Last year, Japan was the best-performing major market in the world – up 57%.
But 2014 has been less kind to Japan bulls. Jitters over the gradual ‘tapering’ of quantitative easing (QE) in the US, and concerns about the impact of a rising consumption tax in Japan, have seen investors rush to take their profits.
Net foreign sales of Japanese shares recently have hit their highest level since the Asian crisis in 1997. Overall, the Nikkei has fallen by around 15% since the start of the year.
So is the bull market out of steam?
We don’t think so. In fact, we think there’s quite a way to go yet. And one of the most promising signs is that Japanese companies are starting to treat shareholders with more respect.
Dividend payouts remind managers of their duty to shareholders
Dividend payments are hugely important to shareholders. They account for a big chunk of shareholder returns in most markets. And they act as a check on management – having to make that cash payment every year to the owners of a company keeps minds focused on shareholder value, rather than empire building.
Yet since the Second World War, Japanese companies have paid a relatively small proportion of their earnings back to shareholders as dividends. In the first few decades after the war, this was understandable.
There was a huge need for capital investment to repair war damage and catch up with other countries. The partial breakup of the ‘Zaibatsu’ conglomerates also meant that firms faced more competition, so needed to invest to keep up.
However, it was clear that in Japanese firms shareholders tended to rank relatively low in the pecking order. A lack of hostile takeovers and the fact that firms tended to own shares in each other (known as cross-shareholdings), kept managers comfortably insulated from shareholder pressure. Rather than shareholder value, executives preferred to focus on expansion, either through increased investment or mergers.
Another factor inhibiting dividend payments was overleveraged balance sheets. During the long boom, firms took on a huge amount of debt. This reached a peak of 200% as a percentage of shareholders’ equity in the late 1970s. Once the economy started slowing after the boom, this debt had to be repaid first in order to put companies on a more sustainable footing.
The good news is that things have improved a great deal since then.
Net debt levels are down to around 50% of equity, giving companies much more breathing room. Cross-shareholdings have fallen sharply since the mid-90s, forcing managers to pay more attention to the needs of shareholders.
As a result, firms are less likely to plough cash into unproductive investments. This has led to a dramatic rise in free cash flow.
A full 95% of listed Japanese companies now pay dividends. And although payout ratios (dividend payments as a percentage of profits) are still low compared to other countries, dividends have grown faster over the last 15 years than in the US.
The government is also encouraging the creation of a new index, JPX-Nikkei Index 400. Instead of simply weighting firms by their size, this index ranks firms on their profitability and return on equity. The hope is that it will further ‘nudge’ companies to use capital wisely, which should increase the money going to shareholders.
Japanese investors are being encouraged to buy more stocks
One thing that has held the Japanese stock market back is that Japanese households are extremely reluctant to buy into their own market. Less than 10% of the average Japanese household’s portfolio is in shares, compared with over 30% in America. This makes the market unusually dependent on foreign investors, who tend to be shorter-term investors than domestic ones.
This aversion to shares among the Japanese can partly be explained by static or falling prices, which makes bonds attractive, even at low yields. An ageing population may also find a fixed income more attractive.
However, the government is trying to encourage a more aggressive investment culture by copying the UK and creating the Japanese Nippon Individual Savings Account (Nisa), allowing households to invest up to ¥1m (£5,836) a year tax-free in stocks or investment trusts.
Tokyo has also been trying to shift the investments in the Government Pension Investment Fund towards riskier assets. The share of the fund invested in domestic bonds has fallen from 70% in 2008 to around 55% at the moment. The share invested in Japanese shares has gone up from less than 10% to 15%, and is due to increase further.
How to invest in Japan
Despite last year’s surge, Japan is still affordably priced. The Topix trades at a reasonable 14 times this year’s earnings. Better yet, it trades at only a 15% premium to book value, compared with the 98% and 159% premiums of the UK and US markets respectively.
So we’re happy to stick with Japan. You can read a lot more in my colleague Merryn Somerset Webb’s recent MoneyWeek magazine cover story on Japan (if you’re not already a subscriber, you can read the article and get your first three issues free by signing up here).
One fund we’ve recently tipped is the JOHCM Japan fund. Run by Scott McGlashan and Ruth Nash, it’s beaten its benchmark over a three and five-year period. But if you want to take advantage of Japan’s improving dividend culture, you should perhaps focus on a new fund from JOHCM – the JOHCM Japan Dividend Growth fund. This aims to find companies that have an above-average dividend yield, and the ability to grow those dividends in the long term.
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