Rays of light in the land of the rising sun
"A weakening yen makes Japanese assets more attractive to foreign investors."
Japan has awakened. The equity market continues to grab headlines, even after its record-breaking rise since last autumn was interrupted by a sharp fall around the end of May. While the market is clearly volatile, Toru Ibayashi believes the outlook for Japanese equities remains positive, and that the exporter stocks are especially well-positioned for further gains – the weakening yen is improving their profit outlook, while their valuations remain quite attractive.
The past few months have been a period of rapid change for Japan, amounting to what could be the start of the renaissance of an economy that has been moribund for the last two decades, and the revival of investors’ interest in a market they had paid little attention to for so long.
The return to power of Prime Minister Shinzō Abe last December was no doubt a catalyst. Elected on a platform of ending an era of deflation, Abe has fired two arrows of his "three-arrow" strategy to boost the economy, first with the rollout of a generous fiscal stimulus plan, and second with the aggressive monetary expansion of the Bank of Japan (BoJ). The third, a "growth-enhancement" package of business-related incentives and reforms, is due for announcement in June.
The second has clearly been most beneficial to financial markets. The arsenal of liquidity the BoJ is preparing - to bring the inflation rate to 2% - exceeded most expectations and successfully generated investor confidence, at least for the near term. Equally important, it has entrenched a trend that had started to build up in anticipation of Abe’s re-election: a substantial weakening of the yen, which makes Japanese assets cheaper for foreign investors.
Positive drivers to continue
In the last seven months, the yen has weakened by 20% against the US dollar while the Nikkei 225 equity index has increased by more than 60%. While this performance is remarkable considering the short period of time in which it has been achieved, we see no good reason to believe either trend will take a U-turn.
First, the roadmap to 2% inflation has been set to two years, which makes it likely for the BoJ to keep interest rates low and the yen weak during this period. Even after those two years, the US will likely have already ended its own monetary-easing program, which would mean that US interest rates will have widened their gap over Japanese interest rates. This, in turn, would make the US dollar more attractive relative to the yen.
Second, the Japanese equity market is not yet overvalued. Currently, the Nikkei 225 is trading at 13.8x price-to-earnings ratio based on two-year earnings forecasts. This is higher than the global average of 12x. However, historical analysis suggests a 15x–16x ratio is justified for the Japanese market, which had traded as high as 20x in the past seven years. In our view, as long as Japan’s earnings momentum is higher than the global average – a scenario we find quite likely – the market’s valuation premium stands on good ground.
For these two reasons, we believe the best way to position in Japanese equities is through companies that generate most of their revenues and earnings from exports. To be sure, not all Japanese exporters are equally attractive. LCD-TV and PC makers, for example, have lost a chunk of their global market shares to South Korean and Chinese competitors. Since they no longer generate as much in sales in US dollars as they used to, a weaker yen would not significantly inflate their revenues. Outside of this exception, Japanese exporters are generally attractive, especially when compared with domestically-focused companies. In the recent reporting season for the fiscal year ending March, Japanese exporters delivered mostly positive results, citing the weaker yen as one of the factors that propelled profit growth. In contrast, domestically oriented companies reported lackluster results. Looking at the TOPIX 500 companies, we find that net profits grew 23% on average. A closer inspection reveals that exporters’ earnings grew a solid 38%, while non-exporters’ earnings grew a mediocre 7.8%.
For the current fiscal year ending March 2014, assuming the yen trades at 95–100 per US dollar, we expect exporters’ earnings to rise by 70% and domestic companies’ by 22%. We estimate that for every 1% depreciation of the yen against the US dollar, exporters’ earnings will grow by an additional 0.6%. While the weaker yen would account for 60% of the exporters’ profit growth, other factors could come into play, such as an improvement in the European economy and in Japan’s diplomatic relations with China.
One factor to consider is the potential negative impact of the yen’s depreciation on future earnings, given that a weaker yen would increase the cost of imported raw materials. We think this is not yet a major risk to exporters, as import prices remain soft due to weak global commodity prices and overcapacity issues at some foreign suppliers. That said, we expect companies across the board to bear higher electricity costs this year as Japan’s dependence on imported oil and gas increases.
Among Japanese exporters, we especially like the automakers. Japanese auto brands have firmly held their market share in developed countries, and are still growing in emerging economies. We expect their bargaining power to limit the impact of higher materials costs to a minimum, and their pricing power in foreign markets to increase in light of the weaker yen. Furthermore, their average P/E ratio is still attractive at less than 15x. Thus, Japanese automakers are at the core of our list of preferred Japanese exporters.
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