Luxembourg
16 Boulevard Royal – L-2449 Luxembourg
 
Monday to Friday
8 am to 5 pm

After decades of disappointments, in 2013 the Japanese stock market posted its best performance in 14 years. The market has benefited from the initial success of Abenomics, the ambitious economic experiment put in place by Prime Minister Shinzo Abe and his government. The aim of this radical program is to revive Japan's economy that has been stagnant for decades and to break out of the deflationary spiral that puts a drag on corporate investments and private consumption.

In September, I published a blog article entitled 'Investing in Japan - The impact of Abenomics' that aimed to give an overview of what Abenomics is, why it has been implemented, what risks are associated with it and how it influences our investment decisions in Japan. In this article, I focus on the structural reforms associated with the programme.

The third arrow of Abenomics

Abenomics is based on three pillars: monetary policy, fiscal stimulus and structural reforms. While there are controversial debates among economists about the extent to which the monetary and fiscal politics make sense or are even dangerous, the structural reforms are widely considered to be the most important element of Abenomics and essential for Abe's experiment to succeed. These reforms call for the development of growth strategies under the slogan "Japan is Back". If implemented successfully, these initiatives could trigger a virtuous circle in which improvements in companies' productivity and wage increases would lead to more robust economic growth. For us, as fundamental investors focused on individual companies and not on macroeconomic developments, this is clearly the most interesting element of Abenomics, as its successful implementation could significantly improve the business environment for Japanese companies.

In order to understand why these structural reforms have become indispensable, we need to assess why, after the collapse of the huge economic and financial bubble of the 1980s, Japan has never been able to return to a path of consistent economic growth. A recent article published on the website of the Asian Century Institute entitled "Why did Japan stop growing?" describes why and how Japan encountered the problems it has now been battling with for decades. Most notably, the country faces some serious issues that prevent it from increasing its workforce and adversely affect the profitability of its companies, two elements that are indispensable in order to achieve real economic growth.

Japan's economic and social issues

On the one hand, because of its poor demographics with a very low birth rate, the working population of Japan is decreasing at an alarming speed. In order to reverse this trend, Japan would have to relax its very restrictive immigration policies and increase the participation rate of Japanese women in the labour force.

One the other hand, compared to their international counterparts, the profitability of Japanese companies is low.

There are several reasons for this:
  • In many business sectors, complex government regulations lead to very low productivity and prevent innovation. For instance the failure to deregulate its service sector, a potential growth sector for a mature economy, has held the economy back. Protective measures in the agriculture sector have also cost the country financially, irritated trading partners and led to an overcapitalized industry with low productivity.
  • Japan has very low levels of imports, inflows of foreign investments and foreign labour. Greater openness to imports would boost competition, efficiency and innovation.
  • To some extent, Japan has also lost its culture of innovation in export-oriented sectors. Former leading electronic giants like Sony and Sharp are now posting losses and being beaten by foreign competitors like Apple or Samsung.
  • Japan has a culture of keeping unprofitable companies afloat and its huge conglomerates shun away from closing loss-making activities. This prevents the healthy process of creative destruction which leads to the failure and disappearance of unprofitable businesses and which increases the incentives for strong and innovative companies to expand their activities.
  • Japan has a very rigid employment and pay system which favours employment for life and the payment of bonuses largely based on seniority and not on performance.

Growth strategies

The structural reforms envisaged by the government are intended to improve the business environment and tackle most of the issues mentioned above. In June 2013, the government approved a draft package of growth strategies and began to implement these measures. These should promote structural reforms and are also designed to stimulate demand, both externally and internally.

Examples of the measures envisaged include:
  • Reform of the employment system with the aim of improving worker flexibility and increasing the female participation rate. The creation of new places at childcare facilities should contribute to eliminating the current problem of waiting lists for childcare. Measures to facilitate worker immigration are also envisaged.
  • Reforms to promote concentration and consolidation in the agricultural sector in order to increase its productivity.
  • Creation of special economic zones. Japan's leading cities could be designated as strategic economic areas where companies could benefit from fiscal advantages, lighter regulations and less bureaucracy.
  • Negotiation of strategic economic partnerships with the aim of significantly increasing the amount of Japan's international trade that falls under free trade agreements; e.g. by joining the TPP (Trans-Pacific Partnership) agreement.
  • Policy measures which should help to better tap the potential of Japan's underdeveloped tourism industry and increase its contribution to economic growth, e.g. by easing the VISA requirements for visitors from Southeast Asia.

This list is by no means exhaustive. In order to gain a more detailed insight into the proposed reforms, I suggest reading the article "The Third Arrow of Abenomics: What economic picture will it draw in the middle-term?" by Akio Egawa at Bruegel.org.

Increase in companies profitability is an opportunity for investors

Putting in place these structural reforms will take longer than the monetary and fiscal policy measures already implemented and will require the emergence of a national consensus between companies, the government and the unions. In the past, Japan has proved several times that under difficult circumstances its society stands together to incorporate the necessary changes. Under the Meiji Restoration at the end of the 19th century, for instance, it went through dramatic social and political changes. The country opened to the West, abolished its feudal system, adopted a modern constitution and imported new technologies, resulting in an explosion in industrial productivity and economic growth. After World War II, the country changed from a military empire to an advanced democratic society that focused on its economic power, leading to strong economic growth and enabling Japan to become the third-largest economy in the world.

The time has come for Japan to prove, once again, that its society can overcome big challenges and put in place the necessary changes to give the economy a much needed boost. A first positive trend that can be observed is the tendency of Japanese companies to improve their shareholder remuneration policy andplace greater emphasis on their profitability. This could constitute an interesting opportunity for equity investors, as traditionally Japanese companies have lagged behind their international counterparts. Whereas, in other regions, margins are already at historically high levels (e.g. in the USA), there is still room for improvement in Japan. Thanks to a significant increase in earnings and profitability, Japanese companies have already managed to reduce the gulf between their ROE (return on equity) and that of their international competitors.

Difference in profitability (ROE) between Japanese companies (Topix) and their international counterparts (MSCI World)

source: Bloomberg

 

The launch of a new stock market index: indication of a mentality change

The launch of a stock market index covering the top 400 Japanese companies in terms of ROE is also proof of a change in mentality in Japan. This new index should enhance the attraction of the Japanese stock market for foreign investors looking for high-quality companies, especially as in terms of P/B (price to book), the Japanese market is still trading at a discount to most other stock markets.

This should also be positive for the companies we invest in, as almost all the companies currently held in BL-Equities Japan (ISIN: LU0578148453) are members of this new stock market index.

 

Difference in valuation between the Japanese market (Topix) and the MSCI World

source: Bloomberg

 

Hitachi – a conglomerate in transformation

Hitachi, Japan's largest industrial electronics firm, is an example of a company that is moving in the right direction. At a recent conference, I had the opportunity to meet with representatives of Hitachi's corporate communication divisions and had an interesting discussion about their corporate strategy. A few years ago, Hitachi started to make significant changes to its vast business-portfolio and decided to focus on activities that offer higher profitability, lower cyclicality and stronger growth potential. Today, Hitachi's business mix is far better than a few years ago, after it exited commoditized and capital-intensive businesses and expanded its more stable and service-oriented social infrastructure divisions. The management has also decided on a better approach to integrating its different businesses and sharing resources among them, which will help reduce costs. Although, in the case of Hitachi, the changes implemented are not directly related to Abenomics, the structural reforms and the incentives put in place by the new government could encourage other companies to follow suit.

What does the future hold for Japan?

For Japan to unlock the growth potential of its economy, it needs to implement structural changes in order to overcome its demographic challenges, promote innovation and encourage the private sector to shift resources from declining businesses to growth segments. If the Japanese authorities can sustain this policy shift and follow through with the regulatory reforms, without losing the support of the population, then theoutlook for the world's third-largest economy could brighten. Japanese companies are already recording significant improvements in profitability and focusing more on shareholders' interests. In light of these developments, and in view of lower valuations than those of other developed markets, Japan represents an interesting investment opportunity.

Focus on quality companies that benefit from a competitive edge

However, patience and persistence will be required and the road to a sustainable economic recovery in Japan is likely to be rocky. Given the uncertain economic outlook, the best approach for an investor is to invest with a long-term perspective and focus on quality companies with a competitive edge. These will be less dependent on the uncertain outcome of the fiscal and monetary policies of Abe's program and are well positioned to benefit from structural reforms. These quality companies should be able to create shareholder value over the long term and turn out to be attractive investments, even if the road to economic recovery in Japan proves to be bumpier than expected.

Steve Glod, Equity Fund Manager

Steve joined Banque de Luxembourg's Financial Analysis and Asset Management department in 2001. Since 2011, he has been in charge of Japanese equity investments for the Bank's funds range. Between 2005 and 2010, he was co-manager of US equity investments for the Bank's funds range. Steve has a degree in Mechanical Engineering with a specialisation in business management, and a doctorate in technical sciences from the Swiss Federal Institute of Technology in Zurich (ETH Zurich). He obtained the CEFA (Certified EFFAS Financial Analyst) diploma in 2002.

Follow me on LinkedIn

Subscribe to
our newsletter
email