- Price to book is 1.1 and price earnings ratio is at 15.
- More monetary and fiscal stimulus can be expected.
- Even if the economy doesn’t pick up Japan is relatively cheap.
We read a lot about how Japan has been in an economic slump for the past 30 years, how incredibly large amounts of quantitative easing have not triggered inflation, and that Japan should be avoided as an investment opportunity.
In this article we are going to see if any of those concerns have merit by looking at the economy, financial markets, fundamentals, currency risks and rewards in order to estimate the rationality of internationally diversifying our portfolio with Japanese stocks.
The Japanese Economy
Japan was an Asian tiger the 1980s and the burst of the 1989 stock market bubble practically eliminated economic growth. Short growth periods are consistently leveled out by recessions.
Figure 1: Japan’s GDP growth. Source: Trading Economics.
Even with no GDP growth, unemployment in Japan—which currently sits at 3.2%—is very low. Not as low as it has been historically, but still relatively low when compared to other economies like the U.S. with 4.9% or Europe with 10.1%.
Figure 2: Japan’s unemployment rate. Source: Trading Economics.
Japan is suffering from the same disease as most of the other developed economies, an aging population. The labor force participation rate is slowly but steadily declining and is currently at 59.8% (U.S. 62.7%). As a consequence, labor productivity in Japan has been declining for the last 10 years.
In order to bring the Japanese economy to a more stable growth path the prime minister, Shinzo Abe, has embarked on an incredible quantitative and qualitative easing plan. The easing consists of pushing the interest rate below zero and purchasing stocks and bonds on the open market with the goal of bringing liquidity to the market and hopefully spurring inflation. The current interest rate is minus 0.1% and the Bank of Japan has largely increased its balance sheet in the last few years.
Figure 3: Bank of Japan balance sheet and interest rate. Source: Bloomberg.
Monetary policy isn’t the only reason for such a drastic decline in yields. Because the Yen is considered a safe haven, Japanese securities are often used as collateral. This keeps demand high, which also helps to keep rates low. Even still, this has not been enough to spur inflation and now there are even rumors, seeing how inflated the Bank of Japan’s balance sheet is, that it has limited maneuvering space for more quantitative easing. But, Former Federal Reserve Chairman Ben Bernanke rejected this notion as he met with Shinzo Abe to discuss how Japan can beat deflation and implement more qualitative and quantitative easing. The idea is to use “helicopter money” where a central bank directly finances government spending and tax cuts which should inevitably lead to inflation.
There is no guarantee this will happen, but seeing that Japan has had a decade of deflation, anything is possible. As investors, we should look for investments that will do well in an inflationary environment with high levels of monetary easing.
Current Market Situation
Neither the Japanese economy nor the stock market has grown much in the last few decades.
Figure 4: Nikkei index. Source: Yahoo Finance.
However, in the last 5 years it has risen 100% when calculated in the Yen. But given the strong depreciation of the Japanese yen in the last 4 years, it only equates to a 60% rise in US dollars.
Figure 5: USD vs YEN since 2006. Source: XE.
Over the last few months the Yen has actually appreciated against the US dollar. But new easing possibilities might once again lower the value of the yen, which in the last week alone depreciated 4% against the dollar. Investors have to be careful here and differentiate what is real market appreciation or just currency depreciation that affects the Japanese stock market. On the other hand, as the above two figures show, the stock market moves in sync with the currency thus there is at least some protection, currency wise.
From a global valuation perspective Japan is undervalued. Knowing that many products that we use on a daily basis are made by Japanese companies, it might be a good idea to dig deeper into Japanese stocks.
Japan’s Cyclically Adjusted Price Earnings ratio (CAPE – uses 10 year earnings average) is at 20.7 while the U.S. the ratio is 24.7. The normal PE ratio for Japan is also relatively low at 15.2 which is one of the lowest PE ratios in the developed world.
Figure 6: Global PE ratios. Source: Star Capital.
In the long term, investment returns are correlated with underlying earnings, therefore diversifying internationally with cheaper Japanese businesses makes sense. Especially since many of these businesses operate globally. Plus, Japan has a strong legal system, is transparent and has a long positive history towards international investments.The iShares MSCI Japan ETF has an even lower PE ratio of 13.09 and a Price to Book value of just 1.16 which are both much lower than the iShares S&P 500 Core ETF with a PE ratio of 19.55 and a price to book ratio of 2.8.
Future Potential Catalysts and Risks
The first potential boost the Japanese stock market might get is from the new easing program where the central bank will directly give money to the government. This could weaken the yen and make Japanese products cheaper.
The second boost might come from increased fiscal stimulus. The prime minister already delayed the higher consumption tax implementation and more measures should be expected.
The third potential catalyst could come from better corporate governance. Japanese companies have lots of assets sitting on their balance sheets, including cash, and there is a slow trend towards more buyback programs and higher dividends, although this not the usual way Japanese companies operate.
There is always the risk that the stimulus might not work and that Japan returns to the familiar cycle of slow growth with constant recessions. If that turns out to be the case, the low valuations and attractive Price to Book values Japanese companies have, should provide some downside protection. And the fact that many Japanese companies operate globally further mitigates country risk.
In hindsight, it is always easy to explain what happened. Maybe in a few years people will look at the extra returns generated from Japan as pure logic, seeing that the PE ratio is much lower than the rest of the developed world and balance sheets much stronger.
Unfortunately, investing is not done in hindsight. It takes courage to invest in something where it looks like everything should turn out well but has not yet happened. Given the fundamentals and macro trends, Japan might just be the perfect example of how markets tend to be irrational for longer periods of time, allowing patient investors to make extraordinary returns.