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Navigating a path for Japanese equities

Japan, Tokyo, Shiodome, aerial view

Japanese equities have enjoyed a resurgence of popularity over the last couple of years among European investors. The Nikkei 225 index has had a mixed ride this year, amid the fallout from the US-China trade war, but Japan’s benchmark index rose more than 5% last month.

Nikkei 225 (one year performance)

Source: Google Finance

Analysts, however, fear Japanese equities could take a hit from the introduction of a 8-10% hike in VAT this week and some worst-case scenario forecasts predict it could tip the economy into a contraction.

Prime Minister Shinzo Abe has pushed ahead with a hike despite robust opposition in Japan’s National Diet, which he argues is necessary to balance the country’s finances.

“The Japanese government has decided to go ahead with fiscal tightening – the VAT hike – at a time when other governments are trying to stimulate the economy. It’s not a smart move by the Japanese government,” said Nicholas Smith, a Japan strategist at brokerage CLSA.

However, Richard Kaye, a portfolio manager focused on Japanese equities at Comgest, said it was too early to gauge the impact of the tax hike. “The impact could be minimal because of various government incentives to limit its impact,” he said.

Monetary easing likely

Many investors in the country said it’s reasonably likely that the Bank of Japan will engage in another round of monetary easing, which could have a negative impact on Japanese banking stocks. Options include cutting interest rates further into negative territory, lowering the target for long-term rates or buying more exchange-traded funds.

“Monetary easing by central banks has crushed the relative performance of banking stocks, and that is especially the case in Japan,” Smith said, adding that other cyclical stocks such as automakers could also be affected.

European fund selector sentiment towards Japanese equities has fallen over the first three quarters of this year, according to Last Word Research.

Fund selector sentiment towards Japanese equities is down

Source: Last Word Research

To counter the risks from the tax rise and further easing, investors should reallocate capital towards quality growth stocks, Smith said.

“Companies with high return on equity that have earnings that are not too tightly correlated with the economy are the place to invest in at the moment,” he said.

“If you look at the valuations of good quality growth [companies], they are not expensive. Many of these companies are trading at below ten-year averages.”

Kaye said: “Further easing, of course, helps quality [companies] by weakening the yield curve case for bank stocks which are typically favoured by value portfolios.”

Meanwhile, dividends of Japanese equities have broadly doubled in this cycle, Smith added.

“Forward dividend deals in this market are at about 2.6%, which is 25% higher than the US market,” he said.

Shareholder returns

Increasing shareholder returns have led to two developments.

Kaye said it had encouraged the trend of the “returning” domestic investor, while Smith pointed to the trend of companies buying back shares.

“This year, share buybacks are really picking up as the market is down,” Smith said.

Japanese corporate culture is changing, and the large amounts of cash many groups hold is now being often used to buy back shares rather than issue dividends, he said.

Ryohei Yanagi, a professor at Waseda University in Tokyo, said there are plenty more opportunities for Japanese companies to unlock value.

“The inconvenient truth is that almost half of listed companies in Japan trade at below equity book value with around 500 companies accumulating cash and securities that is greater than their market capitalisation,” Yanagi said.

Yoshikazu Maeda, director of responsible investment at Governance for Owners Japan, an asset manager focused on stewardship services, said: “Investors are stepping up and requesting more payouts given the companies’ cash generation capacity and growth investment outlook. One clear example for that is increasingly aggressive shareholder activism in Japanese markets.

“As a result, the direction of travel will not reverse easily and we expect the rise to continue, as long as the companies generate sufficient operating cash flow.”

Elena Johansson

Senior Reporter

Part of the Mark Allen Group.