Bullish on Japanese Equities (Blue Tower Asset Management)



  • There has been a general pessimism towards investment in Japanese equities
  • Bear thesis against Japan has centered around a few central themes: low birthrates and high longevity creating demographic imbalances, Japanese corporate culture not being focused on creating shareholder value, and low GDP growth since the economic bubble of the late-1980s


  • Japan has one of the lowest birth rates in the world and the highest life expectancy
  • Fears that this will eventually lead to a workforce incapable of generating enough tax revenue to support the swelling ranks of pensioners
  • These fears are genuine but not unique to Japan: total fertility rates and age dependency ratio for Japan are comparable to several developed European economies (Germany, Switzerland, France, UK, Italy)
  • While the demographic issues are real, they are not unique to Japan and afflict almost all developed economies. It should therefore not be seen as a particular reason to avoid investing in Japan

Poor Capital Allocation

  • Another reason for pessimism on Japanese equity markets is the perception of poor capital allocation by corporate management
  • Japanese companies are seen as hoarding large amounts of cash rather than buying back stock, paying dividends, or reinvesting in growth
  • Western investors are therefore less likely to ascribe value to the rich balance sheets of Japanese companies as the assets are seen as “locked up” by Japanese management
  • Shinzo Abe began pushing a series of reforms starting in April 2014 to make Japanese companies more competitive
    • Japanese Stewardship Code which sets reforms for how institutional investors engage with the companies they are investing. Code requests that companies aim to achieve a minimum 8% ROE and also calls for companies to have at least two independent board members
    • While the code does not advocate specific actions to take or even advocate that the investors interfere management in the internal activities of the business, it does set out the goals for investors to justify how management’s actions are aligned with good stewardship and build shareholder value
    • The code is voluntary for institutional investors to adhere to, but a public record is kept of which institutions are participating and which are not
  • There is a system of cross holdings across Japanese companies, where the companies own shares of each other. This is known as the keiretsu This creates a conflict of interest as business decisions may be made for the benefit of other companies under the ownership umbrella, rather than for the best interests of the main business
    • Amount of shares held under the keiretsu system has been declining significantly, increasing the competitiveness of Japanese businesses
    • Ratio of holdings of Japanese stocks by listed Japanese banks and non-financial companies was 10.3% at year-end 2015 compared to 34% at its height in 1990
  • Japanese corporate growth rates have been far outstripping the growth rate of the overall economy in recent years. From 1Q12 to 1Q17, Japanese Corporate Profits increased from 12.6 trillion JPY to 22.4 trillion JPY (12.2% annualized) while the nominal GDP change between those two quarters was 1.2% annualized

Value Investing Works Well in Japan

  • 2013 study of Japanese equity returns from 1975-2011 which includes Japan’s post-bubble bear market where Japanese stocks lost over 62% of their value
  • Value investing greatly outperformed during this 37-year period but the outperformance was even more pronounced during the post-bubble bear market
  • Selecting low P/B as our value metric and selecting the cheapest, equally-weighted quintile with monthly rebalancing gives an annual return of 19.3% for the 1975-2011 (annual outperformance of 13.6% relative to overall Japanese market) and 10.6% for the 1990-2011 bear market (outperformance of 13.2% per year)
  • Selecting low P/E as our value metric and selecting the cheapest, equally-weighted quintile with monthly rebalancing gives an annual return of 23.6% for 1975-2011 (annual outperformance of 17.7% relative to overall market) and 16.9% for 1990-2011 bear market (annual outperformance of 19.7%)
  • Japanese value stocks clearly had an impressive performance in this period

Valuation of Japanese Small Caps Depressed

  • Aggregate valuations of Japanese small cap stocks make it clear that this is currently a target rich environment for value investors
  • At the end of September 2017, forward P/E of Japanese small caps was 70% of the average for small caps globally and 58% of the US small cap average
  • Additionally, P/B is 65% of the world small cap average and 54% of US small cap P/B

Blue Tower Asset Management 3Q17 Letter, October 26, 2017

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