February 23rd 2011 Financial Times
“What most likely happened was pedal misapplication.” So concluded an official of the National Highway Traffic Safety Administration, the US body which has just published its report on the spate of accidents involving Toyota cars.
This time last year, remember, Toyota had to make an eight million vehicle recall. American politicians were in full cry. The families of accident victims gave emotional testimony at congressional hearings, and Toyota’s CEO flew to the US to apologize in person.
The media was quick to draw harsh parallels between the decline of Toyota and the decline of Japan.
Now it turns out that Toyota wasn’t declining at all. The problem was “the driver stepped on the gas rather than the brake or in addition to the brake.”
Has the global investment community been making a similar error about the decline of Japan? Underweighting Japan to fund an overweight position in emerging markets has been a popular strategy for several years. The last time you were hurt by not owning Japan was in 2005, which is a lifetime ago in the fickle mind of Mr. Market.
Over the longer haul, Japan’s twenty year bear market has extinguished investor confidence and created a number of damaging myths that can be used to justify a pessimistic stance. On closer examination, though, Japan is not as uniquely hopeless as its reputation suggests.
The first myth is that Japanese companies have no growth potential. In fact since the peak of the IT boom in 1999-2000 Topix has managed EPS growth of 200% – much better than most other developed markets and only narrowly beaten by the Shanghai Composite. Japan’s nominal GDP has indeed been stagnant, but the profits of listed Japanese companies are increasingly driven by global conditions.
Second myth – Japan has a huge demographic problem that will ultimately blow up the bond market. The reality is Japan has already been greying rapidly for the past twenty years, a period in which bond yields, far from rising, have fallen to the lowest levels in recorded history. True, the household savings ratio has plunged, but the savings in the corporate sector have risen dramatically as companies invest less. So the economy as a whole still churns out a savings surplus. There is no reason for this to change.
By contrast Europe and China are at a much earlier stage of their demographic crunch, and appear worse equipped to handle it. In Japan the labour force participation ratio of the over-65s is 20%. In most European countries it is below 4%.
Third myth – Japan has appalling corporate governance. There is indeed room for improvement, but the recent surge in MBOs and other corporate actions (such as the Nippon Steel-Sumitomo Metal merger) suggests change is in the air – though in the usual gradualistic Japanese way. In contrast, investors who have bought the emerging market story have to tolerate murky deals – such as the 40% of revenues that China’s top moutai maker reserves for communist party officials – as part of the economic landscape.
Last myth – the global credit crisis has accelerated the marginalization of Japan. Yes, in terms of local currency GDP, which is how economic performance is usually discussed, Japan was indeed a big loser. It took an 8% hit to output, the largest of any OECD country, of which it has subsequently recovered about half. However, look in common currency terms and the picture is very different. Since the sub-prime crisis kicked off, the yen has risen 33% against the dollar, 48% against the pound, and 35% against the euro. Compared to other developed countries, as opposed to the emerging world, Japan’s global presence has grown, not fallen. The yen is a safe haven, and profits in yen – earned by companies and investors – are more valuable than ever.
Given all this, why has Japan been such a poor performer for so long? The answer is simple. Japan was astonishingly overvalued at the peak of its 1980s bubble – more overvalued than the US market in 2000 or Shanghai in 2007. The de-bubbling process inflicted huge damage on the corporate sector, from which it was finally recovering when the sub-prime crisis hit.
Today Japan is no longer an expensive market; it is average or cheap, depending on which metric you use. Investors need to stop looking in the rear-view mirror and take good care to avoid pedal misapplication.