Japan is unloved by investors, yet all the necessary changes are in place for a new bull market. The potential upside will be spectacular, says James Ferguson.
Although I have spent the majority of my career covering the Japanese stockmarket, I have largely resisted the temptation to write anything about it for MoneyWeek. For years, I wasn’t clear whether the market really was cheap or not. And more recently, even as it looked like it might offer value, it’s been hard to see what might get it growing. It has long looked to me like something of a value trap.
However, things have now changed: I am finally getting excited again about my old alma mater. For starters, Japan’s Topix stockmarket index is indisputably cheap. Since its peak in January 1990, the index has fallen by more than 70%. The total book value of the Topix is now barely above its market capitalisation. In other words, if you could buy every company in the index, then liquidate their assets, in theory you’d get all your money back. By comparison, the S&P 500 trades on more than twice book value.
And if you look at the first chart below, you will see that 800 has provided a pretty solid floor for the Topix over the last two to three years. That’s despite the fact that it has been a pretty nasty few years for the country. The Western world’s banking crisis came on top of Japan’s own crisis, which has been going on now for a decade and a half. Then there was the dramatic collapse in world trade in 2008-2009. That hit exporters such as Japan especially hard. Then, in March, there was the devastating Fukushima earthquake and tsunami. Yet for the last two years, the only day the index closed below 800 was 15 March (and the very next day it was up 6.6%). This is very important. Why? Because, regardless of the case I’m making here, there is always a chance that Japan will remain in a value trap. So knowing where your downside will be supported has to be a good thing.
Japanese stocks are looking cheap
However, Japanese stocks aren’t just cheap compared to their net asset value. They’re also cheap compared to sales and profits. They trade on average at prices that reflect half their annual sales. US stocks trade closer to 1.3 times their annual revenues. When you look at their price/earnings (p/e) ratios, Japanese stocks don’t immediately look so cheap: they’re on 17 times historic earnings, whereas US equities are on 15 times. But there is a simple reason for this. US profit margins are more than double those of Japanese companies. If you consider the low price-to-sales ratio as a good indicator that there is plenty of potential for improving profit margins in Japan, then you shouldn’t see the p/e as off-putting. Meanwhile, the dividend yield of 2.11% in Japan is now higher than that of American stocks, on an average yield of 1.95%.
At the same time, profitability has been improving fast in Japan. The market may be down 70% since the late 1980s peak, but recurring profits are actually higher now than they were then. On the second chart, we have overlaid Japanese pre-tax profits on the Topix stock index. You can see that the market was on bubble valuations from the mid-1980s to the early 1990 peak. Then, as the market fell in the 1990s, stocks remained over-priced because earnings were falling just as fast. From 2003, the market began to look better. Now it’s as cheap compared with recurring profits as at any time since the data began in the 1960s.
However, the fact that it looks very good value isn’t enough on its own to justify buying into Japan. Time and again over the last two decades, Japan has committed grievous bodily harm to any investor looking for value in either the stock or property markets. The Topix in the 1990s had to halve because p/es were too high. But no sooner had it done so than investors saw that falling profits meant the p/e was just as high as before, so the index had to halve again. And then again. What we need if we want to make money is not just a great value proposition, but a catalyst for change. A self-sustaining bull market would be one that could double and still be cheap enough and fast-growing enough to double again.
An end to the banking crisis
So what might make that happen? The obvious answer is a final resolution to the banking crisis, something that might actually be under way at last. To resolve a banking crisis requires not only that banks clear their books of all their impaired assets (bad debt), but that the losses they realise as a result don’t absorb all their capital in the process.
Japan’s cumulative losses have came to more than 20% of total loans, double the 10% rate typical in bank crises. But loan loss provisioning is now much lower than it was. There’s a good chance that the banks are all but done with the business of clearing their books. The problem, of course, is that the brutal crisis has taken a nasty toll on the banks’ capital. For regulatory purposes, Japanese banks are still allowed to count gains on securities and some other quirks as capital. But if we look only at pure (tangible common equity) measures of capital, it doesn’t look so good. The largest bank in Japan, Mitsubishi UFJ, is the best capitalised. It has ¥7.5trn of tangible common equity against ¥206trn of total assets, a leverage ratio of 3.6%. In the US, the lowest leverage ratio a bank can have and still be considered ‘adequately’ capitalised is 4%. That’s why the big banks are being slow to start lending again.
But they shouldn’t be so shy about it. Why? First, because they do have the capacity to lend. UK banks have loans exceeding their deposits. But Mitsubishi UFJ has ¥135trn of deposits and only ¥81trn has been lent out. Second, because lending is the key to transforming Japan. When you’re talking about a country where commercial land prices are lower today than they were in 1973, and where 130 million people crowd onto a few narrow islands, raising bank lending could rapidly kick-start a land-price inflationary cycle.
Imagine that Mitsubishi UFJ decided it had enough capital to start lending again. That one bank has an excess lending capacity (deposits less loans) of ¥54trn ($685bn) or 13.5% of GDP. That kind of lending could easily cause a 10% rise in land prices. That would add some ¥18trn to the value of firms’ land banks, a sum equivalent to nearly 10% of market capitalisation.
But lending would do a great deal more than just bump up property values. In a fractional banking system, the main way that nominal GDP grows is via growth in broad money supply. That in turn is highly dependent on bank lending. The Bank of England’s Monetary Policy Committee reckons 8%-9% growth in broad money supply is synonymous with real GDP growth of around 3% and consumer price inflation of 2%. But for the last 20 years, Japan’s broad money supply has averaged just over 2% annual growth and consequently nominal GDP has averaged zero growth.
The cure for Japan’s malaise
To get Japan back in the race, this log jam must be broken. The Bank of Japan (BoJ) knows this and so has started a second campaign to boost bank reserves (it did this in 2005 as well, but cut it off too early) by buying short-dated Japanese Government Bonds (JGBs) and bills off the banks and crediting them with deposits at the BoJ. What we hope will happen now is that the banks will lend those reserves out to the overnight markets, swapping risk-free assets for risky loans and initiating the money-multiplier effect.
If this happens (ie, bank lending starts in earnest) things could move fast. There’s ¥175trn of land held on Japanese firms’ books. Rising values for that would boost balance sheets and, for those that sold, profits. Thus the market could rise and yet still find it remains cheap on both price-to-book and p/e measures. Then we’d have a positive feedback loop and, finally, a self-sustaining secular bull market.
So what might stop this happening? First, lack of confidence on the part of the banks. If they don’t increase lending, and there are no other catalysts for growth (it is hard to see any coming from abroad), Japan could remain a value trap for a few more years. Japan also continues to suffer from terrible demographic trends: its population is ageing and birth rates sliding at an almost alarming rate. On top of that, the mind-set of the average Japanese citizen is no longer a borrowing one. It’s been almost a generation since a mid-level bank manager made a loan, or a citizen took one out. There has been little going on to inspire a new generation of entrepreneurs. From the outside it has long looked as though Japan’s young are wrapped in a blanket of inertia.
However, while these are serious problems, they may not be as bad as we think. A friend just back from Tokyo told me that, when he suggested a Friday night drink to his Japanese colleagues, they said no. Instead, they were going up to Fukushima, as they did every weekend, to help with the clean-up. The horror of the tsunami has united the nation, but, more importantly, given them a purpose to strive for: perhaps the disaster has prompted the Japanese to break out of their two-decade trance.
So, finally, it looks as though Japan is sporting real value, trading as it does on sales and net asset metrics at well below half the valuations of America. A combination of unspectacular but steadily-rising earnings and considerably lower share prices have conspired to offer real value. Admittedly, profit margins are still low, so the p/e ratio is marginally worse than the US. However, it is worth noting that this is partly because of the strength of the yen. While this has prevented exporters from making easy money, it has also forged them into a world-class act. Even as their sales prices in yen shrink year after year, they have maintained a reputation for quality, technological excellence and reliability. How many Chinese firms could boast the same?
Japan remains as tantalisingly poised for take-off as at any time in the last two decades. But this time the share-price support is there. The valuation speaks for itself. The potential financial catalyst, with bank reserves rising again, is there. The positive resurgence of national identity and purpose is there. And the best developed-market growth story in 2012 is there too. Yet Japan remains unloved by investors. The last bulls threw in the towel when the earthquake struck. Most of the people I knew in Japan are now pursuing careers in other areas. The abandonment is almost complete, and the scene is set for a sustained, multi-year bull market to begin.
The question now is: will it begin this year? Or will Japan spring one more value trap on us? Actually, I’m not sure the answer really matters. The index is strongly supported at 800 (making the downside risk a mere 6%-7%) and, even if the market doesn’t move, foreign investors are getting the steady rise of the yen against sterling to support their returns. The opportunity cost in not being elsewhere is low and getting lower by the day: most markets look expensive already and global growth prospects are being scaled back.
Finally, even if you do have to wait for it, the potential upside is spectacular. If Tokyo traded on the same price-to-book ratio as the S&P, the Topix index would be 1,835. If it went to the same price-to-sales ratio, the Topix would hit 2,300. Once Japan finally breaks free of its two lost decades, the sky really will be the limit and this is as good a set of prerequisites for lift-off as I’ve seen in those 20 years. Indeed, since mid-May, the Topix has risen 3.5%. The S&P is down 1.5%. Perhaps the countdown has already begun.
The best ways to play Japan
So what’s the best way to get exposure to Japan’s market? Back in March, just after the disastrous earthquake and tsunami had hit, Merryn Somerset Webb tipped the Baillie Gifford Japan Trust (LSE: BGFD) as being a good way to play the Japanese market. The trust has since recovered by 9.4%. It is still trading on a discount to net asset value of 12%, which looks like a decent deal to us (effectively you’re able to buy the underlying assets for 88p in the pound). The trust is fairly highly leveraged (around 18%, according to FT Adviser), so it’s likely to be more volatile, but also to offer larger returns in a rising market.
Other investment trusts in the sector include the JP Morgan Japanese Investment Trust (LSE: JFJ), which trades on a discount of 14.7%. For a more specific play on small Japanese companies, where some of the best value in the market is, there’s the Baillie Gifford Shin Nippon PLC investment trust (LSE: BGS), currently trading on a discount of around 10%.
What about currency risk? There are a number of currency-hedged funds for those who are concerned about a collapse in the yen. It’s not a bad idea to have some exposure to these, but also bear in mind that a yen collapse is by no means a foregone conclusion – see Wondering why Japan hasn’t collapsed yet? Here’s why for more detail on why Japan’s government debt situation may not be quite as catastrophic as everyone assumes. Options include the Melchior Japan Advantage (tel: 020-7367 5400), Jo Hambro Japan Fund (020-7747 5678), and GLG’s Japan CoreAlpha (020-7016 7000).
If you want to get exposure to Japan, but aren’t keen to go ‘all in’, one of the few unit trusts we like is the Ruffer Total Return Fund. Steve Russell, who co-manages the fund with David Ballance, a regular at MoneyWeek’s roundtable discussions, is a fan of Japan and a couple of weeks ago tipped both electronics giant Sony (JP: 6758) and ice-machine maker Hoshizaki Electric (JP: 6465) in the magazine. As of last month, Japanese stocks were the fund’s biggest equity holding, accounting for 17% of the holdings. “For us, Japanese equities represent an alluring mix of risk and reward under many different scenarios – and it was the best-performing major equity market in June, up by all of 1.4%.” As well as Japanese equities, the fund holds gold, index-linked bonds of various nationalities, and various defensive blue-chip stocks – it’s positioned for long-term inflation, and as such, chimes very well with MoneyWeek’s long-term views.
Over the past five years the Ruffer fund has returned more than 60%, compared with 24% for the FTSE All Share. As with most unit trusts, you can avoid the 5% up-front fee by investing through a fund supermarket such as Hargreaves Lansdown. The total expense ratio is 1.54%.