Why investors are looking east towards Japan

Accentuate the positive
Exciting things are happening in Japan, and they should be of interest to anyone looking for investment opportunities in 2019. Over the last 15 years, returns from the Japanese equity market, reported in sterling and including dividend income, have actually been very close to those from the UK. Since the end of 2002, the FTSE All-Share Index has generated compound annual returns of 8.6%, compared with the TOPIX Index of 8.0% and the narrower Nikkei 225 Index of larger companies of 9.7%. What’s more, there’s potential for further progress.
This may all come as a surprise, as the overwhelming perception of Japan in recent years has been one of decline. After all, for the past 25 years corporate Japan has suffered from a powerfully negative set of headwinds.

Evaluate the negative
Having been a much-feared global titan up to the early 1990s, Japan began to be seen as a shrinking, almost uninvestable pensioner, for various reasons:

Its population began to decline from around 127 million to a projected 100 million or so by 2050

At the same time, the population is ageing – on current trends, by 2050 nearly 40% of Japanese will be older than 65

Historically, Japan had a complex equity market, sustained by webs of cross shareholdings and a management culture that was hard for Westerners to understand – focused on revenues, rather than returns, and with shareholders last in the queue.

The banking system was shattered by a mountain of bad loans, while the economy was blighted by persistent deflation. To combat this the authorities borrowed more and more, with government debt reaching an eye-popping 253% of GDP by the end of 2017. This was financed and made possible by the Bank of Japan reducing interest rates effectively to zero, crushing returns for Japan’s army of pensioners and savers. Moreover, much of the ensuing public spending was wasted, with the countryside scarred by bridges people neither wanted nor needed, roads leading to nowhere, and rivers concreted over for no good reason.
Latch on to the affirmative
How has this seeming basket case been able to produce a similar outcome to the UK (and indeed Europe excluding the UK)? Only the US has done better during this period.
There are three main reasons for Japan’s success that make it an attractive prospect for investing in 2019:
1. Innovation in automation
Japan’s poor demographic profile has spurred innovative ways of tackling the relative shortage of workers. Alongside Germany – another country at risk from a shrinking population – Japan is a world leader in automation and robotisation. This, combined with a gradual but powerful move to improve corporate profitability, has seen returns on equity climb much closer to US levels, boosting productivity and cash flow.
2. Proximity to China
Japan is also a big beneficiary of China’s growth, both in industrial exports and in the consumer sector.
3. Solid balance sheets
Finally, Japan’s bank balance sheets are now in solid shape and able to support company investment plans.
All of this has been underpinned by Prime Minster Shinzō Abe’s ‘three arrows’ approach to economic reform, launched after his election in late 2012. This includes high government spending, almost limitless quantitative easing, measures to boost structural growth and – by far the most important – corporate reform.
How has the improved cash flow helped companies in Japan and created investor opportunities?
It has enabled companies to pay down debt. Although the Japanese government is among the most indebted in the world, its companies are amongst the least. In turn, the enhanced cash flow has:

Given companies flexibility to improve shareholder returns

Reduced valuations

Allowed an increase in dividends and share buybacks.

Japanese equities now yield more than their US equivalents and are on a PE^[1] rating of 13x compared with the US on 19x. Although the population is shrinking, GDP per capita of growth of 7.5% is almost exactly the same as in the US over the last 10 years – and significantly more than the UK’s 4.9%.
Our conclusion
When we look at all these improvements, we already get a good story. Add to that the potential for further progress on shareholder-friendly corporate reform, plus the enthusiasm generated by the 2020 Olympics in Tokyo, and we get a compelling one. That’s why we find Japan not just investable but an extremely exciting investment opportunity. And why we consider it a key investment theme for 2019.
The sun is indeed rising in the East.
[1] PE – price earnings ratio – share price divided by earnings per share. It shows how much investors are willing to pay per pound of earnings.
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