US investors are struggling to escape their bias towards optimism. After the Trump tantrum, they were back to “buying the dip” yesterday.
And maybe they’re right. History shows that political drama rarely has a lasting effect on markets – assuming that it remains a drama, rather than a crisis. Of course, history also shows that stock markets are remarkably oblivious.
I’d be far more open to “buying the dip” if US stocks were cheap. But they’re not. Not on any conventional measure you can care to imagine.
So what can you buy instead?
The US looks expensive, but Japan doesn’t
For a country that once had near-Italian levels of leadership turnover, Japan has been remarkably free of political drama for a good few years now.
Indeed, when you look at Donald Trump in the US, Brexit in Britain, and the constant spectre of geopolitical hissy fits in the eurozone, you have to admit that Japan may be one of the most politically stable developed economies on the planet right now.
(Even as I write that, I realise it’s something of a hostage to fortune, but let’s run with the idea for now.)
Anyway, so you’ve got a politically calm country. The central bank – again by comparison to many other developed countries – has made its views pretty clear, and is neither itching to pull the plug on money printing, nor desperate to do more. And the economy has just recorded its best run of GDP growth since 2006 – five straight quarters of growth.
That’s quite appealing, surely? Well, not judging by investors’ attitudes. Fund managers pulled money out of Japan in favour of Europe this month. And Japanese companies remain cheap compared to US businesses.
Matthew C Klein of FT Alphaville runs through figures from New York University finance professor Aswath Damodaran to make the case.
According to Damodaran’s data, Japanese companies trade on an average enterprise value to EBITDA ratio (without fussing over the details right now, this is a bit like a more all-encompassing version of the price/earnings ratio) of around 7.4. That compares to more than 12 for the US.
Looking back over the last 20 years or so, this is an unusually large discount for Japanese stocks vs US ones. In fact, up until around 2000 or so, Japanese stocks were consistently more expensive on this measure than US ones.
Even in the early 2000s, the gap never got quite as wide as it is now. Indeed, only a couple of years ago, Japanese and US stocks were still trading at roughly the same EV/EBITDA.
On top of this, Japanese companies are nowhere near as indebted as their US or European peers.
What’s particularly interesting is that Japanese profitability has improved a great deal over the last few years. As a result, Japanese share prices have risen strongly. But in terms of valuation – the multiple that investors are willing to pay for those profits – that hasn’t changed at all.
That might be understandable if nothing had changed and those earnings and profit margins were expected to come back down in the future.
But if this is a lasting change – if improving profits can be channeled into investment in expansion for the future, and even better profitability down the line – then shareholders should really be willing to pay more for shares in these companies.
Japanese companies are being nicer to shareholders
So is it a lasting change?
Abenomics – the policies put in place by prime minister Shinzo Abe – were never meant to be solely about printing money and weakening the yen to make life easier for exporters. It was also meant to be about deeper social change.
That sort of stuff takes time to come through and it’s also very hard to get off the ground. You can move a currency very quickly with the right announcements from the right people. Changing a culture is more like turning an oil tanker around. You can say what you like, but it takes persistent action to make a difference.
As Katsushi Saito of Nomura tells Institutional Investor, corporate governance reforms are having an effect. Japanese companies are slowly but surely becoming more shareholder-friendly.
Not only have share buybacks and dividend payouts risen, but measures of profitability (such as return on equity) have been adopted as performance indicators by the boards of increasing numbers of companies. They are also becoming more transparent and open to merger and acquisition activity.
None of this is overnight stuff, but all of it increases the quality of Japanese companies and thus the multiple that investors should be willing to pay for a share of their profits.
In any case, as Klein points out, even if the reforms fizzle, the downside – relative to the US – is small. Given that Japanese stocks are already cheap and expectations are relatively low, reform failure is likely to be met with a shrug. Success however, could take many investors by surprise.
If there are surprises in store, you want them to be to the upside rather than to the downside, and this probably sums up the main difference between US and Japanese equities. US equities are priced for perfection – Japanese ones for ongoing mediocrity. One of those is a much easier benchmark to beat than the other. I know which one I’d rather bet on.