When Nomura’s equity strategists visited investors in London, Paris, Boston and New York, in late May, they were struck by how many hedge funds and long-only managers were hungry for an update on the progress of Abenomics. The Nomura team met 26 investors on its whistle-stop tour of Europe and the US East coast. “This was among the highest number of meetings we have held on such a trip to date, reaffirming to us that demand for Japanese equities is brisk at present,” Nomura reported.
Others have noticed a similar trend. “Late last year, weightings in Japanese equities among international investors were extremely low,” says Taro Hayashi, Chairman of SMBC Nikko in London. “Although investors are probably still underweight, these weightings rose steadily over the first half of this year.”
It is not just investors whose interest in Japanese equities has been rekindled by the ambitious growth plans of Prime Minister Abe. International investment banks also appear to be convinced about the longer term prospects for the Japanese equity market, with Bank of America Merrill Lynch (BAML), Barclays and UBS all reported to be adding to their Tokyo-based equity sales and trading operations.
There are no prizes for identifying why Japanese equities have become the focus of such intense investor attention in recent months. Economists say that the key to the explosive performance of the market since last year’s election has been the weakening of the yen, the performance of which is very strongly correlated to the Nikkei and Topix indices. “The fall in the value of the yen has changed the corporate landscape entirely, especially in the manufacturing sector,” says Kiichi Murashima, managing director of economics and rates strategy at Citi in Tokyo. “By early August, recurring profits at listed companies that had reported were up 53%.”
There is still plenty of scope for those profits to rise equally strongly over the coming year, if the general consensus about the outlook for the yen is anything to go by. In an update published in August, Mizuho Securities forecast that the yen would continue its downward march over the next 24 months, reaching 105 against the dollar at the end of 2013, 107.5 by December 2014 and 110 by the end of 2015.
The prospects for continued weakness in the currency, further supporting earnings growth, is one reason why Nomura, for one, expects the rally in Japanese equities to continue over the remainder of this year. By mid-August, it was still advising that its year-end target for the Nikkei index was 18,000.
Reality check?
Some argue, however, that there are still plenty of arguments for being mistrustful of the Japanese equity rally. Foremost among these is the perennial complaint that standards of corporate governance and commitment to shareholder value in Japan remain poor relative to the US and Europe. “Most at issue is the creation of a market in corporate control,” noted Brendan Brown, chief economist at Mitsubishi UFJ Securities in London, in an update in July. “As of now there are many practical and legal barriers which impede domestic or foreign takeovers of Japanese companies. In consequence, in many cases these can retain large surpluses or plough these into uneconomic low-return areas which detract from shareholder value. In turn the low returns to capital discourage equity investment.”
Brown added that “an efficient market in corporate control would stimulate a run-down of high savings in the company sector, with these being paid out in higher dividends or on new equity buy-back programmes. In turn that would add to the attraction of Japanese equity both to domestic and foreign investors.”
Some hedge funds continue to be frustrated at what they see as the intransigence of Japanese management over underperforming or unproductive subsidiaries. Take, as an example, the recent spat between the New York-based activist hedge fund, Loeb Third Point, and the Japanese electronics giant, Sony. Loeb, which has built a 6.9% stake in the Japanese electronics company, is urging Sony to spin off a 15%-20% stake of its entertainment business in an IPO, arguing its case in no uncertain terms in a recent letter to investors.
This says that in contrast to Sony’s electronics business, the entertainment operation is “poorly managed, with a famously bloated corporate structure, generous perk packages, high salaries for underperforming senior executives, and marketing budgets that do not seem to be in line with any sense of return on capital invested.”
For now, Sony is digging its heels in over the Loeb proposal. Refusing to bow to external pressure, its CEO, Kazuo Hirai, has insisted that he is “very focused on increasing margins” at Sony Pictures.
Tomochika Kitaoka, senior economist in the equity research group at Mizuho Securities in Tokyo, says that with foreign investors now owning some 30% of the Japanese equity market, it is inevitable that activists such as Loeb and others should be making their presence felt. But he adds that local insurance companies are also making more use of proxy voting to put pressure on underperforming companies, which is another signal of growing maturity of the broader Japanese equity market.
Others are less hopeful that US hedge fund managers such as Loeb will make much headway in Japan. “I think Loeb may be learning the hard way that activism does not work in Japan,” says Akihiro Ohara, head of equity sales and trading at Société Générale in Tokyo.
That may be. But Tokyo-based equity strategists argue that if sabre-rattling by investors such as Third Point push the likes of Sony to reappraise its approach to the creation of shareholder value it will have done its job. They also say that it is precisely the potential for change within the Japanese corporate universe that is making the equity market considerably more attractive to long-only managers as well as hedge funds than it has been for decades.
Many also say there is more to applaud than to condemn in the shift in the attitude of Japanese management to looking after their shareholders. Naoki Kamiyama, managing director and head of Japan equity strategy at Merrill Lynch Japan Securities, says that one of the clearest examples of this changing mind-set is that improving margins at the expense of turnover is no longer a taboo in Japanese boardrooms. He points to a company like Panasonic as one that has publicly recognised that expanding sales does not necessarily generate profits for shareholders.
Increased margin consciousness across the listed corporate universe, says Kamiyama, ought to lead to a re-rating of Japanese stocks. “The best margins in Japan these days are about 9%, compared with 14%-16% in the US and Europe, so in many cases there is the potential for return in equity (ROE) to be doubled in Japan,” he says.
Hand-in-hand with a more intense focus on margins, says Kamiyama, there has been a conspicuous improvement in capital efficiency at Japanese companies, with many of the larger operators increasingly recognising that any excess capital that is not used productively should be returned to shareholders. “Since activist shareholders started to come to Japan in 2004 and 2005, dividend payouts at listed companies have risen from ¥3tr to between ¥6tr and ¥7tr,” he says.
Consumption tax looms
In the shorter term, a number of external events are expected to have a more immediate impact on Japanese equities than these long term trends. The first is the announcement on which way Japan intends to jump in terms of its long-overdue increase in the consumption tax. Superficially, an increase in the tax looks negative for Japanese equities. As Kitaoka at Mizuho Securities says, the first phase of the two-part increase can be expected to cost the consumer between ¥7tr and ¥8tr. This is about 1.5% of GDP, which Kitaoka says will lead to a contraction in the economy in the second quarter of 2014. That is not quite as severe a reduction as in 1997, when an increase in the tax from 3% to 5% was regarded as one of several factors responsible for causing a lengthy recession in Japan. Nevertheless, as Citi notes in a recent update, the tax hike “would be bound to lead to a deceleration in consumption”.
“This is why a supplementary budget is highly likely as a compromise between the different policy groups,” says Kitaoka.
Historical precedent would suggest that an increase in the consumption tax is likely to be negative for Japanese equities. In the nine months between June 1996, when the Cabinet decision was made to raise the tax by 2%, and April 1997, when the rise took effect, the Topix declined by about 20%, according to Citi.
However, analysts are much more sanguine about the likely impact of the tax rise this time around, for a number of reasons. The first is based on the belief that unlike in 1996, Japanese equities are not overvalued, even after the rise in the main indices since Abe’s victory at the polls. Citi’s research puts Japan’s cyclically adjusted P/E ratio at an undemanding 11.7 times in early July, well below the multiple of around 20 times that has usually signalled the onset of Japanese bear markets since the 1990s. The one-year forward P/E ratio at the same date was 13.6 times on the same day, according to Citi, which again is well below the ratio of 20 times before the Lehman collapse.
The second reason why equity analysts say that the market would probably welcome a tax hike in line with the original schedule is that it would re-emphasise the commitment of the Abe administration to fiscal consolidation and financial discipline.
Besides, as Kamiyama at BAML says, a rise in the consumption tax has long since been discounted by equity investors. The real surprise, he says, would be if the tax rise was delayed or watered down.
A third reason why the equity market probably has less to fear from the tax increase than it did in the late 1990s is that any hike is almost certain to be accompanied by a supplementary budget, which Nomura expects will be worth as much as ¥5tr. That, thinks Nomura, will be positive for sectors such as construction.
All this helps to explain why 57% of respondents to a recent Nomura survey indicated that they would expect equities to rise in response to a firm commitment by the government to increase the tax. A further 17% said the tax rise would have no impact.
TPP influence
Among other themes that are expected to exert a positive influence in the Japanese equity market, one is the potential of Japan’s participation in the Trans-Pacific Partnership (TPP). Although he faces stiff opposition from the agricultural lobby, among others, Prime Minister Abe is a vocal supporter of the TPP, which would liberalise trade across an economic region with a combined GDP of more than $24tr.
In August, Japan’s trade minister, Toshimutsu Motegi and US trade representative Michael Froman announced that both parties were committed to reaching a conclusion on free trade negotiations by the end of 2013.
By exposing Japanese companies to an altogether more challenging competitive environment, the TPP will reward the more efficient operators and penalise the weaker ones, which mirrors an important broader long term trend. This is the emergence of a more Darwinian operating backdrop, which is welcomed by many bankers. “We’re in an environment in which clear winners and losers are emerging, which is going to make stock-picking increasingly important,” says Brendan O’Dea, head of equity markets at Citi in Tokyo. “Investors are moving away from simply investing in the index.”
Seijiro Takeshita, director at Mizuho International in London, says that the emergence of winners and losers in the equity market is symptomatic of a deeper shift in the business model of Japan Inc. “Japanese management is walking away from the cluster model that used to characterise Japanese industry, and which meant that companies all moved in the same strategic direction,” he says. “That is changing, and the result is a polarisation between winners and losers which Japan has never seen before.”
As well as rewarding investors able to generate alpha by stock-picking, the process of polarisation will ultimately lead to more consolidation within the Japanese corporate landscape. “A number of domestic industries are made up of small companies that will face more pressure to consolidate,” says O’Dea.
Reit good value
Another theme that has been increasingly important for equity investors has been a marked improvement in sentiment towards the Japanese real estate sector in general and the market for real estate investment trusts (J-Reits) in particular. By some metrics, however, J-Reits appear to remain modestly valued relative to their peers in other markets.
According to the 3Q2013 report on Japanese real estate published by Deutsche Asset and Wealth Management (DeAWM), “the J-Reit dividend yield still provides a spread of more than 300bp (and 242bp for office Reits) over the 10 year government bond yield, compared to about 100bp of spreads both in the US-Reit and UK-Reit markets.”
Strong investor support for the Japanese real estate sector has been an important prop for the primary equity market in 2013. Much of this activity was driven by the J-Reits sector, with the $1bn Nippon Prologis IPO in February followed in June by a $1.8bn issue from the Nomura Real Estate Master Fund.
Comfortably the largest IPO in Japan this year, however, has been the $3.9bn share sale in July by Suntory Beverage & Food, the soft drinks subsidiary of the acquisitive Osaka-based Suntory Holdings. Arranged by Nomura, Morgan Stanley and JP Morgan, the Suntory BF IPO was priced at ¥3,100 per share, which was towards the lower end of its ¥3,000-¥3,800 range. That ensured that the domestic tranche was more than three times oversubscribed, with the international tranche oversubscribed almost two times. Significantly, a big chunk of this international demand is reported to have come from sovereign wealth funds.
Beyond IPOs, there was also a vibrant market in 2013 for follow-on offerings, which rose four-fold to $18.3bn in the first half of the year. The largest of these — and the largest follow-on offering globally outside the FIG sector since 2011 — was the $7.78bn global secondary offering from Japan Tobacco in February. Some 42.5% of the JT issue was sold internationally, with strength of demand for the domestic and overseas tranche allowing the offer to be priced at a 2% discount, which was the low end of the 2%-4% range.
According to SMBC Nikko, by the end of August total Japanese ECM volume had reached $35bn, compared with $26bn for the whole of 2012. Bankers are hopeful about the prospects for the new issue market, both in equities and equity-linked products. “With more than $20bn of Japanese convertible bonds due to be redeemed this year and next, the opportunities for refinancing via hybrids are excellent,” says Hayashi at SMBC Nikko.