japanese companies remain significantly lower than those in the U.S. and Europe 

We see this play out by the relatively low bankruptcy rate in the country to date. Although the rate has increased, especially in the service sector, it still remains extremely low compared with historical levels. Japan’s tight labor market, relative lack of workforce disruption and reopening of the country has offered a clearer window to recovery from the pandemic.

Valuations continue to be attractive

After outperforming in the early-to-mid 2010s, equity returns in Japan have lagged the U.S. and Europe over the last several years. Given cheaper valuations, there could be an opportunity for expected returns in Japan to normalize higher, especially when considering the possibility of a quicker path to recovery in a post-coronavirus world.

Figure 3: Estimated 12-month forward price-to-earnings ratios 

The Japanese equity market has suffered continued de-rating during the current cycle, with the U.S. now trading at around a 45% premium and Europe at a 15% premium–Japanese equities are trading at 14.4x price-to-earnings, compared with 21.0x for the U.S. and 16.5 for Europe. A large reason has been due to outflows from foreign investors, who have sold a whopping ¥6.5 trillion in Japanese equities year-to-date. However, this has left investors significantly underweight Japanese equities and has affected portfolio diversification, which may be an unintended consequence for investors seeking international exposure. Should Japan experience a quicker recovery from the pandemic than Europe, we could see a major opportunity for capital to migrate from Europe back into Japan. Despite outflows, the rapid growth in assets under management for Japanese equity strategies among institutional investors is a promising trend. Over the last decade, the Japan equity universe has increased by 442%, growing to $618 billion as of 30 April 2020, according to eVestment.

Strong secular outlook for enhanced shareholder returns

Corporate governance and shareholder accountability have been a strong, improving trend in Japan, and prior to the coronavirus pandemic, share buybacks and dividends were on pace for another record year in 2020. In 2019, the cumulative value of share buyback announcements reached ¥8.3 trillion, a 31% increase year over year. In contrast, buybacks as of May were down almost 74% year over year. However, we see this as a temporary bump in the road as Japanese corporate balance sheets still remain flush with cash. Approximately 55% of non-financial companies in the Topix Index are net cash, significantly higher than the 23% in MSCI Euro and 15% in the S&P 500. As the outlook for economic activity becomes clearer, we could eventually see the prior pace of buybacks return.

While share buybacks have fallen, dividends have not. In a period when many European companies have cut or suspended their dividends, Goldman Sachs reports that 83% of reporting companies in Japan have either hiked or maintained their dividends as of March fiscal year-end. Concerns that Japan will follow a similar pattern as Europe should be low as Japanese companies have a history of avoiding dividend cuts in all but the most extreme circumstances. Dividend yields for Japanese stocks, which have been dreadfully low for decades, have overtaken those in the U.S. Moreover, dividend-payout ratios in Japan remain significantly lower than other developed markets, leaving room for further growth. Dividends per share (DPS) have quadrupled over the past two decades, which have resulted in Japan leading in dividend growth. Through May, DPS expectations for the Topix have held up meaningfully better, declining just 4.5%, whereas expectations for the S&P 500 have declined 5.0% and 18.8% for MSCI Europe, according to research from CLSA.

Figure 4: Percentage of non-financials that are net cash, by market 

Historically, returns on equity (ROE) have been affected by prevalent cross-shareholdings—ownership by a publicly-traded corporation in the stock of another publicly-traded corporation—which has maintained corporate stability but dampened returns for many Japanese companies. In our view, this has been a relatively inefficient means of allocating capital, with the consequence of depressing ROE growth for some companies. We believe that Japan’s revised Corporate Governance Code, which obligates Japanese companies to disclose their rationale for cross-shareholdings, should be a catalyst for ROEs to improve in the medium to long-term.

Emphasis on corporate governance reform has increasingly prompted Japanese companies to divest non-core businesses or merge to consolidate market share. We’ve seen a rise in business restructurings and hostile takeover attempts as tender-offer activity has gained steam. The total amount of tender offers reached ¥2.1 trillion in 2019, marking the highest level since 2007. Even with the change in the Japanese Foreign Exchange and Foreign Trade Act, which opponents have labeled as an “anti-activism” law, we don’t believe that this necessarily equates to a reduction in restructuring and/or common sense initiatives by shareholders. The rise in unsolicited bids should likely continue, along with the number of companies that have abandoned takeover defense measures.

Equity valuations for Japanese companies continue to be attractive, particularly compared with American and European counterparts."

Rise of ESG adoption in Japan

The adoption and integration of ESG factors into corporate business and investment practices in Japan have moved increasingly to the forefront in recent years. Developments include the initiation of a new Japan Stewardship Code and Corporate Governance Code, which changed how institutional investors engaged with Japanese businesses and established fundamental principles for effective corporate governance at listed companies in Japan. Japan’s Government Pension Investment Fund (GPIF), the world’s largest pension fund, has also made its own strides towards ESG integration as it became a signatory to the United Nations Principles for Responsible Investment (UNPRI) in 2015 and backed the launch of multiple Japanese ESG indexes. Nuveen (and its investment specialist teams, including NWQ) formally endorsed the UN Principles for Responsible Investing (UN PRI) 2018.

As the push for corporate reform deepens, we expect more Japanese companies to improve disclosure and implementation of sustainable practices. Corporate governance, environmental impact and social issues are important focus areas for investors. And we believe the recent trends in ESG adoption in Japan present a great opportunity for further engagement with Japanese companies to drive positive ESG practices, which in turn should unlock greater returns to stakeholders.

Learn more about NWQ

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Dimitrios N. Stathopoulos
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The TOPIX Index is a capitalization-weighted index of all companies listed on the First Section of the Tokyo Stock Exchange.
The CSI 300 Index is a free-float weighted index that consists of 300 A-share stocks listed on the Shanghai or Shenzhen Stock Exchanges.
The Deutsche Borse AG German Stock Index (DAX Index) is a total return index of 30 selected German blue chip stocks traded on the Frankfurt Stock Exchange.
The MSCI Euro Index is a subset of the broader MSCI EMU Index. It was created to serve as the basis for derivative contracts, exchange traded funds and other passive investment products. The index comprises large and liquid securities with the goal of capturing 90% of the capitalization of the broader benchmark.
The FTSE All-Share Index is a capitalization-weighted index comprising the FTSE 350 and the FTSE Small Cap Indexes.
The Standard & Poor’s 1500 Composite is a broad-based capitalization-weighted index of 1500 U.S. companies and is comprised of the S&P 400, S&P 500, and the S&P 600. The index was developed with a base value of 100 as of December 30, 1994.
The S&P 500 Index is widely regarded as the best single gauge of large-cap U.S. equities and serves as the foundation for a wide range of investment products. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization.

A word on risk
All investments carry a certain degree of risk, including possible loss of principal, and there is no assurance that an investment will provide positive performance over any period of time. Equity investments are subject to market risk or the risk that stocks will decline in response to such factors as adverse company news or industry developments or a general economic decline. Non-U.S. investments involve risks such as currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards. These risks are magnified in emerging markets. This report should not be regarded by the recipients as a substitute for the exercise of their own judgment. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager.

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