We visited Japan recently and met up with 13 Japanese organizations (Japan Exchange Group, Nippon Steel & Sumitomo Metal Mining, Shimizu Corp, Tokai Tokyo Financial Holdings, SONY Corp, Honda Motors, TEPCO, Sumitomo Corp, Japan Tobacco, Japan Bank for International Cooperation, AEON (Japan), Tokyo Gas, Central Japan Railway Co). We were also privileged to have the opportunity for a plant tour in Toyota’s assembly plant in Toyota City. Investors are anticipating that the prolonged deflation in Japan is finally coming to an end, thanks to the Bank of Japan (BOJ)’s aggressive monetary easing policies. In the past, nominal GDP had been lower than real GDP indicating a deflating economy; however, this has since reversed as inflation is now kicking in. The government introduced a Consumption Tax hike from 5% to 8% back in Apr-14 which was met with a negative GDP growth of -0.1% in 2014. However, the market expects growth to recover with an estimated GDP growth of 0.9% to 1.4% over 2015-16.

An improving labour market is a positive indicator that Japan is coming out of a deflationary mode. Although inflation is expected to remain low (<1.0% vs. BOJ’s target of 2.0%) for a while, it is to be expected that the interest rate environment will be kept low too. However, this is a common phenomenon in developed counties like Germany and the US. So clearly, one of the other stimuli to the economy is via wage hikes. Overall, many corporations have been increasing wages to attract talent (including the likes of Toyota, which has been increasing wages over the last 3 years) while minimum wage levels will likely be increased as well. The labour market has also tightened up a lot as the jobs to applicants ratio has improved to 1.19x from its 2010 low from less than 0.5x, while the unemployment ratio has eased to 3.4x compared to its high of c. 5.5x in 2010. We also note that Japanese households are also enjoying increasing financial assets’ value in terms of stocks and property, which bode well in terms of consumer spending and risk appetite.

Inbound demand has also been a booster to the economy. Thanks to the deregulation under Abenomics and the depreciation of JPY, Japan has been enjoying increasing tourism arrivals, which has boosted departmental store sales significantly. The number of international travellers grew by 25-30% YoY in 2013-14 and is expected to grow by close to 50% by 2015.

Japanese corporations are turning more aggressive and profit margins have improved a lot since 1954. Before this improvement, most Japanese corporates concentrated on only cost control measures rather than expansion due to the general conservative nature of the Japanese. While this has limited shareholders’ returns in the last decade, it has turned out to be a blessing in disguise as many Japanese corporates possess extremely strong balance sheets and efficient operating procedures, which enable them to weather out volatile periods, including the current low commodity price environment. It appears that some Japan-based economists take the view that even with the increasing wage trends, profit margins can still improve as long as inflation remains higher than input cost. Since our last visit back in 2011, we have noted a change in the Japanese corporate approach to foreign investors. The government of Japan has recently introduced the new Corporate Governance Code (CGC) which aims to improve transparency and interaction with shareholders, particularly addressing the concerns of global investors. One of the resulting effects of this CGC is a higher dividend payout ratio. In the past, dividend payout ratios amongst Japanese corporations were on a declining trend which had deterred many investors. Based on our company visits, we note that 30%-40% of them are reviewing or have increased their dividend payout ratios. We also observe that many of the Japanese corporations have intensive expansion plans, particularly overseas. For a summary of Japan’s new CGC, please refer to the APPENDIX.

Devaluing JPY has not deterred investors from Japanese equities. Under Abenomics, the JPY has been devalued but at a slower rate than other Asian currencies, especially China’s RMB. Foreign investors are opting for auto makers (e.g. Toyota) and manufacturing firms, which revenues are largely overseas driven, which bodes well for a depreciating JPY against the USD. In essence, these investors are betting on a higher rate of earnings growth which will outstrip the devaluing JPY’s effect. We also met up with Japan Bank for International Cooperation (JBIC) to get an overview of the Japanese government’s direction to revamp its economy. JBIC is a policy-based financial institution which is wholly-owned by the Japanese government with a net asset base of JPY2.46t and is affiliated with the Ministry of Finance. The Japanese government wants its corporates to expand overseas given their declining population growth and stagnating economic outlook. So the main role of JBIC in the revitalisation of Japan’s economy is to target: (i) industry revitalisation, (ii) strategic market creation plans, and (iii) strategic global outreach. The 3 main areas that require heavy investments includes: (i) infrastructure export strategy, (ii) overseas M&A, and (iii) reducing procurement costs of LNG and to diversify supply of LNG sources. In terms of its loan portfolio, it has USD122b outstanding loans, of which 81.5% are related to Japanese companies overseas. The overseas loan exposure is evenly spread out globally. However, Asia remains an area of growth for infrastructure projects. Currently, JBIC is trying to participate at the planning stages of major infrastructure projects in emerging markets. In India, JBIC has established an industrial development corridor company with the government of India where JBIC will play the role of an advisor and will be assisting in the blue-print plans of India. This will help to align these projects with potential Japanese companies wanting to participate in these mega projects.

How does this relate to Malaysian corporations? AEON Japan is looking to grow in Malaysia via the financial services segment or via AEON Credit Service (M) as its retail and shopping business in Malaysia has hit a saturation point. Japan Tobacco also explained to us their rationale of the privatisation of JTI Malaysia; certain listing requirements were no longer required and thus, allowing a foreign party such as Japan Tobacco, to wholly own its subsidiary in Malaysia. For Auto players like Honda, they will be delving into more fuel-efficient cars such as the recent HR-V while local production base will have to be more cost efficient as there is a mandate to revisit all suppliers’ costing structures to achieve more competitive pricing. From our conversations with JBIC, Tokyo Gas and TEPCO, it appears that the relationship with Malaysia remains strong, but it appears that growth opportunities will be limited from here-on for the likes of PETGAS and MISC as these organizations are looking to diversify Japan’s overall source of LNG to smoothen out tariff fluctuations in the longer-run. Weak steel prices are likely to persist as the oversupply issues in China is unlikely to dissipate quickly albeit the recent actions by the China government, according to Nippon Steel; we believe our local steel industry players (MASTEEL, ANNJOO) will continue to see persistent weakness in steel prices as well. In terms of market dynamics, the Japan Stock Exchange (JSE)’s average daily trading volumes are at JPY3.1t while foreign shareholding is high at c. 30% compared to BURSA’s RM2.0b and 23%, respectively. Amidst the volatility that most of Asia is going through, mainly sparked by the recent devaluation of China’s RMB and the low commodity prices’ cycle, we can understand why investors are willing to take a bet on Japan. It offers more stability and many of its corporations are set to be net USD beneficiaries as most of the companies we visited are heavily reliant on overseas projects. Additionally, with the new CGC in place, foreign investors can look forward to better shareholders’ returns. However, investors should note that the Nikkei 225 has hit historical highs (18-year and 6 months high on 24-June) after its long-slump and the market appears to be overheating. Currently, we are seeing Japanese shares entering into a consolidation phase post the rally.

Investors will have to be very selective as much of the positives have been priced-in or they should take longer-term views on those with long-term CAPEX expansion plans.

Source: Kenanga Research - 2 Sep 2015