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Investment of the quarter: Japan equities still trade du jour

Calling it the end of a two-decade bear market is perhaps a step too far. But analysts remain almost universally bullish on prospects for Japanese equities in 2016 even after the country was among the best performing markets in 2015.

Calling it the end of a two-decade bear market is perhaps a step too far.

But analysts remain almost universally bullish on prospects for Japanese equities in 2016 even after the country was among the best performing markets in 2015.

After decades of risk aversion, an improvement in the economy is leading companies to start addressing the chronically low returns on equity their investors have endured for years.

Stricken by what economists have come to call a ‘balance sheet recession’ after a period when companies borrowed and invested too much, Japanese corporations have become wary of taking on too much risk.
Many paid off their debts in the 1990s, after a financial crisis, then built up large cash balances in the 2000s. This meant low earnings and sales growth, poor returns on equity, and predictably ugly stock market performance.

Cash held on the balance sheets of Japanese corporates exceeds JPY100 trillion ($831 billion), according to calculations from analysts at Nikko Asset Management.

Now revitalised by experimental central bank policy and economic reform under prime minister Shinz? Abe, Japan’s capital markets could be ready to take the next step in their return to health argues Dean Cashman, portfolio manager at asset manager Eastspring Investments, part of insurer Prudential.
“In aggregate, the long process of balance sheet repair in Japan is well and truly over,” says Cashman.
“Arguably for many companies, balance sheet health is “too strong”, which points to a level of inefficiency. In fact, some companies are now focused on improved capital efficiency, generating significant cash flow, and applying renewed balance sheet strength to pursue sensible expansion strategies.”

Japanese corporates are also on a share buyback spree driven by increasing confidence, the need to deploy capital to beat inflation, and in some cases ease pressure from shareholders. Dividends plus buybacks will reach historic highs in 2016, estimate analysts at Nikko Asset Management.
Revisions to Japan’s corporate governance code should also lead to more shareholder-friendly action, Nikko’s analysts say.

“We have found, on a stock-by-stock basis, high conviction names with strong valuation signals across much of the market,” adds Cashman.

“There are names in major banks, insurance companies, consumer electronics and information technology, specialist materials and industrials, auto-related as well as domestic names.”
There are a couple of important caveats to analysts’ new-found bullishness.

First, despite pursuing policies to increase inflation expectations, convincing investors and corporations that the country can break out of decades of deflation will be tough.
“The 15-year deflationary period may still be having a psychological effect on Japanese investors, making it difficult for them to change their behaviour in a relatively short period of time,” argue analysts at Nikko.

“Japanese households and corporations currently hold more than $10 trillion in cash. If the Japanese are unable to change their mindset towards consumption and investing, revitalising Japan’s economy could prove challenging.”

And second, the tail risk of a hard landing in China accompanied by an aggressive depreciation could also put Japan’s recovery in jeopardy. China is Japan’s second-largest trading partner, say analysts at Hang Seng Bank in a 2016 outlook commentary. A slowdown there could hurt exports, competitiveness, and economic growth. 


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