Bilal’s Macroscope: Japan’s Corporate Renaissance

Summary

• The Japanese stock market has performed strongly in recent years thanks to improved fundamentals.
• More recently, the Tokyo Stock Exchange (TSE) has begun encouraging companies with a price/book (P/B) ratio of below 1.0 to boost dividends and share buybacks to increase multiples.
• We provide several metrics for tracking improved corporate governance, including the dividend payout ratio, decrease in capital stock, and percentage of companies trading below book value.

Market Implications

• We remain overweight Japanese stocks and prefer to gain exposure by being overweight value, banks, and small caps.

TSE Pushes for Higher Dividends and Buybacks

Japanese corporate reform has gone into overdrive recently as the TSE, which controls the Tokyo and Osaka exchanges, takes up the mantle of driving further improvements. In 2022, the TSE sought to reform the listing criteria for firms, adding requirements for companies wanting to list on a public exchange. In March 2023, it began pushing for companies to publish plans to improve corporate value to trade above a P/B valuation of 1.0 (i.e., above book value).

The TSE aims to do this via an unprecedented strategy. Each month, they intend to release a list of companies that have disclosed an action plan to investors to raise their valuation. The objective is to nudge companies still to announce a plan.

Companies that have announced an action plan and then implemented it by returning capital to shareholders have been highlighted as ‘success stories’. This list not only boosts reforming firms’ reputations but also offers investors a hunting ground for ideas.

Japan also wants to become an ‘Asset Management Centre’, channelling household cash savings into productive investments that should boost corporate value and drive a cycle of reinvestment and consumption. The initiative involves reducing barriers to entry, establishing special zones encouraging foreign asset managers to open in Japan, and reforming domestic pension funds.

So, have these initiatives been working? We examine a series of metrics we think best capture their objective. These include:

1. Growth in dividends per share.
2. Dividend payout ratio.
3. Decrease in share capital stock (a proxy for share buybacks).
4. Percentage of stocks trading below book value (P/B below 1.0).
5. Percentage of stocks with an ROE below 8%.

We find that since the end of 2019, Japanese corporates have increased dividends per share by 35%, versus 21% for the S&P 500 and 18% in Europe. It sounds positive so far.

However, the dividend payout ratio (dividends paid relative to net income) has remained broadly stable since 2022, meaning the portion of profits being paid out to shareholders has stayed the same. This should be an area of improvement going forward.

The improvement is more visible in the decrease in capital stock. We use this metric as a proxy for share buybacks (while excluding the financial sector). Notably, Japanese companies now spend a greater proportion of their market cap relative to their European peers. The value spent on buybacks is also near record highs, with stated buyback intentions suggesting further highs later this year (Chart 2).

The rally in Japanese equities has resulted in the number of companies trading below a P/B ratio of 1 falling to below 20% for companies within the MSCI Japan index (mostly large caps), however for the broader TOPIX index, this number remains close to 50%. As action plans begin to be enforced, we’d expect this number to decline sustainably.

Overall, the data are mixed. However, there are reasons to believe this is just the beginning. For instance, TSE’s latest update shows that 50% of ‘Prime Market’ listings or 815 firms have already disclosed an action plan to boost shareholder returns, including large corporates such as Toyota.

Japanese Equity Fundamentals Have Improved

TSE’s reforms come in a broader context. Initially, they were closely linked to Shinzo Abe’s third arrow on structural reforms.

The idea was that companies had become too lax and lost their dynamism. They were sitting on excess cash, which should be either used to increase wages and/or capex or returned to shareholders.

Specifically, the Abe government introduced several initiatives to boost shareholder power. These include:

1. The Shareholder Stewardship Code – 2014.
2. The Corporate Governance Code – 2015.
3. Fair M&A Guidelines – 2019.

Japan’s Governance Code sets best practices for companies. Meanwhile, the Stewardship Code (signed by major asset managers) promotes voting transparency and aims to align investment decisions with shareholder interests (a win for ESG?).

Fuelled by Shinzo Abe’s corporate reforms, Japanese equities became the second-best performing major market from 2011-2018, trailing only the US (Chart 1).

Importantly, we find these initiatives improved fundamentals, which have underpinned Japan’s strong equity performance. Since 2011, we find that:

1. Japanese equities have seen the highest increase in earnings (helped by a weaker JPY). Over the past six months, Japanese stocks have increased EPS by over 20%, versus no growth in either the US or Europe (Chart 5).
2. Corporates are not just more profitable but also earn higher returns on equity (ROE). Rising efficiency has partly driven this, as operating margins have expanded by almost 200 bps since 2011 (Chart 6). While overall margins are still lower than their US peers, the trajectory has been positive.

We Remain Overweight

We remain bullish on Japanese stocks and believe the improvement in corporate governance will continue to drive shareholder yields higher.

Given these initiatives target companies trading below book value, being overweight value makes sense and provides a differentiated exposure to other regions such as the US and Europe where growth has done better (Chart 8). Banks in particular have traded on the lowest multiple relative to other industries. Yet they also have the highest shareholder disclosure rate, making them a prime candidate for multiple expansion (with the added tailwind of positive nominal interest rates to come).

Also, much of the strong performance has so far come via large cap outperformance (Chart 9). TSE data shows 50% of companies with a market cap above ¥100bn have currently disclosed action plans, versus just 22% for companies below a market cap of ¥25bn. As smaller companies begin to roll out action plans, we expect recent strong performance to broaden beyond mainly large caps.

Another benefit of allocating to smaller companies is greater exposure to the domestic market and less reliance on the weak JPY for outperformance. Since 2022, Japanese outperformance versus the US has been mostly driven by a stronger USD/JPY (JPY depreciating), which has helped export competitiveness and corporate profits (Chart 10).

Finally, Japan’s apparent success in raising stock valuations via corporate governance reforms seems contagious. South Korean officials recently announced plans to narrow the ‘Korean discount’ and encourage almost 60% of companies within the Kospi index to take action.

What Japan’s story tells us, however, is that reforms take time to get buy-in from companies, so investors must be patient when looking for results.

Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.

Viresh Kanabar is an investment strategist with 8+ years of experience, notably contributing to portfolio construction and risk management at CCLA Investment Management, a £12 billion fund. Viresh was also a voting member of the Investment Committee and ran the private asset valuation process.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)