The Nikkei tells a new story

The odds on Japan being the developed world’s best-performing equity market in 2013 had been narrowing rapidly up until the day when the Nikkei took its 7.3% tumble in late May, which was followed by a number of other sharp falls. 

Before that drop, however, the Nikkei-225 index had passed through 15,300, its highest level for 65 months. True, that was still a far cry from the peak it reached soon after Christmas 1989, when the Nikkei closed just shy of 39,000. But it was a rise of 87.5% since the low of a little over 8,000 as recently as November 2011 and of 77.5% since November 14, 2012, the day before Japan’s parliament was dissolved, paving the way for Shinzo Abe’s landslide victory at the polls.

This explosive rally, underpinned in general by Abenomics and in particular by the depreciating yen, has forced equity strategists to make repeated upward revisions to their short-term targets for the Nikkei-225 and the broader Topix indices. This is because there has traditionally been a very strong correlation between the performance of the benchmark index and the yen. Brandon Ginsberg, managing director and head of equity sales and trading at SMBC Nikko Capital Markets in London, says that as a rule of thumb, a ¥1 fall in the value of the Japanese currency against the dollar is worth between 300-400 points on the Nikkei.

One forecaster unlikely to make an upward revision to his latest forecast for the Nikkei index, however, is Ryoji Musha, former vice chairman and chief investment advisor at Deutsche Securities in Tokyo. Musha, now president of the Musha Research Company, has just published a book entitled A Once-in-a-Century Japanese Stock Market Rally is Here, which sets a target for the Nikkei of 20,000 in the short term, and to 40,000 in a second stage. His uber-bullish argument is accessible via his website, and is based on the view that, “the world is poised for an unprecedented period of economic prosperity”.

Japanese equities have seen plenty of dramatic, short-term rallies over the last decade or so. Between January 1999 and February 2000, Japan outperformed the global index by 35%, while in the mini bull phase of the first half of 2002 it outperformed by 48%. In a more extended bull market between April 2003 and February 2007 Japanese equities surged by 148%, according to Société Générale.

But the latest rally, which began late last year, say strategists, is different from many previous ones in that it is driven by tangible and persuasive technical and fundamental factors. At a technical level, an obvious cause for the outperformance of the market has been the Bank of Japan’s asset-purchasing programme, which has been especially supportive of the listed real estate sector. 

As Deutsche Asset and Wealth Management (DeAWM) put it in its latest quarterly review: “In the first quarter of 2013, confidence in the Japanese macro economy experienced one of the most significant surges in recent history… The J-Reit index has skyrocketed to its highest point since the global credit crisis, and the aggregate amount of equity raised by J-Reits in the six months to March 2013 set an all time record.” Although there was a sharp correction in the J-Reit index in May, analysts viewed this setback as a buying opportunity, given the BoJ’s commitment to buying Reits as part of its asset-purchase programme.

More broadly, however, investors have been attracted by the much improved growth prospects for the economy, twinned with the beneficial effect of the weakening of the yen, both of which support rising earnings. That in turn has meant that even after the recent surge in Japanese equities, valuations remain undemanding both by historical standards and by international comparison.

At SMBC Nikko, Ginsberg says Japanese equities are now trading at a price/earnings ratio of about 16.5. “This ratio is based on the companies’ own forecasts for 2013/2014 earnings which are based on a yen/dollar rate of 90 or 95,” he says. “But the yen/dollar rate is already 102 and if the yen is allowed to weaken further to 110 or 120 the impact on companies’ earnings will be massive.”

He continues: “Even if you conservatively plug a yen/dollar rate of 102 into earnings projections, the P/E ratio comes down to just under 14,” Ginsberg adds. “That compares with a P/E for US stocks of about 18 or 19. So even on this conservative assumption, Japanese equities could rise a further 25%.”

Japan still looks cheap, say equity strategists, by a number of other yardsticks. “Earnings are difficult to predict,” says Jonathan Allum, equity strategist at SMBC Nikko. “But on a price to book value (P/BV) basis, which is probably the most reliable way of comparing markets, Japan is now trading on a ratio of about 1.3 times, which is still a massive discount compared to most developed markets. It was as low as 0.9 times, so there has been a bounce, but there is still a long way to go before the P/BV converges with other markets.”

It is not just against markets like the US that Japan has had a lot of catching-up to do. Unlike equity markets elsewhere in the developed world, which this year have tested new all-time highs, even if the Nikkei index doubled from the level it reached at the end of May, it would be almost 10,000 points off its high. “The index has come very far, very fast, but that needs to be compared to where it was coming from,” says Allum at SMBC Nikko. “Last October, it was trading not just at post-Lehman lows, but at multi-decade lows. This year’s chart may look toppy, but if you look at a 20-year chart, what is striking is not how much Japan has gone up, but how far it has fallen.”

Allum says that the first wave of companies to benefit from the stunning rally in Japanese equities were, unsurprisingly, the leading exporters. “We’ve also seen strength in areas like real estate and financials, which suggests that the outperformance is being driven by the domestic recovery and by domestic reflation, rather than just a knee-jerk reaction to the weakening of the currency,” he says. “Whether or not this move from deflation to inflation materialises is the big question. But if Japan does make this move, the market could be in for a period of sustained outperformance, the like of which we haven’t seen since the 1980s.”

While large cap stocks have been the principal beneficiaries of the domestic and international liquidity flowing into Japanese equities, market participants believe that there is also substantial value to be unearthed among smaller listed companies. “In the early stage of the this rally, investors’ main focus was on large cap and liquid stocks,” says Masayuki Azuma, managing director and head of securities products group at SMBC Nikko in London. “Increasingly, investors are looking at the potential for small to mid-cap companies, and some Japanese small cap mutual funds are reaching their capacity limits as a result.”

It was this conviction that was behind the launch, in April, of a new Japanese smaller companies fund by SuMi Trust, the international arm of Japan’s largest asset manager, Sumitomo Mitsui Trust Group. The SuMi Trust Small Cap Fund will use the firm’s Japanese Small Cap strategy, which generated a 41.2% return last year, an excess return of 22.8% versus its benchmark, the Russell Nomura Small Cap Index.

At the time of the fund’s launch, SuMi Trust advised: “The low brokerage cost of smaller companies in Japan creates opportunities for generating returns from undervalued stocks.” It added: “Smaller companies are more likely to be less correlated to the macro economy… and therefore have greater non-cyclical growth potential than large caps.”

Although the outlook for Japanese equities probably looks more compelling now than at any time in the last two decades, not all investors are convinced. Goldman Sachs reports that US institutional investors have three main concerns about the prospects for Japanese equities.

The first is that Abenomics will be limited to fiscal and monetary stimuli and will not be able to deliver on the meaningful structural reforms that Japan needs to implement if it is to address its deep-seated long term challenges.

A second concern is that the recent spike in JGB volatility suggests that the BoJ may not be entirely in control and that higher rates in Japan could have negative repercussions for the equity market and the real economy.

The third misgiving was that “most foreigners are already long or overweight Japan, so it is hard to envision where incremental foreign buying will come from, and domestic investors remain sidelined,” says Goldman.

Although Bank of America Merrill Lynch’s most recent fund manager survey appears to show that many international asset managers are overweight Japanese equities, analysts believe there is still an abundance of firepower waiting to be invested in the Japanese market, from a number of sources.

According to Goldman Sachs, while foreigners had purchased a cumulative total of ¥9.3tr ($91bn) in Japanese equities between November 2012 and early May 2013, this still represents just a quarter of their cumulative purchases during the Koizumi rally of 2003-2007, when they ploughed ¥39tr into the market. “Though many hedge funds are long Japanese equities, this is not the case for many long-only institutions, and we met quite a number of US investors who remain underweight Japan relative to their respective benchmarks,” Goldman reports.

That is perhaps unsurprising, given the miserable performance of Japanese equities for the best part of two decades. “Japan represents 8% of the MSCI, so it is a very significant part of the global index,” says Ginsberg. “But because staying underweight has been a safe call for so long, some funds have been completely out of the market for the last 10 years.”

At SMBC Nikko in London, Allum agrees. “The investors who have bought into this rally most heavily are the global macro hedge funds, where the most popular momentum trade in the last six months has been to go long the Nikkei and short the yen,” he says. “But in spite of what the surveys say, I doubt that the more conventional long-only funds, which have probably been underweight Japan for a very long time, even have a market weight yet.”

Valuations aside, most of the arguments international investors have traditionally made for not buying Japanese equities have been progressively dismantled, says SMBC’s Ginsberg, who recently relocated to London after 21 years in Tokyo. He says that while concerns about demographics inevitably remain, a number of other misgivings, such as weak government, high valuations, low dividends and a failure of Japanese companies to restructure are no longer valid. “There has been an enormous amount of restructuring in the Japanese corporate sector since 2008,” he says. “Global industry leaders such as Toshiba and Hitachi have done a great deal to take out costs and spin off non-core subsidiaries.”

Another reason given by some international investors for remaining underweight in Japanese equities has been the occasionally weak standards of corporate governance in Japan. This, too, say strategists, looks like an increasingly antiquated excuse for avoiding the market.

“I find it slightly peculiar that on the one hand investors complain about Japanese corporate governance, but on the other are happy to buy stocks in some emerging markets where standards of corporate governance are much lower,” says Allum. “So I think the corporate governance story is a bit phony.”

Besides, say Allum and others, corporate governance standards and the broader focus on shareholder value has improved beyond recognition over the last decade. Look, for example, at Japanese companies’ dividend policies. “There has certainly been a trend towards higher pay-out ratios which has been something of a bugbear among international investors in recent years,” says Allum. “Japanese investors can now get higher yields on stocks than on government bonds, which is encouraging some institutions to move some of their allocation from bonds to equities.”

Retail investors, disillusioned since the end of the 1980s by the feeble performance of equities, are also starting to recover their appetite for the stock market, with monthly inflows into Japanese equity mutual funds reaching a six year high of ¥994bn in March.

Longer term confidence among retail investors is expected to be supported by the government’s Individual Savings Account (ISA) initiative, whereby from January 1, 2014, savers will be allowed to invest up to ¥1m a year over a five year period into listed equities, with all capital gains and dividends exempt from income tax.

In a recent survey of private investors, Nomura found that most individuals appear to be well informed about the initiative and well disposed towards the scheme. According to Nomura, 79.4% of respondents to its survey had heard of the ISA project, and 79.1% indicated that they intended to take advantage of it, with 87.4% planning to invest directly in Japanese equities through ISAs, and 23.3% intending to buy equity investment trusts. A third of the respondents said they planned to make use of their full ¥5m allowance over the five year period. 

Another source of demand for Japanese equities is the corporate sector itself. As Goldman commented in a recent research update: “Since listed companies have ¥73tr (more than $900bn) of cash and cash equivalents on their balance sheets, we believe they will continue to deploy some of this cash via share repurchases.”

The buyer with the most firepower, however, is the Bank of Japan, through its asset purchasing programme. “The BoJ is a structural and aggressive buyer of equities which provides a significant backstop when the market dips,” says Ginsberg.

The well diversified demand for Japanese equities bodes well for the primary market. Recently, in terms of the number of deals, the market has been dominated by the J-Reit sector. Following the $1.3bn IPO from Global Logistics Properties (GLP) in December, the largest offering in the J-Reit sector in 2013 was the $1.08bn IPO for Nippon Prologis Reit in February. Priced at the top of its ¥510,000-¥550,000 range, this surged by 24% on its trading debut. 

Comfortably the biggest equity offering in recent months, however, was the delayed sale by the government of a $7.8bn stake in Japan Tobacco. 

The JT offer, the proceeds of which were earmarked for reconstruction spending in the areas most effected by the 2011 earthquake and tsunami, was the largest IPO since the $11bn sale of Dai-Ichi Insurance in 2010.

More broadly, bankers say that the pipeline for primary deals in the Japanese equity market looks encouragingly strong and diverse. “The IPO market has been very healthy this year, and although it has been concentrated in smaller deals, there are some large issues in the pipeline,” says Allum.

Beyond the J-Reit sector, one of the largest of these is the planned IPO this summer of the beverage and food unit of Suntory Holding, which will raise between ¥300bn-¥500bn.