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A combination of structural changes and undervalued equities has made Japan ripe for growth in the near future. Now it is up to investors to take advantage.

Political stability, stringent corporate governance and low valuations make it an excellent time to invest in the Japanese market. Despite being the third largest economy in the world by gross domestic product, Japan is an afterthought to many investors. But not having exposure to Japanese equities deprives investors of a market that can provide strong dividend income and relative stability to investors.

Nikko Asset Management predicts the Nikkei 225 will rise about 16% between now and March 2020, compared to 5% for the S&P 500. John Vail, chief global strategist at Nikko Asset Management, attributes this projected outperformance to a combination of low valuations and momentum. Twelve-month forward price-to-earnings ratios in the 1st week of July 2019 were near historic lows, according to numbers from Bloomberg.

Low valuations, increasing dividends

“Valuations in Japan have sunk quite sharply to the lowest level they’ve been since Abenomics began, whereas US valuations remain very high,” Mr Vail said. “We’re obviously hoping that cash dividends are guided much higher and much more solidly in Japan to boost a lot of confidence in that market, and we’re seeing good signs of that. Dividends, for instance, are growing much faster—about mid-teens growth—than earnings right now—low single digits.”

One portfolio manager says Japanese companies have become much leaner since the financial crisis in 2008—having streamlined their structures—and they now have large amounts of cash reserves. “They are investing that excess cash into their companies,” said Masa Takeda of SPARX Asset Management and subadvisor of the Hennessy Japan Fund. “This bodes well for sustainable growth going forward.”

Dividend payouts have also increased as a result of corporate governance reforms that emphasise taking care of shareholders. For example, the TOPIX payout ratio has jumped to around 30% as of May 9 2019, up from about 17% in 2004, according to data from Bloomberg. This makes Japanese equities attractive, particularly for investors looking to generate income.

Kathy Matsui, vice chair at Goldman Sachs Japan, said that in addition to attractive valuations, profits are likely to rebound even with a stronger yen thanks to continued GDP growth in Japan and globally. Goldman Sachs forecasts earnings-per-share growth of 6% for the Japanese market in 2019 and 2020, respectively, even if the yen averages a rate of 105 to $1.

Abenomics and structural reform

The engine for much of this growth has been corporate governance reform and Abenomics. When Shinzo Abe took the reins as prime minister of Japan in December 2012, he put forward an economic policy called Abenomics to help spur growth. Abenomics is based on the “three arrows” of monetary easing, fiscal stimulus and structural reforms. Mr. Takeda said the economy is now at the point where structural reforms are taking centre stage, because monetary easing and fiscal stimulus have done their part in aiding economic growth over the past six years.

The government is moving in the right direction in my view, corporate tax cuts and corporate governance reform are working and will hopefully move the needle over the next few years

Masa Takeda
SPARX Asset Management and subadvisor of the Hennessy, Japan Fund

A main pillar of structural reform has been Japan’s corporate governance reform. In 2014, the Japanese government’s fiscal watchdog, the Financial Services Agency (FSA), introduced a new corporate stewardship code. The code was meant to counter the perception that institutional investors were too cozy with company management. Further guidance was published in 2017 enhancing disclosures and monitoring practice. These measures, Mr. Vail said, give the Japanese market a structural advantage over competitors, because only the United States comes close in terms of taking care of shareholders.

“This has resulted in much higher corporate profit margins, much higher shareholder payouts, and a much better relationship with shareholders in general,” Mr. Vail said. “There were always some very good companies, but the majority treated equity investors as second-class citizens. That has completely changed, whereby not only companies are being forced to pay more attention to shareholders and institutions who manage money in Japan—shareholders are now much more proactive in terms of how they vote and interact with corporations.”

How to invest in Japan

Investors outside of Japan have several ways to invest in the Japanese market. American Depositary Receipts (ADRs) are always an option for investors looking to add some of the large Japanese conglomerates to their portfolios, but institutional investors generally prefer mutual funds or exchange-traded funds because of the diversification they offer.

There are 52 US-domiciled mutual funds and exchange traded funds focused on Japan, according to data from Lipper from Refinitiv. Likewise, Japanese investors also use exchange-traded funds to access their own market, including several that track the Nikkei 225 index.

Investors are beginning to pay attention to the Japanese market because of all the positives of structural reform, as well as political stability. Vail noted Japan is far more stable than the U.S. and China, which are currently locking horns in a trade war, and the European Union, which has been thrown into turmoil since the Brexit vote in 2016. Despite this, Japanese equities remain underbought, he contends, leaving an opening for investors looking for stability, dividend income and select growth opportunities.

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