As we are witnessing in the current earnings season, news from Japan is turning increasingly positive. In fact Japanese corporate profit margins have recently surged to historical highs and are now nearly double their levels from 10 years ago, long before Abenomics began.
During Japan's 1980s bubble, recurring pretax profit margins hit 3.7% before falling back to average 2.7% in the following 'lost decade' of the 1990s and early 2000s. However, in the latter part of this lost decade, corporate Japan undertook a huge amount of M&A and restructuring across many industries, both manufacturing and non-manufacturing, rationalizing what used to be upwards of ten players in each industry down to a few stronger and more profitable leaders. Those skeptical that Japan has undertaken significant restructuring would do well to remember that such corporate stalwarts as Nippon Steel and Sumitomo Metal Industries are now one company, while the three biggest banks, Mitsubishi UFJ, Sumitomo Mitsui and Mizuho, are the product of mergers among nearly a dozen institutions.
Given Japan's considerate nature for its employees and, of course, some internal politics as well, these rationalizations were rather slow, but their benefits did eventually materialize. An additional catalyst appeared in 2004-'05, when a number of Japanese companies came under attack by activist investors for low profitability and shareholder returns. These attacks were not just by foreigners, with the most high profile attack, on the television company, TBS, by local activist. Fearing such attacks, a new emphasis was placed upon improving shareholder returns, and this, coupled with the restructurings and the improving global economic recovery, pushed recurring pretax profit margins to a historic high of 4.0%, while dividends rose nearly 250% in the four years through 2007.
This progress was dashed by the global financial crisis and a series of external and internal economic crises, including the Tohoku earthquake and tsunami of 2011, which suppressed Japanese corporate profits through 2012. In late 2012, Prime Minister Shinzo Abe was elected and his first major act was to nominate Haruhiko Kuroda, an aggressive inflation targeter, as the new governor of the Bank of Japan. The strong yen, which had hindered economic growth and corporate profitability, began to normalize and this, coupled with a global economic recovery, led corporate profit margins to expand to 4.8% by early 2014.
Continuing “relatively normal” global economic conditions have allowed these profit margins to rise to 5% in recent quarters. An important fact to note is that the non-manufacturing sector's profitability is rising just as fast as the manufacturing sector, showing that this improvement is more about restructuring and the concentration on profitability, rather than just the normalization of the yen.
Interestingly, this 10-year improvement in corporate profitability has occurred despite a declining working population (similar to Germany's experience), thus debunking the theory held in some quarters that demographics have an important relationship with corporate profits or equity price movements.
Japan skeptics should also note that this increase in profitability is structural in nature, 10 years in the making, and has now become a source of corporate pride. Indeed, CEOs now see inclusion in the JPX-Nikkei 400 index, launched in 2014 and based on return on equity measurements, as a badge of honor in corporate Japan.
Once Japan decides to move in one direction, with the clear support of the voting public, the course is rarely changed and, in fact, usually accelerates. Mr. Abe and Mr. Kuroda have zero intention of reversing course, nor do Japanese corporations with their new focus on profitability. As for shareholder returns, over a year ago I predicted that the “market dividend” would approximately double in the five years to 2018, taking the dividend payout ratio to 37%, equaling that of U.S. equities. If anything, this goal now seems conservative.
Japanese investors have been showered with these profits, leading to a new equity culture and improved wealth effects. However, until 2015, global investors could ignore Japan because declines in the yen offset much of the gains in equity prices, at least relative to other major global markets. But this year, skeptics cannot ignore the true, long-term corporate reformation that is coming into full bloom without any help from further yen declines.
Looking forward, there will be support from more reforms — a key reform to watch is the Trans-Pacific Partnership, which is moving close to a conclusion. This will force a long overdue shakeup and reform of the agricultural sector and other service industries. Quite a few investors are not assuming TPP will come to fruition, and yet it is considered the most powerful potential “third arrow” of Abenomics, so its success should be a positive surprise to the equity market.
In sum, although Japan will never likely reach for completely Western-style profitability or shareholder culture, the quiet reformation to date has surprised many skeptics and will very likely continue to provide more positive surprises in the future.
John Vail is chief global strategist at Nikko Asset Management.
