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Japanese equity – looking like dependable long-term investment?

5 September 2018

The Japanese equity market has now undergone a full fundamental recovery, allowing long-term investment. The market even has the potential to exceed its historical high by around 2027-28, says Tetsuji Sakai, Senior Strategist, Nomura Asset Management.

Investors should have heard at least once that “long-term investment in stocks is rewarded“. Warren Buffett has also recommended to general investors in the US that they ought to invest for the long term in index funds linked to the S&P500.

Looking back at the performance of the S&P 500 Index for the past 60 years to confirm whether long-term investment in US equities is in fact rewarded shows that the Index has risen by approximately 47 times from January 1960 to May 2018. In addition, corporate profits (S&P500 constituents) during the same period have increased by approximately 51 times, expanding at an annual rate of slightly less than 7%. Simply put, share prices have increased in accordance with the rise in corporate profits.

Since the underlying force behind the long term rise in the US equity market is strong corporate profit growth; thanks to US companies delivering solid profits, equity investors have been rewarded.

Generally, corporate profits and share prices have moved roughly in the same manner

Another important point is that corporate profits and share prices have moved almost in the same direction. The average Price to Earnings Ratio (PER) of the entire period is 16, so above we have shown an implied “fair value” for the market using earnings multiplied by the slightly conservative multiple of 15. The long term correlation to actual share prices is very clear.

What is noteworthy here is that in the US stock market, market participants have invested by recognizing such reasonable levels. There is little evidence of buying and selling the market in a contrarian fashion beyond this reasonable level. This could be the result of investors having learnt to take a moderating stance as they adapted to the market over the years. It is a combination of corporate management’s ability to deliver earnings growth, together with the sophistication of investors, that has created the conditions for such share price formation.

Japan was once a market where long term investment was not rewarded

Let us take a look back at the Japanese stock market. The chart (below) shows the actual market price (Nikkei Average Index) and projection based on corporate profits (projected price based on a reasonable level of PER, i.e., US equity market PER of 15 multiplied by the EPS forecast). We can clearly see that historically, the market moved in a very different pattern compared with the US equity market.

The period Ⓐ covers the bubble and the bubble collapse. At the time of the bubble in the 1980s, share prices steadily deviated from the reasonable price level; this spread expanded by 3.5-fold when the market peaked at the end of 1989. In the 1990s, the market collapsed and as a result the gap from reasonable levels temporarily narrowed. However, with the collapse of the bubble, corporate profits fell sharply, pulling down the reasonable share price level too, and preventing the gap between the actual market prices and the reasonable market levels from closing. The deviation remained nearly 4-fold on average through the 1990s. After a long period of divergence from reasonable levels, the gap suddenly narrowed in the early 2000s.

Japanese equity market is beginning to look like a dependable long term investment

Look at period Ⓑ, from 2003 onwards, the Nikkei Stock Average Index fell sharply, falling short of 8,000 yen, but converging with the assumed “reasonable” market level, this marked the end of an era of the large longstanding divergence. Since then, as with the US stock market, the share price has moved around its reasonable level, leading to the view that Japan’s stock market has normalized at last.

After overcoming the Lehman shock in 2008, the bull market supported by “Abenomics” policies since the end of 2012 has been accompanied by corporate earnings growth, and share prices have moved in accordance with the projected reasonable level.

Earnings growth driven by overseas business development

More “normal” conditions have been restored, whereby share prices rise in line with corporate earnings growth; but will corporate profits continue to increase in the future? Japan’s population is declining, and the population of productive age has begun to shrink. Can companies raise profits in such an environment?

Looking at the Japanese companies that have grown profitable under such challenging economic conditions, there appears to be some common features – they have successfully strengthened their areas of specialty and have increased earnings on a global basis. The figure on the right is the share price trend of electronic component producer NIDEC, and its domestic and international sales. In FY2000, the company delivered about 250 billion yen in net sales, when the ratio of domestic and overseas sales was roughly equal. Since then, overseas sales increased by about tenfold, and sales in FY2017 increased to about 1.5 trillion yen (approximately 14 billion USD). Specialising in motors and supplying to a wide range of industries from computers to automobiles, NIDEC has gained the world’s largest market share.

It is well known that Toyota (overseas sales ratio of 75%) and precision instrument maker Canon (78%) earn most of their revenue from overseas, but recently, consumer goods maker Shiseido (55%) has expanded sales in Asia and apparel company Fast Retailing (UNIQLO) (43%) also increased its overseas sales.

Increasingly, Japanese companies are learning to cope well with the sluggish growth of the domestic economy. We seem to have entered an era in which Japanese companies are no longer willing to settle for the compromise of delivering low growth that merely reflects the slow pace of the domestic economy.

With earnings growth of 6% p.a., Japan could renew its historical market high in 2027-28

According to IMF forecast, the global economy is expected to grow at around 6% per annum on a nominal basis. If many Japanese companies manage to develop business on a global basis and continue their efforts to raise EPS through share buybacks etc., overall Japanese long-term average corporate profits could expand by approximately 6% annually. Incidentally, the profit growth rate for 2003– 2017, which included the Lehman shock, was about 8% annually. So if the companies continue to grow at an annual rate of around 6% on average, the Nikkei 225 Average Index could technically exceed its historical high of 38,915 yen by around 2027-28.


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