Japan has had its hiccups and looks to be recovering, although the pace may be muted. A stronger yen and market volatility could weigh on expectations, making forecasts for 2018 at Japanese corporations conservative by our estimates. Though global growth remains healthy, it is slower after a strong year, and this could prove to be a tailwind for Japanese corporates.
The Bank of Japan (BOJ), the country’s central bank, can maintain positive initiatives to help Japan’s economic progress, though there will be much for the bank to monitor. In recent events, the Japanese government nominated Haruhiko Kuroda as Governor of the Bank of Japan (BOJ) for another 5-year term, suggesting that his stimulus program to achieve a 2% inflation target may well continue.
The BOJ will also have to closely watch how expected rising wages and subsequent gains in consumer prices could impact the economy. Labor shortages across Japan’s industries have made it difficult for some companies to build and grow their businesses. These labor shortages in part led to some fall in sentiment also across a range of service industries. About 70% of Japan’s companies are dealing with labor shortages, according to a report released earlier this year by Japan’s Ministry of Finance.
Another factor in muted expectations were the cost realities of doing business today. A recent survey of business leaders conducted by the BOJ found that business sentiment was down for the first time in two years because of rising raw materials prices. While costs are growing, and wage growth and inflation remains low, we believe there are positive aspects to the fundamental Japanese corporate environment.
Corporates: profit focus is paying off
Japanese companies have become more focused on their most profitable businesses, with profitability remaining high with the yen at current levels. Across sectors, factory automation and semiconductor-related industries have reported higher-than-expected earnings. Elsewhere, the growth of incoming Chinese tourists has provided a boon to cosmetics and toiletries industries, given that their products are highly sought after by mainland consumers for their perceived quality and stylishness.
Across sectors, factory automation and semiconductor-related industries have reported higher-than-expected earnings.
Meanwhile, disruption is taking root via autonomous driving, electrification and connectivity in the automotive sector. This will work itself through supply chains, benefiting companies that are well positioned to capitalise on the structural trends.
Valuations are also fair and even slightly cheaper than peers in other parts of the world. This makes Japanese corporates fair and good buys in the current market environment. In addition, balance sheets and cash flows remain strong. With a larger emphasis on profitability among Japanese companies, some are now flush with cash. The percentage of non-financial companies that are net cash, or in other words have strong balance sheets, are higher within the Topix than in the S&P 500, MSCI Europe and FTSE All-Share indices, according to Bloomberg data as of end of December 2017.
Overall, the dividends of Japanese corporates remain sustainable though share buybacks have moderated, and Japan’s Topix payout ratio was 29%, compared to 39% of the S&P 500, according to CLSA and Bloomberg data as of September 2017.
Governance reform: slowly but surely
Corporate governance reform remains slow but is improving. Japan still has some way to go versus its developed market peers, when we look at two key indicators. Its percentage of independent board directors remains low compared to the United States, Singapore and Germany, which are far more progressive. Chief executive officers at Japanese companies also tend to stay longer than their Western counterparts. About 76% of Japanese CEOs have no outside experience, and 24% have experience at other companies, according to a 2017 study by PwC. In comparison, 84% of CEOs in the US and Canada have experience at other companies, and 91% of Western European CEOs have experience elsewhere.
Things are changing, though. A large part has to do with the Abe administration, which is paying more care to this area, to make companies more competitive and attractive to foreign investors. It is reviewing the corporate governance code. For instance, companies are required to have at least two external board members. The government is also prodding them to improve standards and enhance shareholder value. This is starting to bear fruit. We’re seeing companies raise payout ratios and/or carry out buybacks where appropriate.
We believe it is important for investors to be invested in more progressive companies that will safeguard the interests of all shareholders. When a company improves capital management and governance, this lowers investment risk. By increasing interaction and engagement with companies, investors can better identify the stronger companies. We’re also finding that companies are increasingly having a good understanding of such issues. On our most recent trip to Tokyo, Nagoya and Osaka we spoke to 16 companies and had meaningful discussions with them.
These are among the key areas we are watching closely in Japan. We remain confident in the fundamentals of Japan’s companies, and the products and services they have to offer the world. While difficult to completely disregard, if you set aside the happenings at the BOJ, government and global politics, and focus on what makes a sustainable or strong company, there are investments to be found that can add to a portfolio for the long term.
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