Explaining Japanese Leveraged Value Equity Returns
In addition to performing replication studies on our factor model and machine learning algorithm, we took a comprehensive look at what worked — and what didn’t work — in Japanese equity markets. Though focused on Japan, this research is relevant to all investors. It should be of deep interest to U.S. investors, as the macroeconomic conditions that Japan has faced for the past 20 years are similar to those currently facing the United States: a high GDP/capita nation, with low GDP growth, and near-zero interest rates. This research is also important because cross-sectional studies of Japanese equities are rare and there hasn't been a major one since 2001.
We have three core findings. First, our results suggest that that Debt/EV is an important variable in explaining the returns of stocks in our target universe — the more leveraged the equity, the higher the equity returns. Second, we confirm prior research finding a very strong value effect in Japan, and a limited impact of size. Third, we find a strong gross profitability premium in Japan, confirming that Professor Novy-Marx’s profitability factor works in Japan.
We summarize our findings of the key variables that drive Japanese equity returns below. Our sample covers the period between 1990 and 2012. In the table below, the numbers in parentheses below the coefficients represent the t-statistic for each coefficient. The first column shows the results of a regression of future annual returns against key explanatory variables across all stocks in our Japanese sample. The second column shows results of the same regression applied to stocks in our target universe. This universe comprises the cheapest 30% of companies in terms of EBITDA/EV and the top 50% of companies in terms of leverage (Debt/EV).
Figure 1: Regressions of One-Year Returns on Factors
Our first major finding is the importance of leverage (Debt/EV). Within our target universe, Debt/EV has a positive coefficient of 0.38 and a t-statistic of 4.40. Therefore, higher Debt/EV is significantly associated with higher returns. This finding supports the attractiveness of Verdad’s strategy in Japan. In a low-growth, low interest-rate environment, the most effective way for companies to improve return on equity is to borrow.
The results also show that investors in Japanese leveraged value equities should seek firms with a track record of prior debt paydown and low debt/assets — the two best metrics of credit health. Why does Debt/EV work so well in Japan? Below are some hypotheses:
In the absence of organic market growth within Japan’s stagnant economy, debt is used to spice equity holders’ returns. Debt enables enhanced returns without having to dramatically improve any other business fundamentals.
Debt/EV is a testament to the aptitude of company management. Japanese companies with debt are likely to allocate capital better — especially when interest rates are so close to zero. It could be a mistake to not take on debt to lower the cost of capital and increase your equity returns.
Our second major finding is to confirm prior research showing that value is a strong predictor of returns, and that size is an insignificant factor over the time period in our sample. We use EBITDA/EV as our value signal and within the regression of stocks in our target universe, we see an EBITDA/EV coefficient of 0.93 with a t-statistic of 6.69. Value is indeed a strong predictor of future returns. Consistent with prior research, we also found that size (as measured by market capitalization) was not a significant factor in Japan over the time period in our sample (1990–2012).
Our third major finding is that there are strong gross profitability effects, confirming Robert Novy-Marx’s findings in the United States in his paper on the profitability premium: "Profitability, measured by gross profits-to-assets, has roughly the same power as book-to-market in predicting the cross-section of average returns ... Controlling for profitability dramatically increases the performance of value strategies, especially among the largest, most liquid stocks." These results echo findings in our initial study of leveraged small value stocks in the United States, in which we argue that “all else equal, investors should prefer companies that produce higher gross profits relative to assets since more productive assets are clearly preferable to less productive assets.” Profitability seems to be an effective predictor of a good stock, both in the United States and Japan.
We are pleased to share these results and we look forward to the continuation of our implementation of these insights in our investment strategy. At Verdad we specialize in leveraged companies and we believe this research further demonstrates the importance of this specialization.