Why Japan Now
The Japanese stock market is cheaper today than at the depths of the financial crisis. The country's stocks trade at the lowest valuations in over twenty years. The gap between valuations in Japan and the United States is larger now than at any point since the peak of the dot-com bubble in 2000.
Figure 1: Enterprise Value to Last Twelve Month’s EBITDA Multiples
Source: S&P Capital IQ. Japan multiples include all listed stocks on the Tokyo Stock Exchange and JASDAQ with market cap over $50mm. TEV/LTM EBITDA multiples on the first trading day of the year indicated.
Investors are pessimistic and foreign investors have fled Japan in droves. Indeed, any which way you cut it (price/earnings, book/equity, EV/EBITDA) across any quartile, Japan in 2017 is the cheapest market in the developed world. The bottom quartile in Japan is now ~1-3 turns cheaper than other major equity markets:
Figure 2: International Cross Section of 2017 EV/EBITDA Valuations
Source: Damodaran Online Global Dataset, NYU Stern School of Business
Are these valuations justified? Is Japan really in worse shape today than at the depths of the 2008 crisis? Or does this represent one of the most attractive investment opportunities in twenty years, a chance to pick up companies at severely depressed valuations despite healthy financials?
Despite extreme investor pessimism, we believe Japan’s economy is as healthy as any. Japanese profitability and business confidence are at highs. Unemployment is at record lows. Debt/GDP has leveled off, with no indications of radical policy change from either the BOJ or the government. Both absolute and per-capita GDP are at highs. We struggle to see a reason why Japanese stocks should be trading at half the level of US stocks and at all-time lows for Japan in this millennium.
Investors point to three primary reasons for pessimism about Japan: high debt to GDP, stagnant GDP growth, and bad capital allocation. Let us address each of these in turn.
Investors may be concerned about the government’s debt burden and Japanese monetary policy. Fair points. Debt to GDP is ~250%. However, the decade-long increasing trend leveled off three years ago:
Figure 3: % Increase in Japanese Government Debt/GDP Ratio
Source: Ministry of Finance of Japan
On monetary policy, it appears that as the US Fed begins interest rate hikes, the Bank of Japan is as resolute as ever to press on with their 30-year tradition of zero interest rates. On March 24, BOJ Governor Haruhiko Kuroda reaffirmed this in no uncertain terms: “The bank will not raise the target level of the long-term interest rates just because of a rise in such rates in other countries.” When asked if the BOJ might be forced to raise rates, Kuroda responded, “That will not happen. In fact, yield curve control is designed to be highly sustainable.”
Investors may be concerned about general stagnation in the Japanese economy. With a shrinking and aging population, Japan has had essentially zero real GDP growth for over a decade. However, recent numbers look promising, with unemployment at a 22-year low and business confidence indicators hitting a 1.5-year high in March. With two lost decades of growth, few investors have picked up on the long-term increase in per-capita GDP, on par with the United States and consistently outperforming Europe.
Figure 4. GDP per Capita
Federal Reserve Economic Data, St. Louis Fed. 2010 constant USD
Investors may be concerned with Japanese corporate governance and capital allocation. We agree! Japanese corporate management teams as a whole are the worst capital allocators among all developed nations from a shareholder’s perspective. However, governance and capital return indicators have been markedly improving since the 90’s and particularly since the great recession:
Figure 5: Total Shareholder Returns of all Listed Companies in Japan
Source: Sebastien Mallet, T.RowePrice, January 2017. *On a common stock basis.
In sum, we do not see evidence of the catastrophically negative catalysts implied by current relative and absolute valuations. This is especially true when targeting the subset of Japanese equities where we believe such hypothetical negative catalysts are mitigated: growth-agnostic, value-oriented, debt-disciplined companies with less dependency on FX dynamics.
At Verdad, we pursue pessimism within markets and across them. As Warren Buffet once explained “The most common cause of low prices is pessimism—sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer.”
Across international equity markets, no developed country meets these conditions as clearly as Japan in 2017.