April 17, 2014
|Archibald Ciganer, portfolio manager of the T. Rowe Price Japan Fund.|
The weaker yen and the recovery in economic activity have provided the ingredients for Japan's recent stock market success. Evidence of a cultural shift within Japanese corporations is inspiring the next wave of confidence in Japan. Some companies are already defying the skeptics by transforming their business practices and governance standards to deliver more consistent profit growth, and this should generate greater shareholder value. As a result, investors may enjoy compelling stock-specific opportunities.
- The increase in shareholder focus may constitute a rich opportunity for investors; corporate governance standards and business practices are already improving.
- We believe Japan deserves a place in all diversified portfolios. Investors have the potential to own stocks with medium-term cyclical tailwinds and the potential for long-term change and reform.
- To ensure the longer-term success of the Japanese economy, wage growth must materialize.
The Abenomics revolution
Prime Minister Shinzo Abe has jump-started the economy and markets with a revolutionary economic reform agenda, which has been coined "Abenomics." This economic remedy is prescribed as a "three arrow" approach of (1) looser monetary policy and inflation targeting, (2) expansionary fiscal policy, and (3) longer-term structural reform. So far, policy measures have certainly surpassed expectations and the renewed confidence has lifted the domestic stock market, along with consumer and business optimism. The yen has also weakened materially on the government's monetary policy decisions, and as a consequence, Japanese exporters have become increasingly competitive, economic activity has picked up, and profit growth has increased.
The evolution of corporate Japan: unlocking shareholder value
For many years, one factor holding back the Japanese market was companies' inflexible approaches to cost management, overstaffing issues, and their inefficient (cash-rich) balance sheets.
Now, with corporate governance standards improving and the promotion of shareholder-friendly measures, there is scope for greater shareholder value. Evidence of change in corporate behavior is already emerging. Management teams are becoming more business savvy, with many employing cost-reduction exercises to globalize the business and focus on profit delivery. In addition, the number of shareholder buybacks is increasing; mergers and acquisitions are no longer a rarity. We expect these transformational actions to be rewarded through higher valuations.
Japan's most credible opportunity yet
This shift in corporate mentality is a longer-term theme that could reward investors' patience. Unlike the failed attempts of previous governments to evoke real change, this time around there are significant incentives in place. One example, the new equity index launched by Nikkei and Topix selectively lists companies that demonstrate a focus on profitability gains and those that are sensitized to tackle governance issues. Given this criterion, there should be a powerful motivation to improve business practices at the margins, where companies are rivaling to enter the index.
The uneven road ahead
We are mindful that it will be a multiyear process, and in the meantime, market volatility is likely to feature. Market sentiment could waver as the efficacy and scope of Abe's reforms are called into question over Japan's period of transformation. For those investors able to take a longer-term view, there is a compelling investment opportunity on the other side of the Japanese journey.
Positive earnings surprises ahead?
While patience is necessary, there are also other potential catalysts in the nearer term. Our research shows that earnings estimates of Japanese corporations have been too conservative and do not reflect many companies' true earnings potential. Exporters, for instance, have not factored into their business plans the full advantages of their currency competitiveness, nor have they exploited this competitive position. As exporters decide to capitalize on the opportunity, we could see substantial earnings growth.
Earnings growth will continue to underpin the recovery
A large proportion of Japan's economy is export oriented and therefore should benefit from a healthier global outlook, led by a U.S. recovery. The increasing global demand for Japanese products could boost earnings growth. Yen weakness is also a big factor in sustaining high profit margins for exporters. We think that these should continue to expand as company cost-cutting and streamlining processes continue.
As for non-exporters, particularly retailers, years of general price declines have kept profit margins historically low. Now that prices are finally rising in Japan, we could see margins move closer toward European and American levels.
Ingredients for a durable recovery
With price inflation in positive territory, we now want wage increases to materialize. For a long-lasting recovery, we believe consumption needs to play a greater role to balance Japan's overreliance on export demand. For this, higher wages and bonuses should arm Japanese consumers with the necessary spending powers. The healthier corporate profit environment and government tax schemes have better incentivized companies to increase wages. Also, with a growing demand for labor, given the limited supply of workers, companies are likely to offer higher pay rates.
Although this feature of Japan's development is surrounded by skepticism, we believe the current trend is promising, particularly as inflation expectations are starting to make a comeback after years of stagnating prices. Japan's transition toward a consumption-led growth model may be the next story to look out for.
The Japanese economy has in the past been negatively affected at times by government intervention and protectionism, an unstable financial services sector, a heavy reliance on international trade, and natural disasters. Some of these factors, as well as other adverse political developments, increases in government debt, and changes to fiscal, monetary, or trade policies, may affect the Japanese markets and significantly harm investment performance.