Macro Wrap – How Cheap is Japan?

by Enis May 16, 2013 8:00 am • Commentary

I have never traded a single share of Japanese stocks.  My knowledge in the stock market there is as an interested financial market observer, but with no illusions about my significant deficiency in assessing Japanese equity markets.

The cries of a new bull market in Japan have piqued my interest, though.  There was some prescient predictions last year about the potential for such a rally on a change in policy, as Bloomberg BusinessWeek wrote in July 2012:

Japan’s stagnating stock market, its aging populace and the slowing global recovery are masking record cash in company accounts and equity valuations that are close to a 20-year low.

The 1,671 companies in the Topix (TPX) Index, the country’s broadest measure of equity performance, had 105.2 trillion yen ($1.34 trillion), or 41 percent of their market value, according to the latest filings compiled by Bloomberg. Almost half have more cash than debt, a record. At the same time, the index’s 75 percent drop since 1989 pushed prices to 0.86 times book value, 4 percent from a two-decade low, data show.

For bulls, the combination makes Japanese shares irresistible as earnings rebound from last year’s earthquake and chief executive officers spend more on buybacks and dividends that have doubled since 2006. Bears say the country has been disappointing investors for the last 20 years and that rising cash shows managers are reluctant to invest as the yen appreciates and the recovery weakens.

“The price that a Japanese company sells for is significantly lower than the rest of the world,” said David Herro, the Chicago-based manager of the $8.5 billion Oakmark International Fund and Morningstar Inc.’s international fund manager of the decade. “What would really ignite the Japanese stock market is an acceleration of better capital allocation and a weakening in the yen. I think those are the only two factors preventing the Japanese from exploding on the upside.”

Well done, David Herro.  I, of course, remember reading that article, and filing it in the interesting bucket, only to forget about it until today.  Not so well done, Enis Taner.

The Japanese equity markets are up about 70% in the past 9 months, an incredible move for any country’s equity markets, but especially for the third largest economy in the world.  As a Johnny come lately to Japan, I wanted to get a quick sense for how valuations looked today, after that massive run.  I used the Topix index rather than the Nikkei, since the Topix is market cap weighted rather than price-weighted.

Here is the adjusted P/E over the past 7 years:

Adjusted P/E of Topix over last 7 years, Courtesy of Bloomberg
Adjusted P/E of Topix over last 7 years, Courtesy of Bloomberg

So it’s back near the higher end of the past 7 years, approaching 18, though the bulls would argue that the earnings picture is going to improve as the yen devaluation, as well as the knock-on effects on the economy from improved confidence, work their way through to corporate profits.  But certainly less appealing risk/reward here than in the low teens.

Valuation from a Price / Book perspective looks cheaper on a historical basis:

Price/Book of Topix over last 7 years, Courtesy of Bloomberg
Price/Book of Topix over last 7 years, Courtesy of Bloomberg

This has been the most bullish argument for more than a year now, as David Herro pointed out.  On this basis, valuations still look quite reasonable.

Japan as a long-term trade probably still has room to run, especially since valuations usually overshoot on the upside just as they do on the downside.  Something to consider as the Japanese fever continues to heat up.