By Katsuaki Ogata, Masahide Ooka
The rapid surge of Japanese equities in recent years has left many investors worried that they may have missed the bus. We believe big changes underway can support further profitability improvements and push the market higher.
The TOPIX has risen more than 125% in yen terms since December 2012, when Prime Minister Shinzo Abe took office and launched his "Abenomics" initiatives. Of course, the yen's sharp decline means that unhedged returns for overseas investors would be less spectacular, but in local terms the TOPIX is scaling seven-year highs and the narrower Nikkei 225 average has broken through the 20,000 level for the first time in 15 years.
Several factors have driven the bull market. First, the government and central bank seem determined to eradicate decades-long deflation. Second, asset allocation by Japan's huge public pension funds have shifted in favor of riskier assets. Third, the yen's export-choking strength over the years has now reversed. And fourth, corporate earnings have improved across industries. In our view, a confluence of all these factors has made the market so combustible.
The problem is that the rally has come in fits and starts. When the market burst forward, many investors could not react quickly enough. And when the market paused, investors had to wonder if the party had ended. With the Nikkei hitting 20,000, people are trying to take a deep breath again to check whether the air is getting a little thin at these altitudes. In Japan, some skepticism is a healthy reaction, given the numerous false dawns that the market went through in the 1990s and 2000s.
What's Different This Time?
For perspective, let's start by looking at the roots of this rally.
Mr. Abe took office in December 2012-just after the 2011 earthquake and tsunami, the euro crisis and the yen's rise to postwar highs against the US dollar. Deflation seemed entrenched, and several big Japanese companies that were household names around the world were in deep trouble. Against this backdrop, investors had little love for the Japanese stock market. Valuations such as earnings multiples and the price-to-book ratio were very depressed, both vis-a-vis other global markets and the Japanese market's own history (Display).
Even today, valuations remain modest despite the market's march upward. That's because corporate earnings have improved sharply over the same period.
Seen through this lens, the Japanese stock market doesn't seem overheated. It hasn't risen as much as other markets relative to earnings improvements (Display). Moreover, we believe that the market still has a way to go, given the structural changes that point to improved prospects for stronger profitability and earnings at Japanese corporations.
More Focus on Profitability and Shareholder Returns
The most important structural change, in our view, is the growing recognition by company management, investors and regulators about the need for companies to make better use of shareholders' money. It has led to a broad advocacy of the newly launched corporate governance code (for company management) and the stewardship code (for institutional investors).
Companies are also facing increased pressure to improve profitability from several directions:
- Proxy-vote service institution ISS and major public pension funds such as the Pension Fund Association (PFA) are urging companies to pay more attention to return on equity (ROE)
- The ROE-screened JPX400 Index has been introduced
- The powerful Government Pension and Investment Fund (GPIF) is allocating a greater portion of its assets to equities, including JPX400
- There's a growing presence of activist investors.
As a result, more companies are returning cash to shareholders via dividend increase and share buybacks (Display). Recent examples of eye-catching corporate actions include men's clothing outlet Aoyama Shoji, which announced it would return 130% of its earnings to shareholders over three years, and machinery-maker Amada, which aims to return 100% of its earnings over two years, in a bid to be included in the JPX400 index.
Supportive Macroeconomic Environment
We'll take a closer look at changes in corporate behavior, particularly those related to corporate governance, as well as macroeconomic factors, in future blogs. In general, the domestic macroeconomic environment is helping-if not forcing-many of these changes.
The path may not necessarily be smooth, with the US Federal Reserve close to raising interest rates, the eurozone still hampered by Greece's financial woes and emerging-market economies-including China-slowing down.
Even with these global challenges, however, we believe there's enough momentum in underlying structural changes at home-both macroeconomic and microeconomic-to support Japanese equities. The market isn't just enjoying a garden-variety, cyclical rally that's about to fizzle out, in our view. And the new trends are also offering an even greater opportunity for active investors who take a thorough look at corporate fundamentals and industry dynamics, as some companies are adapting to the changes better than others.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.
Katsuaki Ogata serves as Chairman - AllianceBernstein Japan and Chief Investment Officer - Japan Value Equities.
Masahide Ooka, CFA, serves as Senior Portfolio Manager - Value Equities at AllianceBernstein.