The Japan opportunity: Potential for attractive long-term returns

JAPANESE equities represent a compelling long-term investment opportunity, with the potential for attractive returns over the coming years. While there are some short-term tactical considerations that might keep some investors on the sidelines, these should be considered in the context of the overall opportunity set for the asset class.

Over the next five to 10 years, M&G Investments thinks Japanese equities could plausibly generate an annual percentage compound total return in the mid-teens. The main driver is likely to be earnings, which could grow at an annual compound rate of 8 per cent, a level corporate Japan has indeed delivered over the past decade.

Dividends could also add to the potential return. The stock market’s starting dividend yield is a little under 3 per cent currently, and dividends have also been growing faster than earnings over the past decade. This has been possible because the payout ratio has been increasing – albeit from a very low level – and company balance sheets are strong. An increase in the payout ratio could increase dividend growth by more than 1 per cent per year, in our view.

And finally, when you include the contribution of share buybacks (the stock market has been buying back around 3 per cent of itself every year), we think it is easy to see how you could plausibly get a mid-teen total return.

Impact of ‘Abenomics’ and Japanese corporate improvement

A decade ago, former prime minister Shinzo Abe launched his “three arrows” programme of economic and corporate reform known as “Abenomics”. As part of these policies, companies were encouraged to go forth and make profits. Abenomics created a tremendous buzz and, over the next couple of years, foreign investors went on a quarter-of-a-trillion yen (S$2.5 billion) buying spree on Japanese equities. They then spent the next eight years selling their shares, disappointed with the apparent lack of progress on corporate reform.

Over the past 10 years, the market recorded a compound annual growth rate (CAGR) in earnings of around 12 per cent to 13 per cent (in local currency terms). This is very respectable compared to other markets.

In Japan, there has also been a coordinated, state-sponsored campaign to drive corporate improvement – in some ways it is a bit like Singapore 20 years ago. It has been a massive institutional project, to upgrade the legal framework in which companies operate.

While there was a perception Abenomics was taking too long for some investors, the pace of change was not unreasonable, in our view. It takes a long time to go from a post-war industrial policy to the mantra of “go forth and make money”. A good example of a business that was an early adopter of change is incumbent telecommunications company NTT. NTT has seen only a modest increase in revenues over the past 10 years, however over that period, investors have enjoyed an internal rate of return (IRR) of 19 per cent in yen terms. This was not due to multiple expansion – it still trades on a similar multiple to the one it did at the start of the period (11x price-to-earnings), rather it was down to increased profit margins, share buybacks and dividend growth. To reiterate our view, double-digit earnings growth across the market was achieved without the complete institutional framework in place, suggesting there is still a lot more earnings growth to come.

Short-term considerations: Currency impact

The Bank of Japan (BOJ)‘s policy of targetting government bond yields in a narrow range around zero per cent, the so-called yield curve control (YCC), was unsustainable, in M&G Investment’s view. The BOJ’s decision in December last year to widen the YCC range is a good sign and an acknowledgement of an improvement in Japan’s economy, where wages and prices are finally beginning to rise. However, some investors will worry about the impact of the policy change on the strength of the yen and the negative impact it might have on earnings, particularly for exporters. We believe this is an overreaction. We do not have a view on the yen – it may or may not strengthen in 2023, but over the long term we believe the stock market will be mainly driven by earnings, not the level of its currency.

Japan is forecast to be one of the fastest-growing developed economies in 2023. Although to be fair, this is partly due to a “base effect”, as the country was still locked down for Covid-19 at the start of 2022. In addition, wages and inflation are both increasing meaningfully, something that has not happened in 25 years. We believe this inflation is structural, driven by wage and price rises, a contrast to cost-push cyclical inflation in the West. Having experienced two decades of deflation, this could be a powerful driver of corporate earnings in Japan.

The writer is co-head of Asia-Pacific equities at M&G Investments.