The Nikkei 225 Index has been mired in a bear market since its peak of nearly 40,000 in 1989. Today the index stands at barely 10,000, a peak to current decline of roughly 75%. What went wrong? First, the economy has spent two decades working off the excesses of their real estate bubble in the 1980’s. Policy mistakes by the Bank of Japan in the 1990’s, exacerbated a long and deep recession that has contributed to a deflationary environment. Couple this with an unfavorable demographic picture. The aging Japanese population has become a burden on the economy, and because the country does not allow immigration, it is difficult to replenish an aging work force. Lastly, Japanese companies have been criticized for not always operating in the interest of shareholders. Japanese companies have historically not been globally competitive on profitability measures such as return on equity, leading many international equity managers to ignore or underweight a country that now accounts for nearly 20% of their respective indices.
Positive Catalysts
With all these problems, why bother with the Japanese equity market? Potential positive catalysts may be on the horizon:
- In 2009 the Democratic Party of Japan (DPJ) won control of the lower house elections from the Liberal Democratic Party (LDP), who controlled the house for virtually 50 years. This DPJ victory created hope that some long needed government and private sector reforms to protect shareholder interests, among other items, would be addressed. Progress has been slow, but could still continue, creating a better environment for stock price appreciation.
- In 2009, many equity markets were buoyed as most central banks around the world aggressively printed money to increase domestic sources of liquidity. The Bank of Japan did not follow suit. Japan was the worst performing developed equity market in 2009, advancing only 6%, compared to 30+ percent gains for the rest of the index. The liquidity environment in Japan is however changing for the better, as the Bank of Japan has publicly stated they will no longer tolerate deflation. They followed up by providing liquidity to the system in December through JGB purchases. This is interesting in that at a time when other developed central banks are contemplating when to reign in liquidity, Japan may be supplying liquidity. This could set up a positive macro environment for Japan that could propel their equity market higher.
- Valuation is attractive, particularly the lower down the capitalization spectrum, where many companies sell below book value. Japan sports the lowest price to book (P/B) ratio among the developed international regions, with the Topix Index currently selling at a P/B ratio just above 1 times book value.
- Lastly, Japan has provided significant downside protection during recent equity market sell offs. Its downside capture ratio to the rest of the developed international world is just 80% over the past five years. During difficult market environments, Japan could again be a source of downside protection. After all, investors cannot sell what they don’t own.
Our view today is that with limited downside risk, there is a favorable risk/reward tradeoff relative to the rest of the world that is hard to ignore.
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