Why Japanese Equities Will Continue to Run

In December 2014, I detailed why the iShares MSCI Japan ETF (NYSEMKT: EWJ), a proxy for participating in Japanese equities, was a timely purchase for investors. In the roughly three years since, although the stock endured a volatile period between mid-2015 and mid-2016, the fund's shares have posted a cumulative total return of roughly 33%. Twenty-three of those percentage points were notched year to date, a period in which the Nikkei 225 and TOPIX (Tokyo Stock Price index) averages have been among the best-performing major stock indices worldwide.

Let's review a few performance factors fueling the rise of Japanese stocks, and examine why their streak may continue for a few years yet.

A governmental jump start

In my initial overview of the Japanese market, I discussed three potential impacts from Abenomics, the broad set of measures instituted by Prime Minister Shinzo Abe's government to pull the world's third-largest economy out of its low-growth, deflationary conditions:

• A then-new mandate compelled Japan's "Government Pension Investment Fund," or GPIF, to allocate half of its holdings in equities, split equally between the Japanese equity market and foreign stock markets; this buying program from the world's largest pension fund would provide support to domestic equity prices.
• A weak Japanese yen, supported by Abe's government's policy, would favor export-heavy ETFs like the iShares MSCI Japan fund.
• A sharper focus by Japanese companies on corporate governance and investor-friendly metrics like return on equity (ROE) would increase corporate profits.

In the intervening years, Abe's government has pumped money into the economy, and the consistent stimulus has kept the yen relatively weak, boosting the fortunes of large capitalization exporters like Toyota Motor Corp. (NYSE: TM), which not only influence the iShares MSCI Japan ETF, but also set the direction for the Japanese market in general.

The GPIF has indeed reallocated its holdings, and steady buying of Japanese equities has pushed domestic stocks to 24.4% of the total GPIF portfolio, essentially achieving the target goal of 25%. The GPIF's total value as of its last reporting period is 156.8 trillion yen, or a mammoth $1.4 trillion at current exchange rates.

If anything, government participation in Japan's stock market is rising. The Bank of Japan, which has separately purchased Japan-centric ETFs since 2010, almost doubled its yearly purchase amount last July, from 3.3 trillion yen to 6 trillion yen (nearly $54 billion).

By the way, so much central bank and public pension money flowing into public markets throws into relief the still relatively meager participation by retail investors, who own less than 20% of outstanding common Japanese shares. Japanese investors, especially those who witnessed the collapse of the asset bubble in the early 1990s, have been frequent sellers into periodic rallies like the current market climb.

Finally, it also appears that zeroing in on corporate behavior has benefited stock valuations. The Japanese government introduced a corporate governance code in 2015, and it hasn't been subtle in pressuring corporations to avoid stockpiling cash (an ingrained habit of Japanese management teams), to increase economic and shareholder returns, and to become more transparent in reporting. In its buying program, GPIF openly favors corporations which put cash to constructive use, and which demonstrate rising annual ROE.

Of course, many other important factors I didn't grasp or foresee also influenced the markets. For one, the rise of Asia-Pacific economies has expanded export opportunities for goods and services by "Japan, Inc.," which had historically leaned on Europe and the U.S. for growth abroad.

While the United States is still Japan's biggest export market, at 22% of total exports, the next 40% of Japan's annual exports are consumed by Asian economies: China at 19%, followed by South Korea, Hong Kong, Thailand, and Singapore (here's a nicely illustrative heat map). The cachet of the "Made in Japan" label, especially among Chinese consumers, is providing new growth opportunities for non-industrial manufacturers of a wide range of goods, from packaged foods to cosmetics.

Why Japanese equities will continue to run

While Japan's GDP (gross domestic product) growth is still quite modest, the country has recorded seven straight quarters of expansion as of the government's most recent report. In real, as opposed to nominal, terms, Japan's last five years have seen 1.2% annualized improvement in GDP:

National GDP is shaking out of its lethargy as long-held specializations of the Japanese economy find new demand in global trade. Robotics companies and components suppliers are prospering as the developed world increasingly turns to automation to reduce labor costs. Companies like Yaskawa Electric Corp. and Denso Corp. -- large-capitalization automation leaders on the Tokyo Stock Exchange, but hardly household names in the U.S. -- are poised to benefit greatly from current trends. According to the International Federation of Robotics, Japan dominates robot manufacturing, delivering 52% of the global supply of industrial robots.

Tightening labor conditions also support rising GDP. Japanese employment recently dropped to its lowest level in 22 years, in part due to rising labor-force participation among women and the elderly. Much has been made of Japan's demographic time bomb, which will have to be addressed with a more relaxed immigration policy and incentives for both highly skilled and low-skilled foreign workers to enter Japan's notoriously hermetic workforce and society.

Yet Abe's efforts to catalyze lagging female participation are already paying off, especially in the youngest cohort of workers. In the chart below, which tracks labor participation of girls and women between the ages of 15 and 24, note the slight but important trend reversal after 2012:

Despite gains, the Japanese market isn't overvalued

The Nikkei 225, the most broadly cited measure of Japanese stocks, has gained more than 140% over the last five years, and currently trades around 22,700. But as the index has bounced between 10,000 and 20,000 for most of this century, the latest upswing, though stronger than previous surges, doesn't indicate an overly expensive market.

Recently, German equity analysis firm StarCapital Research ranked Japan the 24th most attractive market out of 40 major global markets, based on an assortment of commonly used equity-valuation metrics. Incidentally, in 38th place, the U.S. won distinction as one of the least attractive markets at present.

Like the U.S., Japan has one of the highest cyclically adjusted price-to-earnings ratios (CAPE ratios) in the world. According to StarCapital, Japan's CAPE as of Sept. 30 stood at 27, versus the U.S. market's reading of 29. But Japanese companies traditionally have been extremely stingy dividend payers, and low aggregate payout ratios are often correlated with a higher CAPE result; a paper accompanying StarCapital's report makes this point, although not specifically in regard to the Japanese market.

For a more balanced view, it's important to note that Japanese firms trade on average at a price-to-earnings ratio (P/E) of 16.4, versus the average U.S. P/E of 22.4. And Japanese equities look much cheaper on a book-value basis, carrying an aggregate price-to-book ratio of 1.4, less than half the current U.S. price-to-book ratio of 3.1. Moreover, U.S. stocks have coasted to all-time highs since the Great Recession in an enduring bull market. In contrast, Japanese shares, slower to catch fire, still have room to play catch-up.

Below, a final chart to ponder, of the historical movement of the Nikkei 225 index:

I'm not sure how relevant the Nikkei's all-time high is today. The surge in the late 1980s was, after all, driven by one of the greatest asset bubbles of the 20th century. Yet, contextually, investors can glean from the above chart that a march toward at least the 30,000 level isn't out of the question.

The path to that next milestone won't necessarily be smooth, as risk factors remain. The low participation rate of Japanese retail investors remains worrisome. And the fact that the Japanese government is such a forceful driver of the stock market, as well as an increasingly significant equity owner, invites potential volatility once GPIF and the Bank of Japan begin to curtail their purchasing.

Yet I believe that enough true economic value is being created by Japanese corporations to offset effects of future diminishment in government buying programs. Given a closer corporate focus on shareholder returns, and the global demand for the outputs of Japan's advanced, high-tech economy, Japanese markets should provide domestic retail investors and foreign buyers alike with ample rewards for their patient capital.

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Asit Sharma has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.