Improving the number of independent directors and other governance issues are very important in the intermediate term for Japan, but it is crucial for investors to understand that much of the profitability message has already been understood by Japanese corporates for a decade. This is shown by the divergence in the profit margin from GDP growth in the chart below.

Since the Koizumi era, Japan has embarked on major rationalizations in virtually every industry, with the number of players often reduced from seven down to three. The fruits of this restructuring were slower to ripen than in Western world examples, and they were hidden by a series of crises (the Lehman shock, the turbulence in China, the strong Yen and of course, the Tohoku crisis), but since Abenomics began, the global backdrop for Japan has been stable, thus allowing the fruits of profits to be fully realized.

Indeed, the 4Q data on overall corporate profits (not just of listed companies) announced on Monday continues this upward trend, showing that the pretax profit margin's four-quarter average hit a new high of 4.95%. We expect that profit margins will expand further in coming quarters, which should further prove that Japan's structural profitability trend continues upward. It is also worth mentioning that forex related profits are not the main driver of improvement, as the profit margin of services industries also surged to a new record high in virtually parabolic fashion, as shown in the second chart below.

Four-quarter Average of Pretax Profit Margin vs. Japanese Nominal GDP YoY Growth
(for all non-financial companies, not just listed ones)

Four-quarter Average of Pretax Profit Margin vs. Japanese Nominal GDP YoY Growth

Sources: Japan Ministry of Finance, Bloomberg, data through 4Q14

...and for Non-manufacturers excluding Financials

Non-manufacturers excluding Financials

Sources: Japan Ministry of Finance, Bloomberg, data through 4Q14

This is but one reason why investors should ignore the macro-based strategists who say that Japanese equities can only rise if the Yen weakens further. If valuations were high, this might be true, but not at their presently low levels and as large corporate tax cuts are likely to be enacted soon, which will drive earnings growth upward even further.

Conclusions

  1. Years of restructuring's progress was hidden (due to successive crises and the gradual nature of Japan's redundancy programs).
  2. “Show me the Money!” corporate governance: Japanese companies do care about corporate profitability.
  3. The dividend paid by TOPIX is surging upward again, and we expect such to double over the next five years.
  4. Abenomics is having a strongly positive effect on profits due to the normalized Yen and further deregulation will gradually push profit margins higher.
  5. Poor demographics are linked with GDP growth, but countries with strong automation and efficiency capabilities can completely offset such (see our report on Debunking Demographics). As these charts show, even if GDP is flat, corporate profits can rise sharply in Japan due to productivity increases and gearing to global growth via multinationalization.
  6. We are now at the stage where domestic macro-factors (including the Yen) are less important to the stock market than the bottom–up increases in corporate profits. Indeed, we still believe equities can continue rise even if the Yen stabilizes at 118-119, although, of course, external factors will also be critically important.