Last month we described Japan’s “Show me the Money” corporate governance as regards the sharp rise in corporate profit margins to new highs. This theme is paralleled by the trend in dividend payments.

Why do dividends matter in Japan?

  1. Because they are growing rapidly.
  2. They already provide attractive yield, especially for domestic investors.
  3. They will grow strongly for the next five to ten years, in our view, as the payout ratio has much further to increase and Japanese companies no longer wish to hoard cash.
  4. Dividends will likely be the most defining factor for Japanese equities in the intermediate term, so stocks that follow this trend could well perform the best.
  5. This trend will encourage domestic shareholders to take more investment risk and initiate an equity culture.

The dividend paid by TOPIX (in Yen) rose during the 1980s bubble and then declined gradually thereafter until 2004 when the initial trend to reward shareholders began. In the following four years until the Lehman crisis, TOPIX’s dividend nearly tripled. Rising earnings, as well increased pressure from intense shareholder activists, played a strong role in this regard, but many corporations’ realization that domestic investors needed income also played a role. After declining due to the Lehman crisis, dividends rebounded from 2011 through 2013 and thanks to Abenomics, have recently moved upward in near parabolic fashion to near alltime highs.

TOPIX Dividend (in Yen)

TOPIX Dividend (in Yen)

Source: Datastream through June, 2014

The chart to the above-right chart shows the payout ratio trend. Firstly, please note that we measure the payout ratio as TOPIX’s dividend vs. its forward 12 month EPS, as the Japan’s Dividend Resurgence: “Show Me the Money” latter series is more stable than using historic earnings. The ratio rose after the 1980s bubble as earnings fell more rapidly than dividends, but in 1995 when earnings finally recovered, the payout ratio fell. The Asian crisis in 1997- 1998 hurt earnings badly, but dividends fell only moderately, so the ratio spiked again. Then, the tech bubble boosted earnings, but companies did not raise dividends, so the ratio fell to a new low of 16%.

TOPIX Dividend Payout Ratio

TOPIX Dividend Payout Ratio

Source: Datastream through June, 2014

As mentioned previously, as corporate profits recovered in the 2004-2005 period, corporations increased dividends at an even faster rate. The ratio rose from 16% to 27% (which was close to the US’s ratio at that time) in just a few years. Of course, the Lehman crisis changed everything and the ratio soared as earnings fell faster than dividends. 2011 and 2012 brought a rising ratio as dividends rebounded faster than earnings; however, despite a near parabolic surge in dividends in the Abenomics period, earnings have risen even faster, so the ratio has retreated to 25%.

Just like the 2004-2008 period, we expect a continuing surge in dividend growth to lead to a sharp increase in the ratio. In fact, we expect the TOPIX dividend to double in the next five years, bringing the ratio to 37%. So, the market is trading at a dividend yield of nearly 4% looking five years forward. This should greatly support Japan’s “equity culture” as well as pleasing foreign institutional investors. Indeed, 37% is near the S&P 500’s current level and Japan’s ratio has been higher in the past, so 37% seems highly attainable given the continuing shift by Japanese corporations towards better reward of shareholders since 2004.

As the next chart shows, Japan’s dividend yield remains very high in a historical context.

TOPIX Dividend and JGB yields

TOPIX Dividend and JGB yields

Source: Datastream through June, 2014

Indeed, excluding recent crisis periods, the dividend yield is about as high as it has ever been. When compared with the rest of the G-3, we see that the S&P500’s dividend yield is 1.9%, which is the well below the 10Y Treasury yield, while TOPIX’s yield is 1.8%, more than triple that of the 10Y JGB. Europe has the highest dividend yield, which at 3.2% is double that of the 10Y German Bund, but only marginally above that of the peripheral countries’ 10Y yields. Also, we expect dividends in Europe to remain under pressure, thus lowering the region’s prospective dividend yield.

Speaking of Europe, its dividend payout ratio is approximately 50%. While this seems high, it has averaged at this level since 1998, and is proper, in our view, for a mature economy. US companies, driven by corporate option incentives, concentrate heavily on share buybacks, and although such are not a guaranteed return for shareholders, this raises its “total payout ratio” to nearly 50%. Thus, 50% seems an appropriate target for Japan, as well. As Japan needs to raise incomes for domestic shareholders and as the equity culture remains in its infancy (many retail investors clearly understand dividend income, but not the purported benefits of share buybacks), concentrating on raising dividends will likely take priority over buybacks.

Our 37% payout ratio in five years is based upon 6% annual growth in earnings and 15% annual growth in dividends. Extending these trends another five years leads to a 50% payout ratio, thus making it a very plausible tenyear target. Of course, earnings will likely go through a down-cycle over this period, but we expect dividends to be much more “sticky” than they were after the Lehman (and Tohoku) crises. Indeed, these trends are all a part of the movement away from Japan’s “crisis cycle” market towards a more normal market, in which the last decade of restructuring bears fruit for shareholders. As Abenomics brings more confidence among domestic investors, as well as dis-incentivizing cautious investments due to negative real fixed income yields, there is a natural inclination to increase equity investments for the long-term.

Conclusion

While we believe that independent directors and other corporate governance improvements are important, cash dividends is likely to provide the most compelling argument for domestic investors to increase their investment risk profile. In this way, a more solid “equity culture” can be established in Japan relatively quickly. Foreign investors will also realize that corporate governance in Japan is a very serious trend (along with the recent surge in profit margins) and gain confidence in the country.

Some current high dividend yielding stocks and some large companies that are rebounding from the Tohoku crisis will benefit from increased concentration on this trend. However, the greatest beneficiaries should be those that increase their dividends the most towards a properly high payout ratio, which we target at 50% in ten years. In particular, companies with large cash positions are likely to realize that distributing more of such to shareholders makes sense, especially now that the government, national and private pension funds and the stock exchange are all encouraging higher ROEs.

The implications of this trend are huge, as the impact of growing asset wealth and income for individual and institutional investors will be key to the continuing success of Abenomics.