Friday HighlightJul 26 2019

The evolution of investing in Japan

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The evolution of investing in Japan

After enjoying a decade as a staple destination for growth investors, a stock market crash and debt crisis saw the country fall out of favour at the beginning of the 1990s.

However, following two decades of economic stagnation, a drive to improve shareholder returns has given Japan a new lease of life among income investors over recent years.

With some way to go until Japan reaches the corporate governance standards of its Western peers, we expect income opportunities in the country to continue growing.

Rise and fall

Having averaged GDP growth of around 7 per cent for 30 years, Japan’s economy was a stalwart in every growth investor’s portfolio in the 1980s.

Japan had become the second wealthiest nation on earth behind the US and even ranked first globally in terms of GNP per capita by the time the 1990s rolled around.

Many economists feel that Japan did not begin to make significant progress until 2012 when Shinzo Abe was elected as prime minister.

However, while Japan looked well on its way to becoming the world’s greatest economic power on the surface, a sinister bubble was inflating at pace in the background.

Factors such as excessive bank lending, ultra low interest rates, and fiscal spending were pushing land prices into unsustainable territory and equity market valuations towards price-to-earnings multiples of up to 70 times earnings.

This situation reached a head at the beginning of the 1990s when Japan’s government began to hike rates upon realising that its rapid growth could not continue indefinitely.

The unexpected change in sentiment triggered a stock market crash and a debt crisis as loan defaults abounded.

Against a backdrop of fierce global competition stemming from the IT revolution and China’s rapid growth, the crisis quickly snowballed to give rise to a banking crisis and several government bailouts.

Once the initial shock passed, Japan entered its infamous ‘lost decade’ of economic stagnation that saw GDP and wage growth sink, deflation reign, and equity and property markets hover close to record lows.

Recognising the shareholder

Although it may be called ‘the lost decade’, many economists feel that Japan did not begin to make significant progress until 2012 when Shinzo Abe was elected as prime minister.

Over the past seven years, Mr Abe has rolled out a reform program that has sought to address many of the issues of the previous two decades.

Under ‘Abenomics’, Japan’s economy is experiencing its longest expansion since the war, with real GDP increasing, unemployment falling below 2.5 per cent, and female workforce participation rising.

Many new policies have also sought to enhance corporate governance standards among Japan’s businesses with the backing of both the Bank of Japan and the Japan Pension Association.

Stewardship and corporate governance codes have improved shareholder engagement and encouraged firms to pay out more to their shareholders in the form of dividends and share buybacks rather than hoard cash.

The positive impact of these efforts can be seen clearly and the Nikkei forecasts that annual dividends paid out by major Japanese corporations would hit a record 10.7tn yen in the year to March 2019, up 15 per cent year-on-year.

Meanwhile, share buybacks were predicted to rise 57 per cent to 4.6tn yen over the same period.

All-in-all, total shareholder returns were set to have doubled over just five years.

These new corporate codes have also sought to encourage company boards to increase research and development investment, raise return on equity, and improve transparency.

With the percentage of listed companies with two or more independent outside directors rising from 17 per cent to 91 per cent, these efforts seem to be working.

Looking for opportunities

Alongside the renewed prospect of returns for growth investors, Mr Abe’s focus on driving shareholder returns standards has created a new opportunity for income investors over the past decade.

While the Topix offers many opportunities, it is overburdened with larger ‘old Japan’ businesses that struggle to adapt to Japan’s new corporate governance culture.

Many firms outside the index have been more adaptable to change, realising returning excess cash and profits to investors is integral to success.

With this in mind, we take an index-agnostic approach, looking for stocks with talented owner-CEOs and robust, sustainable growth strategies.

Importantly, they must also reward shareholders with appropriate annual distributions, reflect underlying growth but also recognise the value to investors of the sustainability of dividends and share buybacks.

Despite Japanese businesses making substantial progress in the way they treat their shareholders, they still have some way to go.

Towards the end of last year, around 50 per cent of the country’s listed non-financial companies had net cash on their balance sheet, equating to over 117tn yen of unproductive assets.

As the corporate culture continues to shift, so too does the outlook for income investors in Japan.

Richard Aston is portfolio manager of the CC Japan Income & Growth Trust and the CC Japan Income & Growth Fund