Will the sun rise over Japanese equities?

With an ageing society the long-term labour input into growth is negative and thus Japan is highly dependent on production and capital productivity. The myth has always been that Japan has low productivity, but if one focus on the working-age population GDP per capita then Japan has followed the most productive OECD countries. This McKinsey report from March 2015 outlines very well the problems and opportunities for Japan in the decades to come. Because Japan will experience the pressure from negative demographics first in the developed world the incentive and pressure on automation will also be the biggest. This could set up Japanese automation and robotics industry for a leading position creating an export engine in the future as demographics will come to haunt the US and Europe in the future causing an ever increasing need for automation offset a shrinking labour pool. Keyence is one of those companies that are leading the automation industry in Japan.

Significant valuation discount, buybacks, and the low interest rate sensitivity

One of the most interesting aspects of the Japanese equity market is its valuation level. Japanese equities are valued on the 12-month forward EV/EBITDA at 6.7x which is a 48% discount to US equities reflecting extraordinary relative pessimism of Japanese companies. The more than a decade bull market in US technology stocks have created an expectations gap between the US and Japan like anything we have ever seen before. This is also evident in the difference in the dividend yield between Japan and the US which has increased from -2%-points to +0.8%-points since 1995. Another positive factor for Japanese equities is the capital productivity improvement by Japanese companies which has made it possible for these companies to increase the payout to shareholders through buybacks. In the past five years, the average buyback yield has averaged 0.9%.

If we follow the classic way of calculating the long-term expected real rate return on Japanese then it is currently 5.4% annualized derived from a dividend yield of 2.4%, 0.9% expected buyback yield, and 2.1% annualized real earnings growth which could prove to be too low if investors underestimate productivity gains and Japanese companies ability to expand overseas freeing them from the constraints of Japan’s low nominal growth economy.

The final interesting factor on Japanese equities is the negative net debt (cash levels exceed debt). This feature means that Japanese companies actually have a positive sensitivity to rising interest rates unlike most other equity markets including the US equity market. With the new BoJ Governor Ueda taking over from Kuroda, the country may adopt a different monetary policy over time which could help strengthen the JPY but also increasing the value of those cash balances in the corporate sector.

Investors have plenty of cheap ETFs to choose from tracking the Japanese equity market and there are even options that hedge the JPY as well if investors do not want the currency risk. For other investors investing in single stocks is more preferred and the list below shows the 10 largest stocks in the Japanese equity market today:

• Toyota
• Sony
• Keyence
• Nippon Telegraph & Telephone
• Mitsubishi UFJ Financial
• Fast Retailing
• KDDI
• Daiichi Sankyo
• Oriental Land
• Shin-Etsu Chemical