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.
The ROE of U.S. companies is roughly twice as high. If Japanese companies were able to improve their ROE to 15 percent, earnings would be 50 percent higher and stocks could go up the same amount without any change in valuation.
Japan trades at a slight discount to the U.S. market. Japanese stocks trade at 17 times earnings and the U.S. is around 19 times earnings (measured over the past 12 months).
Japan also trails the U.S. in dividends. Japanese stocks yield 1.6 percent compared with the U.S.’ 2.2 percent payout yield.
The structural reforms introduced by Abe create an environment where improved growth and corporate efficiency should allow Japanese stocks to outperform global stocks by a comfortable margin in coming years. While markets can quickly recognize value (or the lack thereof) and price moves can be rapid, this opportunity is expected to play out over one to two years.
Structural changes take time, and the long-held negative views toward Japan will take a while to change. So what makes Abe’s structural reforms so important? Structural reforms, at their most basic level, are changes to the economic-governmental structure.
Examples from around the globe include making it easier to lay off workers, privatizing government assets, changing the retirement age, improving corporate governance and changing tax rates. Abe’s structural reforms are more likely to succeed because they show a greater political skill than seen in other countries.
For example, Japan needs to improve the efficiency of its service industries and lower agricultural subsidies. Rather than implement needed reforms unilaterally, Abe agrees to include them as part of the TPP trade negotiations. So, Japan will now benefit from additional growth opportunities while making changes it needs to make anyway.
Changes To Corporate Governance
Perhaps the most effective reforms are the Stewardship and Corporate Governance codes. The Stewardship Code doesn’t require any specific action and is not legally binding. Instead, institutional investors who have adopted the code must ether comply with the code or explain, in writing, why they didn’t follow the code in a particular situation.
The Corporate Governance Code is similar because most of its rules and guidelines can be ignored provided there is a written explanation. So companies can maintain cross-holdings in firms, but have to explain why. The code also requires at least two independent directors for listed firms. In 2014, only one-third of the firms on the Tokyo exchange had two or more outside directors.
The power of the Stewardship and Corporate Governance codes is to bring firms to a higher standard without mandating the change. Both codes, through investors and independent board members, bring additional pressure on firms to be more responsive to shareholders without additional government action.
Faced with a declining population, Abe introduces programs to allow women to continue or return to work while parenting. Women are crucial to the Japanese economy because they are very well educated, but are often not working or stuck in lower-level positions. In fact, 63 percent of women between the ages of 25 and 34 have college degrees. That number is 8 percent higher than men of the same age range.
Japan’s corporate tax rate was also too high. In 2015, that rate was cut 2.5 percent and it will be cut by a smaller amount again next year. In addition, a host of narrower proposals focus on increasing tax exemptions, changing incentives and making the tax code simpler.
This is Abe’s second run as prime minister.
He learned from the first term’s challenges. Instead of legislating productivity reforms through a long public process, he is making policy adjustments that gradually reshape Japanese industry. He uses a trade pact to introduce the changes that brings additional benefits. Rather than force change on companies, he introduces codes to make investors and board members his agents of change.
Japan reminds me of Texas in the early stages of its growth revival. A string of Texas governors found ways to make it easy for businesses to expand and then economic growth followed. Japan’s government continues to look for clever ways to stay popular while instituting reforms. The whole process can be good for investors.
CLS Investments is an Omaha, Nebraska.-based third-party investment manager and ETF strategist. CLS began to emphasize ETFs in individual investor portfolios in 2002, and is now one of the largest active money managers using exchange-traded funds, with more than $2 billion invested. Contact CLS’ Chief Investment Strategist Scott Kubie at 402-896-7406 or at [email protected]. Please click here for a complete list of relevant disclosures and definitions.