Market consensus appears to be that the third arrow reforms of Abenomics have been disappointingly slow. However, we think that is partly due to over-optimistic expectations on the speed of implementation. While it is true that not all reforms are developing as swiftly as market participants might hope, we believe there is significant and undeniable progress in areas of corporate governance reform with a positive impact on companies' return on equity.
Prime Minister Abe's recent success in the Upper House elections not only reinforces the country's political stability in a time where other countries are experiencing considerable volatility, but it also provides a solid mandate for further structural and corporate reforms.
In a previous article, 'Abenomics hasn't failed yet, but it does face global headwinds', we focused on the first and second 'arrows' of Abenomics: fiscal stimulus and monetary policy. The focus of this article is the third arrow of structural reform, particularly in terms of corporate governance and the opportunities that those reforms might present for equity market investors.
Although the 'easy gains' of the early days of Abenomics are a thing of the past and Japan is currently battling the headwind of a stronger Yen, we believe that certain companies are becoming increasingly profitable in light of these reforms, creating opportunities in the Japanese share market for investors to focus on.
Abenomics is pushing the economy in the right direction, but reforms take time
In June 2014, Abe announced a reform package that included corporate governance improvements, agricultural liberalisation and regulatory initiatives related to sectors such as energy and healthcare. The first steps towards agricultural reform have included limiting the power of a large national agriculture cooperative, which had long been opposed to modernisation, and Abe's commitment to the Trans-Pacific Partnership (TPP), which Japan's agricultural industry strongly opposes. Japan is also on track to fully liberalise its electricity market this year in an attempt to end regional monopolies and to allow new entrants across sectors and regions.
Despite the successes we are beginning to see in these areas, we have to acknowledge there are other areas where change is far slower. Although we have seen the introduction of a new gender equality law, increasing female participation in the labour market remains a slow process. Although there seems to be improvement in terms of social acceptance, the shortage of childcare options continues to act as a barrier. Another area where we have seen few results is in overall labour market reform. In late 2015, the government abandoned its proposed 'white collar exemption' change to the Labor Standards Act, which would have allowed employees in certain highly skilled professions to be paid according to their performance rather than number of hours worked. Given the success of Abe's Liberal Democratic Party (LDP) in the Upper House elections in early July, however, we believe that the Prime Minister can now proceed more easily with labour market reform.
Following the landslide victory at the Upper House elections, some have suggested that Abe will lose focus on these reforms and start concentrating instead on constitutional reform. However, we disagree and believe he will keep a clear emphasis on the economy. The LDP's coalition partner, Komeito is not on the same page, in our view, when it comes to constitutional reform and focusing on this issue might actually jeopardise the coalition. In addition, given the market environment post-Brexit, Abe needs to ensure that the economy is his number one priority. We believe he will make this clear in coming months, which should be positive for markets.
One of the areas where the third arrow has had most success is corporate governance. We expected it would take time to fully feel the impact of these reforms, but we believe they are proceeding well.
Progress on corporate governance reforms undeniable
This is one of the most important set of reforms for investors due to the potential for earnings power improvement.
Tackling the problem of low ROE
For a long time, international investors have felt that Japan had a problem with corporate governance, particularly in terms of Japanese companies' low return on equity (ROE). Under Abenomics, the government has implemented a number of measures, which have led to a shift in institutional investors' expectations about management's responsibility to deliver higher ROE. These include introducing stewardship codes for institutional investors in 2014, with corporate governance codes adopted by most listed companies towards the end of 2015. These codes focus on making Japanese corporations more transparent and more responsive to shareholders.
Japanese equities are significantly cheaper than other developed markets, such as the US, based on revenue and earnings. However, low ROE compared with other major markets, which has been a problem since the 1980s, continues to concern investors. In our view, low ROE stems from low profitability. The key driver of this has been a tendency for Japanese companies to focus on size, such as the number of employees and market share, rather than ratios like profit margins or ROE. This led companies into price wars which resulted in low profitability.
However, there is now consensus among politicians, corporate management and academics in Japan that improving the ROE of Japanese corporations is an essential policy issue. With the advent of the Stewardship Code and Corporate Governance Code, we expect more focus on ratio-related management measures, which should lead to a significant improvement in ROE levels over the medium term.
It is worth noting that Japanese firms have greater reform potential than US and European firms. If ROE could be raised to the levels of Europe and the US, we could see share prices rise 1.5 times to over 25,000 Nikkei average in Yen terms. Although we believe it will take some years before ROE levels are comparable with counterparts in Europe and the US, for investors who have confidence in the determination of Japanese companies to place more emphasis on growth and efficiency over scale and stability, Japan could provide fertile ground for investment opportunities.
Marked increase in share buybacks and dividend payouts
One of the main purposes of the reforms has been to encourage 'cash-rich' Japanese firms to stop hoarding cash and funnel some of it back into the economy. It is notable that the tendency to hoard cash is particularly high among small to mid-sized enterprises (SMEs). This stems from the legacy of Japan's credit crunch in the late 1990s, during which senior management found themselves cut off from bank lending. Although SMEs continue to rely heavily on bank finance to fund operations, they maintain large cash cushions. However, as chart 1 shows, even large firms in Japan have been building up cash on the balance sheet since the 2008 financial crisis.
Chart 1: Cash and deposit holdings by firm size (% of total assets, non-financial companies)
Source: Ministry of Finance, as of July 2016. Source data available from the Ministry of Finance Japan website doesn't include finance or insurance so only non-financial company data is shown.
While this tendency to hold cash means that the quality of assets on Japanese balance sheets is usually fairly high, it has led to weak growth for both companies and the economy as a whole.
However, clearly, some of these cash-rich companies are changing their attitudes towards shareholders. As evidence of this growing shift in corporate behaviour and as a result of the increasing pressure on corporate governance from the government and institutional investors to improve ROE, the past few years have seen a marked increase in share buybacks and dividend payouts. In Japan fiscal year 2015, both dividends and buybacks rose to a record level (see chart 2), with Japanese companies paying out almost Yen 10 trillion in dividends and large firms announcing significant buyback programmes.
Chart 2: Trend in dividends and buybacks (JPY trillion) FY 2000-2015
Japanese companies are not usually 'market timers' — i.e. they don't typically initiate more buybacks when share prices are falling. In our view, the recent increase in share buybacks and dividend payouts is more likely to be attributable to Abenomics and corporate governance reforms. Buybacks and dividend announcements have continued to surge in 2016, suggesting that they may outstrip the record numbers seen in 2015. In addition to the impact of the corporate governance reforms, there is mounting pressure on Japanese management teams to protect their large cash holdings from negative interest rates.
It is interesting to note that buybacks were at similar levels in 2007. In 2005-2007, we experienced the first wave of corporate governance in Japan, with activist investors, mainly from the US and UK, attempting to place pressure on management to improve capital efficiency. This activity had its desired effect and we saw a high level of buyback activities prior to the onset of the GFC. This time, we believe what we are seeing is a stronger, more sustainable secular change since Japanese financial institutions are integral to the increase in buybacks and the corporate governance codes have now been adopted by most listed companies.
Despite the recent stronger Yen, we still see opportunities in Japanese equities
Certainly much of the share market growth under Abenomics has been due to a weaker Yen and (as a result) stronger exports, with the Nikkei1 rising 57% in 2013, 8% in 2014 and 11% in 2015 in USD terms (source: Bloomberg). However, with a trend reversal over the past six months towards an appreciating Yen, the Nikkei has reversed some of those gains, falling 18% over the first six months of 2016 when measured in USD terms.
However, in our view, there are still opportunities to be found for active stock pickers, even with the Yen at its current levels. For example, a stronger Yen can be a benefit to stocks and sectors that profit from cheaper imports, such as those importing many of the constituents for their products (e.g. foods and pharmaceuticals) and those whose main market is domestic. Utility companies are another beneficiary since they import oil, coal and petrol-related products, as are pulp & paper manufacturers due to the fact that they are energy-intensive so lower energy prices can be a boon. In our view, the key for investors is to identify stocks where the impact of Yen appreciation is mitigated by relatively price inelastic overseas demand, or where domestic market opportunities for importers are improving.
In addition, we do not expect the Yen to strengthen further from current levels. In our view, it should remain quite stable in its current range of USD 100-105 and this stability should benefit Japanese companies as long as export volumes increase as a result of global aggregate demand growth. This volume effect should help to reduce inventory and increase production. June trade data from both the Ministry of Finance and Bank of Japan show some improvement in export volumes. If this continues, large exporting companies, including auto and machinery manufacturers, should benefit.
Health care remains relatively strong because sales do not depend on the economic cycle and the sector is well supported by government prices. Domestic real estate investment trusts (REITs) present another opportunity for investors since they are strongly supported by the Bank of Japan's (BoJ's) asset purchases. This is inflation-related as opposed to structural reform-related so REITs are benefiting more from the first arrow of Abenomics. REITs have benefited from the BoJ's stimulative policies, since the BoJ has bought REITs as a part of its quantitative and qualitative easing (QQE) programme. The BoJ's easing measures have thus helped support REIT performance through capital gains. If the BoJ is successful in stimulating inflation, it would be even more positive for REITs in terms of the income gain since in an inflationary environment, we should expect higher rents in the real estate sector.
We also see value in some small to mid-sized companies (SMEs). In general, SMEs are not as affected by major global fluctuations, including Yen appreciation, as large-cap companies. In addition, they tend to be more nimble, so they can often drive structural improvements more swiftly, for example in corporate governance. It is also easier for analysts to gain deep insight into SMEs and achieve regular, effective communication with management that can help identify where the real investment opportunities lie.
Early indications suggest the third arrow is beginning to hit its mark
June/July marks the first shareholder meeting season since the Corporate Governance Code was established. Although it is too early to declare that corporate governance reforms have been a resounding success, the results have shown us no reason to be disappointed at this stage. Thanks to Abenomics, corporate profitability has been increasing and there is now an intense focus on shareholder returns with dividend hikes, increases in share buybacks, a rise in the number of independent directors and fewer cross-holdings among business partners.
Structural reforms are rarely swift in any country, particularly where it requires a significant change of mind-set not only from companies, but also from the wider populace. However, Japan is a consensus-driven culture and improved corporate governance is now the consensus. There are clear signs that many companies are moving towards more shareholder-oriented management, although this will take time to be reflected in profit levels. We believe that the seeds for corporate earning power reform have been sown and Abe's recent success in the Upper House elections may provide the impetus to accelerate the process.
- Nikkei 225 Total Return USD Hedged Index — measures the return of the Nikkei 225 achieved by fully hedging its currency risk for investors outside Japan.