JAPAN: A POSITIVE OUTLOOK TAKES HOLD

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1 TAKES HOLD OCTOBER 2017 Daisuke Nomoto, CMA (SAAJ) Head of Japanese Equities, Senior Portfolio Manager Japan s economy and corporate earnings continue to show consistent growth: GDP has seen a steady expansion for six consecutive quarters; inflation has not reached the 2% Bank of Japan (BOJ) target, but has stayed above zero for most of the past four years; corporate earnings for April/June quarter grew roughly 20% year over year driven by improved profits and decent topline growth. THE VIEW FROM THE STREET We recently spent two weeks in Japan for a research trip, not only in Tokyo but also in rural cities. Our on-the-ground research and discussions suggest that economic confidence is not yet overheated, but remains fairly strong, even after taking into consideration the geopolitical uncertainty of the region. We met roughly 50 companies during the trip, and management teams sounded upbeat with many sharing the same optimistic business outlook. We were pleasantly surprised by the number of young Japanese dining out and socializing late at night in the Tokyo neighborhood of Omotesando (similar to SoHo in New York City), which we took as confirmation of wage increases for the younger generation. Multiple times we had extended waits in restaurants, an indication of a labor supply shortage and a job seekers market (see exhibit 1: Jobs-toapplicant ratio). Exhibit 1: Jobs to applicant ratio There are 1.5 jobs available for one job seeker Sources: Bloomberg; Ministry of Health, Labor and Welfare, Japan For Institutional Use Only. 1

2 Statistics from the Japan National Tourist Organization show there were large numbers of foreign visitors to Japan (see exhibit 2: Japan Foreign Visitor Arrivals), and capacity utilization on the Shinkansen superexpress trains is nearly full, which suggests strong economic activity. The number of foreign visitors to Japan has risen to 24 million in 2016 from 8.4 million in 2013 thanks to deregulation easing the visa requirements for foreign travelers. The government further expects the number of visitors to increase to 40 million in 2020 and 60 million in Approximately $2,000 is spent per traveler during the trip, which has averaged out to as much as $10 billion incremental consumption per year an offsetting factor to population decline. Scenes in regional cities were somewhat less vigorous compared to Tokyo, but it is our sense that over time there may be a population shift from overcrowded Tokyo to larger regional cities. This will be driven, we believe, by the increasing number of companies starting to consider tele-working. This work-fromhome employment pattern has not been largely accepted in Japanese society for cultural reasons. However, demographics may necessitate this shift, which would enable employees to balance work, care for elderly parents, and provide flexible schedules for women returning to the workforce. Exhibit 2: Japan foreign visitors arrivals 3,000,000 Targeting 40mn in ,500,000 2,000,000 1,500,000 1,000, ,000 0 Jan-03 May-05 Sep-07 Jan-10 May-12 Sep-14 Jan-17 Sources: Bloomberg; Japan National Tourism Organization For Institutional Use Only. 2

3 CORPORATE GOVERNANCE REFORM Topics of discussion with Japanese corporate management have shifted materially over the last decade towards long-term corporate strategy, principal-agency relationships, etc. This positive development has derived from the implementation of corporate governance reform which was introduced two years ago and has gradually but surely helped increase the return on equity (ROE) for Japanese companies. We believe that better corporate governance will continue to help unleash the value that has been hidden within Japanese equities. Two of the major objectives of the changes to corporate governance incentives are: 1) to eliminate conflicts of interest that exist between managements and shareholders, and 2) to ensure that a company s assets are used effectively in the best interests of stakeholders. There is a positive correlation between the level of improved corporate governance and ROE in Japanese companies. As you can see below (see exhibit 3: Return on equity), the average ROE of Japanese companies was substantially lower than in the U.S. and Europe, but the gap has been narrowing noticeably. Exhibit 3: Return on Equity 15% 12% 9% 6% 3% 0% Japan (Topix 500) Europe (Bloomberg Europe 500) U.S. (S&P 500) /30/2017 Source: Bloomberg Japan s Financial Services Agency proposed a Stewardship Code and suggested Japanese asset managers disclose the results of proxy voting. This Stewardship Code is based on a similar concept introduced in the UK in 2010, but Japan s code endeavors to promote sustainable growth in the corporate sector in addition to achieving fair investment returns for clients and beneficiaries. We are witnessing Japanese companies significantly raising dividends and initiating share buybacks as shown below (see exhibit 4: Dividends and Share Repurchases). With total cash sitting on corporate Japan s balance sheet amounting to a record high level of more than 250 trillion ($2.3 trillion) 1, it is likely that Japanese companies will continue to raise dividends, increase mergers and acquisitions (M&A), and complete further share repurchases to mitigate the drag of excessive cash balances on ROE. 1 as of 06/30/2017; Bank Of Japan flow of funds data For Institutional Use Only. 3

4 Exhibit 4: Dividend and share repurchases ( \tn) Dividends Share Buybacks Source: Nomura; based on company disclosures and Toyo Keizai data Returning excess cash to shareholders or putting cash to work for investments is a reasonable management decision since cash balances earn at zero, or sometimes a negative return, after inflation. We believe that investors will reward companies that generate sustainable free cash flow, earn returns significantly above their cost of capital and regularly conduct shareholder-friendly capital management such as increasing dividends, buying back shares, and pursuing accretive M&As. Additionally, Japan s Government Pension Investment Fund (GPIF), the world largest public pension fund with assets under management of approximately $1.3 trillion, has been starting to focus on ESG-oriented investments. Given the size of the fund and its influence in the investment community, GPIF s stance towards ESG will force Japanese companies to be increasingly aware of improving corporate governance as well as their social/environment behaviors. Corporate governance reform is not a single-year event, but an irreversible structural move, which should continue to be welcomed by equity investors. For Institutional Use Only. 4

5 IMPROVING PRODUCTIVITY LABOR MARKET REFORM Productivity is a far more critical concept for the Japanese economy and its corporate sector than simply high growth. Prime Minister Abe drove labor reforms forward with a goal of encouraging women and retired workers to return to work, increasing the rate of labor force participation. The government s various efforts are starting to bear fruit some 1.5 million Japanese women have been added to the workforce over the last four years and, as shown in exhibit 5, the female labor participation rate (15-64) has risen to 68% up 8 percentage point in the last fifteen years, having caught up with the U.S. according to OECD data. Also, the total number of employed has increased more than 2.4 million over the last four years. Exhibit 5: OECD female labor force participation rate (ages 15-64) % Japan Labor force participation rate U.S. Labor force participation rate Source: OECD Deregulation of Japan s two-layered labor structure is underway i.e. fulltime workers with guaranteed employment versus lower-income non-full time workers (approximately 40% of the total workforce) with less job protection with the goal of increasing salaries and providing better career opportunities for nonfulltime workers. As part of Abe s structural reforms, the government introduced the concept of equal pay for equal work called Hatarakikata-Kaikaku with an aim to improve labor productivity. It is still premature to quantify the level of productivity growth derived from Hatarakikata Kaikaku, but according to McKinsey s report titled The Future of Japan: Reigniting Productivity and Growth, if Japan succeeds in doubling its rate of productivity, it could boost GDP growth to about 3 percent and increase GDP by up to 30 percent by Note that the Japanese government s goal is to increase GDP to 600 trillion (currently 546 trillion), or to $5.5 trillion, by 2020 (source: Japan Revitalization Strategy 2016) For Institutional Use Only. 5

6 CAN COMPANIES MAINTAIN THEIR COMPETITIVENESS? A belief among some is that Japanese companies are simply not competitive. This argument stems primarily from two assumptions: 1) that Japanese companies are not producing value-added products/services; and 2) that Japanese companies are not pricing products/services appropriately (i.e. selling value-add at significant discounts). With regard to the first point, there are multiple ways to assess the level of competitiveness of companies and industries. The Atlas of Economic Complexity 2, and their Economic Complexity Index, measures the extent of critical knowledge incorporated in an economy, implying the relative uniqueness of the products that are marketed to overseas trading partners (see exhibit 6: Atlas of Economic Complexity Ranking). Japan has been rated as the world s most complex economy every single year since the start of this data collection in 1995, which suggests that Japanese companies have continued to bring value-added products to market. Exhibit 6: Atlas of Economic Complexity Ranking (1 = the most complex) Japan U.S. China Korea Germany Source: "The Atlas of Economic Complexity," Center for International Development at Harvard University, On pricing, we think there is huge room for improvement. The irrational behavior of excessive price discounts among Japanese companies was to some extent exacerbated by deflation, which plagued Japan for more than a decade, and also by excessively competitive market dynamics (too many competitors in the same industry). Although inflation has not reached the level targeted by BOJ yet (2%), at least we can say that Japan was able to defeat deflation. Also, data compiled by Nomura shows increasing M&A activity from 2010 through 2016 industry consolidation has been taking place gradually but surely (see exhibit 7: Japan Historical number of M&A transactions). Demographics come into play here as well. Given the aging society, an increasing number of small business owners are starting to think about retirement. Japan s small/medium enterprises account for about 99% of its total number of companies, employ 70% of the workforce, and has seen the average age of their presidents climb each year. These businesses will continue to come up for sale, fueling industry consolidation, and eventually increasing pricing power. 2 R. Hausmann, C.A. Hidalgo, S. Bustos, M. Coscia, S. Chung, J. Jimenez, A. Simoes, M. Yildirim. The Atlas of Economic Complexity. Puritan Press. Cambridge MA. (2011) For Institutional Use Only. 6

7 Exhibit 7: Japan Historical number of M&A transactions 900 Number of Q Q Q Q Q Q Q2 Inbound Outbound Domestic Source: Nomura; based on Bloomberg data. Inbound = Foreign company merges/acquires with Japanese company; Outbound = Japanese company merges/acquires non-japanese company; domestic = two Japanese companies involved. It can be said that Japan s elevated economic complexity over decades has been supported by high levels of patents and R&D (see exhibits 8, 9). We believe that through its continued investments in future technologies, Japan should be able to maintain its leading technological edge across such industries as robotics, automation, games, specialty materials, and precision equipment. Exhibit 8: World share of triadic patent families registered w/ U.S., E.U. & Japan Others 8% European Union 26% Japan 30% United States 27% China 3% Korea 6% Source: OECD; 2014 For Institutional Use Only. 7

8 Exhibit 9: R&D Spending as a % of GDP 3.5% 3.0% 2.5% 2.0% 1.5% Japan U.S. Europe World Average Source: OECD We are witnessing many technologies and inventions emerging in Japan supported by its researchoriented corporate culture. There are multiple ways for Japanese companies to enhance their competitive advantage and increase operating productivity. McKinsey s Future of Japan report claims that simply by adopting global best practices, deploying next-generation technologies, and organizing for discipline and performance, Japanese companies can achieve at least 50% of their productivity goal by applying practices that are already in use elsewhere around the world. CAPITALIZING ON OPPORTUNITIES IN JAPAN We believe there are various opportunities in the Japanese equity market that favor an active approach that allows concentrated investments in high-conviction areas. While it is encouraging that further improvement in ROE for Japanese companies as a whole is expected, we believe that identifying businesses with a high probability of expected outperformance is far more important. We believe companies that benefit from the structural tailwind provided by automation, robotics, data storage, advanced new materials, and outsourcing, should outperform irrespective of any near-term changes in the macro/political environment. For Institutional Use Only. 8

9 This document and the information contained herein is for informational purposes only and should not be considered a solicitation or offer of any investment product or service to any person in any jurisdiction where such solicitation or offer would be unlawful. The views expressed are as of the date given, may change as market or other conditions change and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, may not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not take into consideration individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon and risk tolerance. Asset classes described may not be suitable for all investors. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that any forecasts are accurate. Information provided by third parties is deemed to be reliable but may be derived using methodologies or techniques that are proprietary or specific to the third-party source. columbiathreadneedle.com Columbia Threadneedle Investments (Columbia Threadneedle) is the global brand name of the Columbia and Threadneedle group of companies. Columbia Management Investment Advisers, LLC is an investment adviser registered with the U.S. Securities and Exchange Commission Columbia Management Investment Advisers, LLC. All rights reserved exp. 9/30/18 For Institutional Use Only. 9