Authored by: Anushree Gupta and Laura Kunkemueller
Much has been made of Japan's lost 20 years and the current ongoing efforts of Prime Minister Abe to reform the economy. To assess possible impacts, we compared the profitability, as measured by return on equity (ROE), and dividend culture, using dividend payout ratios, across Japanese sectors to those in the U.S. and Europe. We noticed a distinct gap. We believe the advent of governance and tax reforms, which in turn will impact labor practices, will narrow this gap for the Industrials sector.
Historically poor corporate governance has prompted the Japanese government to push reform. Recent creation of stewardship and corporate governance codes should result in improved financial transparency, increasingly independent boards and better shareholder access, thereby bringing Japanese corporate governance closer to that practiced in the U.S. and European Union. We expect this improved oversight of corporate assets to drive better medium- and long-term returns.
The Japanese government implemented a tax reform package in April 2018 that reduces the corporate tax rate by up to 15% over the next three years from the current average rate of over 30%. The tax reforms reward companies that increase wages at least 3% and invest in domestic innovative technologies such as Internet of Things (IoT) and Artificial Intelligence (AI)-both necessary changes in industries where labor shortages have posed problems.
Over the past 10 years, Japanese Industrials have generated particularly low average ROE ratios of 7% to 8% compared with the average in the U.S. and Europe, which range from 16% to 17% and 14% to 18%, respectively. Similarly, dividend payout ratios for Japanese Industrials are also lower than their U.S. and European counterparts. Over the past 20 years, Japanese companies' ROE ratios have lagged peers by 9 and 17 percentage points on average. While the lag has tightened over the past four years, there is still a 10 percentage point disparity.
Exhibit 1: Japanese Industrials Positioned for Improvement
Source: MSCI World Index. As of December 2017.
To understand this further, we analyzed the components of ROE (profit margin, asset turnover and financial leverage) and how these metrics compared across regions. Most notably, the profit margin for Japanese Industrials was anywhere from 4 to 7 percentage points below that of companies in the U.S. and Europe (Exhibit 2). In fact, Japan was the only region where companies had negative profit margins during the last 20 years. However, there has been steady improvement in profit margins and ROE over the past five years. This trajectory of profit margin growth is especially important for Japanese companies as there tends to be a high correlation between profit margin and ROE (Exhibit 2).
Labor market dynamics in Japan have contributed to these secularly low profit margins. Historically, labor mobility was almost nonexistent as employees typically worked at the same firm their entire careers and were promoted as a function of tenure rather than skill. Labor arbitrage was limited, and people rarely sought out alternate positions that may have been better suited for their talents and experience. However, as the skilled labor shortage in Japan accelerates, we expect this mentality will change.
Exhibit 2: Profit Margin
Source: MSCI World Index. As of December 2017 (Historical Profit Margin for Industrials Companies). Bloomberg. As of December 2017. BNY Mellon AMNA calculations (Correlation of Profit Margin and ROE).
Japanese Industrials with the highest profit margins are in factory automation equipment and measurement instruments manufacturing. IoT and automation has become increasingly prevalent among these higher-margin, higher-growth companies, compensating for a shortage of human labor. Their robust performance is not surprising, but it is useful to identify the underlying factors that could contribute to overall returns and stock momentum. Sub-industry groups within Japanese Industrials show an interesting variance in ROE and its components (Exhibit 3). Factory automation and measurement instrument manufacturing companies have larger profit margins, but this has not yet translated into the strongest ROE, possibly because these industries have lower asset turnover and financial leverage than the sector averages.
Exhibit 3: Selected ROE and Components by Sub-Industry within the Tokyo Stock Exchange (TPX)
Source: Bloomberg. As of October 2017.
We see anecdotal evidence of the importance of driving ROE change to improve shareholder returns. For example, one electronics conglomerate began eliminating unprofitable businesses and improved operating margins in the remaining businesses through the stewardship of a new CEO in 2013. The company was able to generate better cash flows through profit growth, asset disposals and lower inventory. The cash was used to reduce debt, improve ROE and increase its payout ratio. Its ROE has consistently exceeded 10% since 2013, with a dividend payout at the upper range of its 30% to 40% target. These initiatives have led the firm to outperform the Tokyo Stock Exchange (TPX) Index by 6.7 percentage points on an annualized basis since March 2013, which demonstrates not only the direct impact that improving ROE can have on returns but also that these changes take time to be appreciated by investors.
In our view, Industrials' valuations are depressed and exhibit the potential for upward pressure on ROE. We believe the government's recent reforms will serve a catalyst to improve profitability and payout ratios for the Japanese Industrials sector, leading to a rerating of these companies over time.