An intriguing play on Japan

Dividends matter when it comes to long-term shareholder returns – which implies that long-term investors should focus on equities that pay a decent dividend, backed by strong balance sheets and some hope of growth. It’s worked in the past and probably will in the future. But dividends matter more in some markets than others.

In Japan, which has been avoided by income-seekers, firms have traditionally clung to a model that emphasises growth at all costs, with excess cash going on capital expenditure. While the economy was racing, that might have made sense – but not now. However, a new investment trust launching in London next week could herald a new way of thinking about Japan. The CC Japan Income & Growth Trust will be managed by Richard Austin of Asian equities specialist Coupland Cardiff, which manages around $1.7bn in assets.

The big challenges

Before I look closer, some caveats. Many other MoneyWeek writers are far more passionate about Japan than I am. On paper, it should be a brilliant opportunity, but three things make me cautious. The first is corporate governance. As the fondness for blowing cash on capex shows, many Japanese managers run their businesses for the benefit of everyone but the shareholders, which has impacted on dividends.

Past attempts by activist investors to force U-turns have had little success. So until senior Japanese business leaders embrace deep cultural change, start listening to shareholders, and – yes – pay investors a big dividend, I’ll keep my distance.

The second challenge is “the balance sheet problem”. Japan responded to its crash in the late 1980s by socialising vast private-sector debts. Sooner or later, the capacity of private Japanese savers to fund this vast bond issuance programme will hit a barrier, necessitating ruinously higher interest rates. Japan’s demography helps – it’s a rapidly ageing society that likes to save – but this also worsens the deflationary vortex.

The third challenge is China. The country represents a huge opportunity for Japanese exporters. But with the Chinese economy slowing, it is also a short-term minefield. And there’s the chance that these two trade allies could come to blows over tiny islands near Taiwan. But challenges one and three could become opportunities – if corporate governance changes, and China perks up (and talks amiably with the Japanese government). And this new investment trust just about convinces me that Japanese business culture is changing.

The importance of face time

The trust’s mandate – based on an existing open-ended fund of the same name – is to run a portfolio of 30 to 40 stocks, yielding 2%-3%-plus. Stocks are categorised as “stable yield” (juicy yield with decent balance sheet); “dividend growth” (lower yield but opportunity for dividend growth); or “special situations” (businesses where corporate change might boost the yield). The overall target yield is 3% – much better than a traditional Japan play – and Austin hopes the dividend will grow over time.

A glance at the stocks in the open-ended fund shows a massive bias towards broad financials (real estate and banks) and consumer discretionary stocks. Industrials and tech/media stocks account for less than 30% of the fund. The fund holds around 400-500 face-to-face meetings with management every year. That’s not unique – rival boutiques such as Baillie Gifford are equally selective – but it does underpin a focus on righting the wrongs of Japanese corporate culture.

Change is on the way

This is where the story gets really convincing. In the early 1990s, total dividends paid by Japanese stocks came to around ¥3trn a year. That grew to ¥12trn in 2007 before falling back. But payouts have powered ahead again, to run at just under ¥16trn, and businesses are choosing dividends over buybacks (in the US, most cash is returned to investors via buybacks). This flow of cash is being helped by robust balance sheets – cash flows into firms listed on the main Topix index of Japanese stocks are running at twice the level of capital expenditure.

This is a real sign that management attitudes have changed. Austin reckons the best opportunities for income-seekers lie with reasonably large businesses with “internationalised” managers, boasting an average market cap of $25bn. The fund isn’t hedging its exposure to the yen, which could be a problem if the currency goes the wrong way – although Austin expects the yen to appreciate over time.

I’m not as optimistic as Austin about the potential for Japanese structural reform and the prospects for inflation. I accept there are signs of wage growth, and that the Bank of Japan will attempt reflation on a huge scale. I even accept that the recent soft macro-economic numbers are more down to lower oil prices than anything else. But Japan’s balance sheet is still bust, and deflation has too deep a grip on its society. However, I’d also concede that the big businesses in this portfolio should benefit from a resurgent China in 2016 or 2017, and that the potential for yield growth will help.

Bottom line – wait a few months to see how big and liquid the fund becomes, watch for signs of economic revival in Japan, and possibly even for glimmers of hope in China. If these all line up, then consider making this a core holding.

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