Asia

The surprising boom in Japanese profits

Japan has been in a funk since 1990. Or so most people tend to think. But Japanese corporate profits have taken off in recent years, leaving the US and Europe for dust. Japanese stocks are reasonably priced and have a healthy yield these days. I recommended a Japanese investment back in August. It’s time for an update.

On 30th August 2016 I recommended investing in Japan (see here). That was after a long period when I was sceptical about Japanese stocks. But I reckoned conditions had changed, so it was time for a shift of stance.

The specific recommendation was the WisdomTree Japan Hedged Equity Fund (NYSE:DXJ). At the time it had a price of $42.73 (US dollars).

As I write it’s priced at $51.69, which is up 21% in under seven months. It’s also paid 55 cents of dividends, which adds another 1.3%. So the total profit is over 22% so far.

That’s a great result in a relatively short time. It’s certainly well ahead of the S&P 500 index of US stocks, which is up 9% over the same period, even including the “Trump bounce”.

I’ll get back to DXJ later, and what to do now. But first let’s take a step back and look at what’s been happening in Japan.

It’s well known that Japan has an ageing and shrinking population. It’s currently a little over 126 million, having peaked at 127.8 million in 2011. What’s more, immigration is virtually non-existent.

But, despite this demographic headwind, Japanese corporations have been doing a good job of growing their profits. Especially when compared with other developed markets such as the USA and Europe.

The surprising boom in Japanese profits

The following chart, from a report by Albert Edwards at the bank Societe Generale, compares earnings-per-share (EPS) since 2002 for stocks from Japan, the US and the eurozone. Figures are indexed for easy comparison, all starting at 100.

Japan Stock Market Boom

It’s perhaps no surprise that the eurozone has been stagnant, apart from the immediate post-crisis bounce from 2009 to 2011. But even US growth has been tepid in the past few years. This leaves Japanese profit growth ahead of the other two, albeit with ups and downs.

The picture is even more stark if we just focus on more recent years. This next chart looks at whole economy profits, which includes all companies, not just ones listed on the stock market. It’s a view of how the private economy is doing. The chart compares Japan with the US.

[Also these figures are less prone to being fiddled by corporate accountants, since they’re based on tax returns. Company managers are often happy to provide a rose tinted view of performance to investors. But few of them lie (much) in their tax returns.]

Japanese Economy Profits

This shows that US profits have basically flatlined since 2012. On the other hand Japanese profits are up by over half. This goes a long way to explaining why Japanese stocks are much better value today than they were a few years ago.

(It’s also extra evidence that pricey US stocks are in a bubble. S&P 500 EPS is up about 20% over the past five years, including the huge boost from massive stock buybacks. But the S&P 500 is up 70%. Why have US stock prices gone up so much given such poor profit performance? Obviously valuation multiples have increased, but it’s hard to find justification at the aggregate index level.)

The crucial point here is that Japanese profits have grown strongly in recent years. In the meantime US progress has been modest at best. While the eurozone is still languishing well below the 2007 profit peak, before the global financial crisis.

In other words – and I’m surprised to hear myself say this – of all the major developed markets, Japan is leading the pack in terms of profit growth. Japanese managers are clearly doing something right.

Now let’s get back to DXJ, my earlier recommendation. Importantly it’s an exchange traded fund (ETF) that’s currency hedged. In other words, if the Japanese yen falls against the US dollar then investors are protected. Alternatively, if the yen rises then investors will take a hit. The government and central bank have been trying to weaken the yen, so it makes sense to hedge it.

The following chart shows the exchange rate between the US dollar and Japanese yen. Since it shows how many yen can be bought with one dollar, a rising line means the yen is weakening, and vice versa.

USD JPY exchange rate, past year

USD JPY exchange rate, 2017

Clearly the yen weakened between August and February, so the hedge paid off. Since then it’s been fairly stable against the dollar, even strengthening slightly.

At the same time Japanese stock prices have risen in yen terms. For example the Nikkei 225 index is up 16.7% since my recommendation, as shown in this next chart.

Nikkei 225, past year

Nikkei 225, 2017

Now let’s put it all together. The following chart compares DXJ (in blue) with the iShares MSCI Japan ETF (NYSE:EWJ) since the recommendation date. EWJ (in red) tracks a slightly different index to DXJ, but the main difference is that it isn’t currency hedged. I’ve also included the SPDR S&P 500 ETF (NYSE:SPY) for comparison (in yellow).

The following chart compares DXJ (in blue) with the iShares MSCI Japan ETF (NYSE:EWJ) since the recommendation date. EWJ (in red) tracks a slightly different index to DXJ, but the main difference is that it isn’t currency hedged. I’ve also included the SPDR S&P 500 ETF (NYSE:SPY) for comparison (in yellow).

Clearly the combination of the rising Japanese stock market and the currency hedge – in the face of a falling yen – have worked well so far. But where does it leave us now?

The price-to-earnings rates (P/E) of DXJ’s underlying stock index, based on last year’s earnings, is 15.7. That’s pretty undemanding given the strong profit growth. (Whereas the bubbly S&P 500 has nearly reached 27 according to multpl.com).

Then there’s a gross dividend yield, which is 2.4% (less ETF fees of 0.48%). On top of that there’s a net buyback yield of 0.9%, taking total cash yield up to 3.3%. (Net buyback yield is the amount of stock bought and cancelled by companies net of new stock issued into the market.)

Also the price-to-sales (P/S) ratio is a relatively modest 0.8. As a general rule of thumb, if P/S is below one then it’s a sign of good value. (The S&P 500 P/S is 2.1.)

Overall the valuation remains undemanding, so if you own DXJ I think you should hold on. But, as with the original recommendation, I recommend you set a tight stop loss 10% below the current price. That would mean instructing your broker to automatically sell if it falls below $46.52.

Usually I don’t go in for stop losses. But because of the currency hedge element I’d recommend it here.

Even though Japanese authorities look keen on having a weak yen, short term forecasting of currency rates is tough. Policies can change overnight, markets can surprise, and currencies are unpredictable beasts at the best of times.

If the yen strengthens Japanese stock prices could fall as exporters become less competitive in global markets. At the same time the currency hedge against a weakening yen would work in reverse, against dollar investors. So there would be a double whammy. Hence the need for a stop loss in this case.

Japanese profits have been on a strong growth trajectory in recent years. Along with undemanding valuations in the market this leaves Japanese stocks as an attractive investment. But, as explained, I recommend you hedge the currency risk. This can be done via an ETF such as DXJ, and with a stop loss in place.

Stay tuned OfWealthers,

Rob Marstrand

robmarstrand@ofwealth.com


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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.