Innovation key to Japan success

This article is part of
The investment case for Japan - August 2013

Some observers have warned that the rapid depreciation of the Japanese yen could spark a currency war, particularly with neighbour South Korea whose exporters have made significant inroads against Japanese exporters in the past decade.

However, it is worthwhile noting that although the yen has weakened significantly from its position 12 months ago, it is still trading above levels seen six to seven years ago.

A further weakening of the yen is not necessary for the positive Japan story to continue. The key to Japan’s future success is more innovation and improvements in productivity.

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If corporate Japan’s improved profits can be ploughed back into research and development, then perhaps we can see a sustained improvement in market share.

Japan is still the world’s third-largest economy and with the eurozone still mired in sovereign debt issues and China on a lower growth trajectory, it’s good for the global economic growth picture for Japan to be stronger.

However, it’s fair to say that there has been less clarity (and more market scrutiny) on Shinzo Abe’s growth and reform policies. Mr Abe’s perceived progress (or lack of) on reform will be keenly watched by markets in the summer, particularly progress on the Trans-Pacific Partnership (TPP) talks, a US-led effort to liberalise trade across the Pacific region, measures to deregulate the labour market (including getting more women into the workforce) and encouraging greater competition in the domestic energy sector (including investment in renewable energy and infrastructure for imports of natural gas.)

The effect on equity valuations? Earnings-per-share (EPS) growth is currently leading the world. The average price earnings ratio for Japan equity is now cheaper than for US equity, in marked contrast with the past decade.

Price-to-book measures are cheaper than those found in many other markets and dividend yield is the same as the US – with real dividend yield even better. Which means we can safely say that Japanese equity valuations are now on a commensurate basis with stockmarkets around the world – although Japan is not egregiously cheap, neither is it expensive.

Historically, it has been tough for Japanese companies to secure loans for working capital. The corporate culture has also been characterised by a concern for stability in short-term bursts in profitability which is why Japan has typically had lower return on-equity ratios (all other things being equal) than other major markets.

Overall, the oft-cited headwinds for Japan of corporate governance, demographics and competitiveness have all been excuses not to invest in Japan while the market was de-rating. Now that this once-in-a-generation de-rating is complete, it’s time to look at these factors afresh.

Alex Treves is head of Japanese equities at Fidelity Worldwide Investment