Japan's Stealth Profit Boom

Have S&P 500 constituents actually outperformed global peers? 
 

By: Verdad Research

The story in global equity markets over the last few decades has been the unrivaled dominance of the S&P 500. Indeed, the S&P 500 index is up 363% since the start of 2010 while Japan’s TOPIX is only up 196% over the same period in local currency. 

Accompanying these return differentials is the common rationalization that American companies (especially the largest) have just been better managed than their Japanese equivalents and have grown profits for shareholders significantly faster during this period.

In our view, there is one small problem with this narrative: it’s wrong. 

The narrative might be a good description of the 2000s. But even careful market observers might not realize that Japanese companies have grown EPS at almost double the rate of US companies since 2010. Below we show the change in revenue and EPS of the largest 500 American stocks compared to that of the largest 500 Japanese stocks over the last 24 years. This is the change in the median revenue and EPS for constituents of those indexes and is expressed as a multiple of the start level.

Figure 1: Top- and Bottom-Line Growth in US and Japan 500 Constituents

Source: Compustat. Change in the median revenue and EPS of the largest 500 American and Japanese stocks listed on the NYSE/NASDAQ and the TSE respectively. Excludes REITs and financials. Through April 1, 2024.

Japanese companies lagged the US in revenue growth from 2000 to 2010, barely growing EPS at all. But since then, the EPS of the biggest 500 Japanese stocks has increased by 5.8x over the last 14 years, almost twice the rate of their American peers now.

These results make it difficult for us to concede that Japanese companies were somehow much worse run than their S&P 500 counterparts. They seem to have improved much more and allocated capital primarily when it increased per-share earnings. This is in line with our research on comparative M&A capital allocation between Japan and the US. At a minimum, the Japanese certainly deserve the “most improved” award of late.

Perennial Japan bull, Jesper Koll, recently put it even more emphatically: “There is no question that Japanese ‘salarymen CEOs’ created more fundamental economic value than Wall Street’s superstar CEOs.” 

But how did this happen? We believe one of the primary reasons is deleveraging balance sheets in Japan. As Japan deleveraged coming out of the non-performing loan crisis at the turn of the century, it became one of the most well capitalized corporate markets in global equities and still enjoys some of the lowest corporate borrowing rates in the world. As a result, very little of every dollar of earnings before interest and taxes (EBIT) goes to interest payments for the typical company.  

For the same top 500 companies in each market, below we show the change in the percentage of companies that have net cash on their balance sheet as well as the amount of interest paid as a percentage of EBIT.

Figure 2: Typical Corporate Leverage and Interest Burden for US and Japan 500 Constituents

Source: Compustat. Median of the largest 500 listed companies for each country. Through April 1, 2024.

Today, roughly half of the Japanese companies have net cash balances, and almost none of their EBIT goes to interest there. By contrast, the lion’s share of US 500 companies owe the banks money, and almost 15% of EBIT goes to lenders in America. Corporate Japan looks quite different today than it did a couple of decades ago, and we believe this has contributed to the bottom line. The magnitude of the financial statement impact of this transition for shareholders is roughly equivalent to eliminating headline corporate taxation entirely.

Regardless of the cause, this newfound profitability in Japan may upset some long-held paradigms, which we believe tend to flow through to market multiples and returns over time. 

As a consequence of having lagged (until recently) in relative equity returns since 2010 while having bottom-line earnings that have gone up much faster, the purchase multiples on Japanese stocks still see a very wide long-term divergence that is nowhere near normalized, in our opinion.

Below we show the P/E and P/B multiple for the S&P 500 compared to the TOPIX since 2010. US companies became 2x as expensive on bottom-line, per-share earnings and a whopping 4x as expensive on book value over this period.

Figure 3: P/E and P/B Multiples of the S&P 500 and the TOPIX

Source: Compustat. Through April 1, 2024.

Because of this, we are not too worried when people note that the Nikkei index hit an all-time high of late. To us, valuation and corporate borrowing risk still appears to be decidedly elsewhere.