Japan Syndrome Reconsidered

Two decades ago, Japan attracted the frenzied admiration of the world. Yet far from becoming the global ‘Number One’, its economy has this year been overtaken by China. Pundits now suggest that Japan’s decline from economic pre-eminence will mirror that of Argentina over the twentieth century. Such gloomy prognostications should whet the appetite of all contrarians.

“Nothing could be more useful [for an investor], than to be well instructed in his Hope and Fears; to be diffident when others exalt, and with a secret Joy buy when others think it in their interest to sell.” This sound advice was provided by Sir Richard Steele in the early 18th century. Had he encountered the stubbornly intractable Japanese stock market, Steele might have shown less mettle. The Nikkei has become a serial underperformer. Japanese stocks are down around 6% this year, while the S&P is up by a similar amount.

Twenty years ago, not owning Japanese stocks was a career-threatening move for international investors. Today, the opposite is the case.  A recent Merrill Lynch survey found that 29% of fund managers were underweight Japan. The reasons for eschewing Japan are numerous. Management doesn’t care about shareholders: over-investment and dilution through new equity issues have been the norm. Returns on equity in Japan bump along at roughly one-third of US levels. Although the Nikkei is down some 75% from its peak, Japanese stocks are still not cheap by some valuation measures. Throw in a declining population and the inexorable rise of China to douse any lingering hopes.

Yet it’s possible to paint a brighter picture of a Japanese sun that has not permanently set but is merely hidden behind a cloud. Poor management is probably not the only reason for Japan’s miserable returns on equity. Morgan Stanley’s Alex Kinmont points to the baleful consequences of deflation. Two decades of falling prices have driven companies to replace debt with equity and lowered asset turnover. Since wages are sticky and the cost of imported commodities has been rising, deflation has also squeezed profit margins.

The Bank of Japan has been timid in comparison to the extravagant quantitative easing operations of the Fed and Bank of England. Yet Japan cannot remain indefinitely a lone outpost of deflation while the rest of the world enjoys the guilty pleasures of the printing press. Things may be about to change. The Bank of Japan is coming under increased political pressure either to end deflation or face the loss of its independence. The central bank is reportedly looking to reduce risk premiums in Japan.

There’s a history of Japanese stocks responding positively to an end to deflation. In late 1931, the country which had suffered from a late return to the gold standard changed course. The currency was allowed to float while the Bank of Japan started acquiring government bonds. Inflation quickly returned and the stock market nearly doubled over the following year.

The skeptics will prefer avoid Japan until its much cheaper than other markets. It’s true that on a cyclically-adjusted price-earnings ratio, Japan is about as expensive as the US. But this overstates things, says Kinmont, due to the exceptional losses that Japanese banks experienced during the last decade on property loans and cross-shareholdings. Exclude these exceptionals and Japan begins to look pretty cheap.

But what about Japanese management’s propensity to over-invest and dilute shareholders? Andrew Smithers notes that corporate investment has been declining in Japan since the onset of the credit crunch. Lower depreciation is set to boost profit margins. Furthermore, Japanese companies have reduced their indebtedness to such an extent over the past twenty years that they are now net recipients of interest payments (including dividends). That’s one less reason for them to issue more shares in future.

Then there’s the margin of safety to consider. Japanese equities are priced at a discount to their book value. Companies also sit on large cash balances and are less leveraged than their US counterparts. Many stocks in Japan meet Ben Graham’s demanding criteria for cheapness, sustained profitability and robust balance sheets. The same cannot be said of the US.

A recent issue of The Economist was devoted to Japan’s shrinking population. Lurid headlines warned of a ‘Dearth of Births, ‘Social Insecurity,’ and Japan’s ‘Journey into the Unknown.’ Investors should take all this with a pinch of salt. There’s no current shortage of workers in Japan given a relatively low labor participation rate among those of a working age (in particular women). Demographic doom-mongers also overlook the fact that investment returns are not derived from economic growth. In fact, research shows there’s a mildly negative correlation between chances in GDP and stock market performance.

There’s not doubt that Japan faces severe challenges including a huge government debt burden, an increasingly assertive China and poor demographics. Yet as a nation Japan has overcome greater challenges in the past. It’s hard to avoid that conclusion that today’s apocalyptic commentary about Japan is as overblown today as the wildly positive effusions of yesteryear. Therein lies the investment opportunity.

Edward Chancellor is a member of GMO’s asset allocation team, as well as a regular columnist in the Financial Times and other publications.