This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Scott Kubie, chief investment strategist of Omaha, Nebraska-based CLS Investments.
For the first time that I can remember, my international allocation is overweight Japan. Japanese companies have remained globally competitive for customers, but not investors. Corporate efficiency has lagged and shareholders have suffered. Prime Minster Shinzo Abe’s reforms provide the needed push to make Japan a better place to invest.
The top ETF for Japan is the broadly diversified iShares MSCI Japan ETF (EWJ |B-99). While the vast majority of Japan ETFs are potential substitutes, the reforms driving potential appreciation are likely to be felt most in large-cap companies. A diversified, cap-weighted index provides consistent exposure to the Japanese stock market.
The bad side of Japan is well-known. Here’s the list:
- The population is shrinking
- The government debt problem is out of control
- The society is too rigid to make changes
- Abe has given up on structural change
- Japanese companies are inefficient
However, the bad side of the Japan narrative represents an account assumed to be true simply because it matches our expectations.
The shrinking population remains a serious challenge. And debt levels, for the government, are indeed very high. But Japan is changing and Prime Minister Abe has found clever ways to implement structural change, which, in my view, overcome these challenges.
Here is a brief preview of Japan’s structural reforms and their benefits:
- The government and central bank are committed to producing inflation, weakening the tendency to hold on to cash for corporations and consumers
- The Trans-Pacific Partnership (TPP), a planned trade agreement between 12 countries, will force Japan to become more efficient, while providing it opportunities for growth
- Abe has introduced a Stewardship Code and a Corporate Governance Code, creating a culture that pressures boards of directors to increase productivity and dividends—both good things for shareholders
- It is easier for women to remain in the labor force, boosting supply and demand in spite of no population growth
Benefits From Reforms
Two major benefits will accrue to investors in Japanese securities because of these reforms. First, the economy will grow.
For years, Japan has seemed to be just entering or exiting a recession. Positive economic growth, even at low levels, benefits investors by reducing multiple risks.
For example, as the risk of recession drops, persistent deflation is less of an issue, and government debt becomes easier to service. All these factors make Japanese stocks less risky.
Improved earnings and dividends are the second benefit for investors in Japanese stocks. Japanese companies currently have a return on equity (ROE) of approximately 10 percent, meaning every ¥1,000 in equity book value earns ¥100 yen in profits.