Most of the media and investment community are ignoring an important development in the world’s second-largest stock market and developed economy, says John Vail, chief global strategist at Nikko Asset Management.
The impression has spread globally, fuelled by a few unfortunate examples, that Japan’s corporate governance is stagnant at poor levels, which is an absolute falsity. Although it will never likely achieve US levels and is far from perfect, its improvement has been very impressive and while never quite as fast as many investors would desire, improvements are occurring to this day, with every reason to expect further improvements.
As for the historical trend, Japan’s profit margins have increased sharply. The first revolution began in the early 2000s, when Japan embarked on major rationalisations in most industries, with the number of players usually reduced from seven down to three or four.
Later in the period between 2005 and 2007, Japanese companies with low profit margins were threatened by acquisition from private equity groups, which prompted most of these companies to realise that if they wanted to maintain control, they must increase profitability and payouts to shareholders.
Ripening fruit The fruits of these restructurings were slower to ripen than in Western-world examples, and they were hidden by a series of crises: the global financial crisis of 2008-09, the strong yen period of 2009-12, the 2011 severe Thai floods that halted a large amount of auto and electronics production, several periods of political turbulence with China that included boycotting many Japanese goods and, of course, the tsunami/nuclear crisis of 2011. But since Abenomics began, the global backdrop for Japan has been stable and there have been no domestic crises, thus allowing these fruits to ripen.
Despite rather low GDP growth, profitability and payouts have surged since prime minister Abe won the LDP party leadership in September 2012. The chart shows how much pre-tax profits have risen despite subdued GDP growth.
Meanwhile post-tax income has risen even more impressively due to Abenomics’ major corporate tax cuts.
Doubling dividendsDividends have risen rapidly too, more than doubling since 2013 for the Tokyo Stock Exchange Index, thus raising the payout ratio from 25% to 31%. Meanwhile, share buybacks, which have accelerated in the last five years, continue to rise sharply, with over 100% year-over-year growth in the first quarter and the major real estate development companies, long laggards in corporate governance improvement, finally agreed to start buybacks.
Crucially, to stabilise Japan’s future, an equity/dividend culture must be better established among retail investors in Japan. There have been gradual image improvements for equity investing since the speculative burst of the 1980s bubble but achieving a structurally higher dividend payout ratio would be a masterstroke, as most domestic retail investors do not accept buybacks as a primary reason to invest long-term in Japanese equities, whereas they adore dividend income, especially given prevailing flat or negative interest rates.
Clearly, much progress has been made regarding dividends in the past few years, but much more is needed on this front.
Payout ratioAs for the corporate view on such, even the most reluctant ones would now agree that their prior resistance to corporate governance reform was unwarranted and should realise that holding excess cash is equally unwarranted now and that Japan’s dividend payout ratio is rather low by mature country standards.
Unfortunately, many corporations prefer buybacks to dividends for exactly the wrong reason: dividends are sticky and hard to cut, whereas buybacks can drop to zero with minor embarrassment. But this argument implies that these Japanese companies have little confidence in their future, or that of the country. Indeed, in order to be effective, dividends must be guaranteed to be maintained at a high level even in a recession, barring grave financial threats to the company. This will protect the Nikkei from falling too far during troubled times and reduce fearful volatility in the long term. Such would crystalise the domestic equity culture that Japan has long tried to instil, just like most of the rest of the developed world, and would also entice foreign investors back into Japanese equities.
While great progress has been made on shareholder payouts already, the goal should be for the Nikkei 225 dividend payout ratio to nearly double from 30% to 50% over five years. The positive market reaction to this would be very swift indeed.
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