Time to Reengage with Japan
I recently had the opportunity to interview Jesper Koll, a Senior Advisor to WisdomTree, on opportunities in Japan’s equity market for our “Behind the Markets” podcast.
Koll believes Japan will be a source of surprise for both economic strength and corporate performance.
Positioning Japan in Portfolios
Koll sees investors as underweight in Japan today as they were at the time of the Fukushima nuclear reactor disaster. This relative positioning makes Japan interesting by itself, but we do see Abenomics showing positive domestic strength. The industrial sector and exporters have certainly been hit by trade fears, but there is outperformance in some of the small and medium-sized companies within the local economy from a profit perspective.
Delivering Growth, but Valuation Multiples Shrinking
Japan has been delivering healthy earnings growth, but valuations have fallen, making Japan even more of a value play. What can unlock this value?
Koll sees signs of corporate activists getting more involved, with 70 different proposals to Japanese companies at the latest June board meetings.
There is increasingly more focus on capital stewardship in the form of more dividends and buybacks at a time when corporate activism is trying to change businesses’ operational focus to shed non-core assets.
Koll has observed twice as many buybacks as this point last year, and dividends already growing at double-digit rates this year. He sees the Japanese pension program, the Government Pension Investment Fund, putting pressure on Japanese companies to deliver meaningful value to investors.
ROE has increased from 3% over the last 15 years, on average, all the way up to 10% for broad market Japan indexes, with a majority of companies having a target of 14%.
Hitachi as an Example of Newfound Operational Focus
Multinational conglomerate Hitachi1 has engaged private equity firm KKR & Co. Inc. to help them restructure their business. This would have been taboo in Japan even five years ago, but now they are going to change their operational focus to be more globally competitive.
Koll believes Japanese companies have a war chest of cash to deploy around the world, and he foresees one of the mega banks in the market likely to buy a major U.S. bank sometime soon.
The Japanese banks are stuck, however, because the Bank of Japan (BoJ) has capped long-term bonds at 10 basis points, limiting their financing opportunities domestically. Japanese banks are now also the largest creditor to non-China Asia. Their portfolios are growing aggressively in Asia, but they desire more of a U.S. presence.
BoJ Policy and Government Debt
Despite Japan’s debt to gross domestic product (GDP) ratio having grown from over 100% of GDP to 300% of GDP, interest expense has fallen and is now only 1% of GDP. The government is getting this debt essentially for free. And despite this “unholy” monetary experiment where the Bank of Japan is financing this debt and capping long-term bond yields, Koll sees no distortions. He sees no signs of an asset bubble, inflation or a collapse in the exchange rate. He believes this program (or bold experiment) may be a precursor of what is to come globally in the future.
Is the BoJ Buying Equity Exchange-Traded Funds (ETFs) a Problem?
Koll sees one of the greatest hesitations that global investors have toward investing in Japan as the Bank of Japan’s ETF purchases, which now account for 5% of total ownership of the equity market. There are even fears that the BoJ may eventually have to wind down and sell these ETFs.
But Koll has a proposal for potential buyers. Who has the money to buy? The older generation in Japan, meaning people over age 65. Their biggest concern is an inheritance tax that is 60% of assets. Koll said jokingly that if they can make ETFs exempt from the estate tax, the BoJ could sell their ETFs to individuals in 24 hours as that would eliminate the tax concerns.
Where Is the Yen Headed?
Koll and I discussed the risk on/risk off funding dynamics that make the yen the preferred trading vehicle of global speculators. But as Koll looks out five years ahead, he sees the yen as a weaker currency driven by capital outflows, with corporate Japan making more acquisitions like the bank discussion above.
Koll makes a compelling case that Japan is an unloved market, ripe for catch-up with other global markets, that gets compounded higher with improving corporate governance. Koll particularly likes small and medium-sized companies that could have performances less synchronized with the rest of the global markets.
Please listen to the full conversation below.
Unless otherwise noted, data source is Bloomberg, as of 7/12/19.