Corporates in Japan remain awash with cash. A staggering 56.3% of non-financial companies listed on the Tokyo Stock Exchange (TOPIX) are sitting on net cash balances (see Figure 1), compared with just 18-20% for those on corresponding indices in the US and Europe.
Putting balance sheets to work
Attempts by the Bank of Japan to ignite domestic inflation and kick-start the economy have rendered borrowing money in Japan almost free, yet companies remain hesitant to take advantage of the opportunity – investment in plants and equipment is still 21% below 2007 levels.
It is not uncommon to meet companies in Japan with cash balances exceeding their market capitalisation. Indeed, around 37% of Japanese stocks are currently trading below their book (realisable) value. Unsurprisingly, a market rich with companies trading below break-up value, with cashed-up balance sheets, provides a hunting ground for activist investors. There was a 40% increase in the number of companies they targeted last year. Where they used to be labelled as ‘vultures’ many in Japan now view these activists as constructive.
Profits high and shareholder returns rising
With profit margins at all-time highs and cashflow generation exceeding dividend increases, we are hopeful that shareholder returns can improve further.TOPIX returns from dividends and share buybacks should be around 3.2% this year, roughly 2% and 1.2% respectively. Share buybacks are up 25.9% year-to-date versus the same period in 2017. Buybacks have been broad-based across sectors and the value is only a whisker away from the 2016 peak already. This week when Toshiba announced its first ever share buyback, the share price immediately rose 6.7%. Meanwhile, dividend payouts continue to rise too (see Figure 2).
The TOPIX offers investors a dividend yield of 1.96%, marginally exceeding 1.9% for the S&P 500. Payout ratios are in line, on a cyclically adjusted basis, and dividends are more widespread – only 1.6% of Japanese companies do not pay dividend versus 16.5% of American firms.
Governance reforms to support shareholders
Cash-saturated balance sheets, which are a drag on underlying returns, leave management defending their positions. The ‘5% rule’, introduced in 2014 by corporate governance specialists Institutional Shareholder Services, proposed that investors should vote against the re-election of the CEO if the five-year average return on equity falls below 5%. A report for the Japanese Ministry of Economy, Trade and Industry by Professor Kunio Ito – the Ito Review – suggested that this should be increased to 8%. However, progress remains slow and investors forgiving. 20% of firms fall short of ISS’s hurdle but not a single CEO has been held accountable, as yet. Last year, returns on equity exceeded those in Europe and for companies where executives own shares it was at twice the average, showing the importance of aligned interests.
Further reforms to improve corporate governance have included the Corporate Governance Code and the Stewardship Code. With companies pressed for more transparency on ‘cross shareholdings’, companies can no longer sit on their laurels.
Last month it was announced that companies can now use their Treasury (own) stock to acquire another company without triggering a capital gains tax bill (until sold). One company we own is trading significantly below book value and could easily be bought out by the parent company using its stock, equivalent to 11% of market cap, and significant cash reserves.
Reforms fall short of taxing excessive cash balances or forced unwinds of cross shareholdings but are steps in the right direction. From this month, companies will also now be required to disclose at their AGMs how much cash is on their balance sheets (and presumably therefore, what they plan to do with it – capital expenditure, wage hikes, buybacks or dividends). Earlier this year measures were also announced to reduce corporation tax for corporates that increase wages of their employees.
Cheap on the global stage
High cash balances also make stocks look more expensive on a P/E basis. Despite this, Japanese stocks still look cheap versus other markets and their longer term averages (see Figure 3):
The impressive pick-up in earnings has held price/earnings multiples steady in Japan.
There is scope too for Japanese investors to add to their equity weightings. Two thirds of Japanese bonds provide a negative yield yet Japan’s pension funds are still badly bloated with these instruments. The Government Pension Investment Fund (GPIF) has only 30% of its asset allocation invested in equities (vs 56% in bonds) – in the US and UK, for instance, equity exposure is typically around 45-50%+. Meanwhile, Japanese investors, like corporates and the GPIF, are risk-averse and sitting on significant cash deposits. Individuals hold around 51% in cash and 10% in equities which is significantly lower than American and European investors’ allocations to stocks.
The current government appears to be serious about ending the deeply ingrained deflationary mindset of individuals and also about improving returns to shareholders. While the cyclicality of the Japanese market, which is highly correlated with global trade, and Yen strength during a market panic, cannot be ignored and represents headwinds, we continue to find many exciting Japanese companies from a bottom-up perspective. Valuation support and improving returns to shareholders give us more comfort in this market than in some others.
Posted 14 June 2018
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