Japan Equity Strategy Brexit: Clear as Mud

Transcription

1 STRATEGY NOTE Equity Strategy Equity Strategy Brexit: Clear as Mud Key Takeaway The Brexit Leave vote was a surprise. The complete lack of leadership in the aftermath was a shock. Uncertainty surrounds the process going forward, resulting in global risk-off. This is exactly what the BOJ didn't need. Pressure on the Yen to appreciate will create problems for the BOJ for the next couple of years and force more aggressive monetary easing. We look at sector selection in this environment and have some non-consensus recommendations. In the best of circumstances, Brexit would take two years to sort out. With a complete lack of leadership, it will be a bumpy ride, along an unknown path, on a runaway horse. Who knows how long it will take and where this journey will end. What we can be certain about is that intermittent periods of risk-off should be expected, putting regular pressure on the Yen to appreciate. This is on top of the 3% structural current account surplus that enjoys as a result of its 1.5 trillion primary income balance. EQUITY STRATEGY JAPAN The strong Yen's impact on inflation: We had written in our "Beware the Bazooka" report on 25th April that headline deflation was only due to the sharp fall in energy prices. Assuming $50/barrel oil price and 100/$ FX rate going forward, we estimate that energy prices would no longer be deflationary from the end of All else being equal, this would result in headline inflation of 1% at the time of next year's Shunto wage negotiations. Assuming a 1 percentage point decrease in food, clothing and furniture price inflation as a result of the strong Yen, we estimate that headline inflation would fall to 0.6%. This is far below what would be needed to get the desired 3% wage increase at next year's Shunto. Another Bazooka: We do not expect the BOJ to act suddenly, especially if the Yen does not appreciate strongly beyond 100/$. However the BOJ does need to provide some significant stimulus if it wants to have any chance of a more successful Shunto wage hike next spring. Otherwise, another year will be wasted without making progress towards its 2% inflation target. The government will probably help with a 10 trillion fiscal stimulus in the autumn. With 15 year JGB yields now negative and 40 year yields at 15bp, the conditions may be aligning for the potential issuance of perpetual zero coupon bonds. Sector Selection: The ese market fell across the board on Friday when news of the Brexit Leave vote was announced. On Monday, the market was more discriminating with some sectors such as pulp & paper, land transport and pharmaceuticals rising over 5%, while others such as mining and securities fell by more than 3%. We review the Topix 33 sectors to identify risks and evaluate which sectors appear the most and least attractive. Attractive: air transport, banks, construction, glass, insurance (P&C), metal products, rubber products. Somewhat Attractive: machinery, non-ferrous metals, oil & coal, other products, transport equipment. Neutral: real estate, warehousing, wholesale trade. May not have bottomed: insurance (life), iron & steel, mining, pulp & paper, securities. High expectations could lead to disappointment: chemicals, electric appliances, finance, food, information & communication, pharmaceuticals, precision instruments, retail, service, textile. Highly indebted: electric power & gas, fishing/agriculture/forestry, land transport, marine transport. Zuhair Khan, CFA * Equity Analyst zuhair.khan@jefferies.com Sean Darby Chief Global Equity Strategist sdarby@jefferies.com Makarim Salman, FIA * Equity Analyst msalman@jefferies.com Takaki Nakanishi * Equity Analyst tnakanishi@jefferies.com Yoshihiro Azuma * Equity Analyst yazuma@jefferies.com Atul Goyal, CFA Equity Analyst agoyal@jefferies.com Masahiro Nakanomyo * Equity Analyst mnakanomyo@jefferies.com Thanh Ha Pham * Equity Analyst tpham@jefferies.com Hiroko Sato * Equity Analyst hsato@jefferies.com Chang Han Joo, CFA * Equity Analyst cjoo@jefferies.com Sho Fukuhara * Equity Analyst sfukuhara@jefferies.com Shinnosuke Takeuchi * Equity Associate stakeuchi@jefferies.com * Jefferies () Limited Jefferies Hong Kong Limited Jefferies Singapore Limited MCI (P) 084/07/2015 Jefferies does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that Jefferies may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Please see analyst certifications, important disclosure information, and information regarding the status of non-us analysts on pages 43 to 47 of this report.

2 YEN APPRECIATION... 2 BACK INTO DEFLATION?... 3 THE YIELD CURVE GOES MORE NEGATIVE... 7 RISK ASSET BAZOOKA IN JULY/SEPTEMBER?... 7 SECTOR SELECTION POST BREXIT... 8 Air Transport Sector Banks Sector Chemicals Sector Construction Sector Electric Power & Gas Sector Electrical Appliances Sector Finance Sector Fishing, Agriculture & Forestry Sector Food Sector Glass Sector Information & Communications Sector Insurance Sector Iron & Steel Sector Land Transport Sector Machinery Sector Marine Transport Sector Metal Products Sector Mining Sector Non-ferrous Metals Sector Oil & Coal Products Sector Other Products Sector Pulp & Paper Sector Pharmaceuticals Sector Precision Instruments Sector Real Estate Sector Retail Sector Rubber Products Sector Securities Sector Service Sector Textile Sector Transport Equipment Sector Warehousing Sector Wholesale Trade Sector Yen appreciation The Brexit Leave vote was a surprise. The complete lack of leadership in the aftermath was a shock. The process going forward, who will lead it and what they will try to achieve are all unclear. This type of uncertainty, leading to global risk-off, is exactly what the BOJ didn't need. The pressure on the Yen to appreciate will create problems for the BOJ for the next couple of years. Risk-off can cause Yen appreciation pressure for the next several years In the best of circumstances, Brexit would take two years to sort out. With a complete lack of leadership, it will be a bumpy ride along an unknown path, on a runaway horse. Who knows how long it will take and where this journey will lead to. What we can be certain about is that intermittent periods of risk-off should be expected, putting regular pressure on the Yen to appreciate. This is on top of the appreciation pressure created by s structural current account surplus. Structurally, unless has a large trade deficit, it will normally enjoy a large current account surplus because of a 1.5 trillion monthly surplus in its primary income balance. This is because is the world s largest net creditor nation, with over 250 trillion in net external assets. page 2 of 47

3 Chart 1: Current Account Components ( bn) 3,000 2,500 2,000 1,500 1, (500) (1,000) (1,500) (2,000) Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Primary Income Secondary Income Trade Services Current Acct As the chart below shows, this surplus is around 3% of GDP. All else being equal, the Yen should continue to appreciate, thereby exerting downward pressure on imported inflation and also wages. Chart 2: Current Account (% of GDP) vs. Exchange Rate Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec Current Account (% of GDP) / $ (RHS) Back into deflation? In the chart below it appears that is falling back into deflation, with the CPI index slipping rapidly from +0.3% in February to -0.3% in April. This is seen as a sign that the Bank of (BOJ) is running out of ammunition and that its Negative Interest Rate Policy (NIRP) is a failure. page 3 of 47

4 Chart 3: CPI (% YoY) falling back into deflation CPI (% YoY) Source: Ministry of Internal Affairs and Communications As we stated in our 25 th April report Beware the Bazooka, we believe that the BOJ had been successful in bringing the underlying inflation dynamics to the 1+% territory. However, since early last year this was being masked by falling energy prices as shown in Chart 4 below. Furthermore, a weak global economy had resulted in deflation/disinflation fears globally. Risk-off from the beginning of this year resulted in a strong Yen. All these factors led the BOJ to add a third dimension to its monetary easing, negative interest rates. Chart 4: Oil Price in (YoY % Change) Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Dec-14 Jun-15 Dec-15 Jun-16 Oil Price (% YoY), Jefferies Estimates In Chart 5, we compare the breakdown of CPI inflation in 2016 versus 2012, when headline inflation was also at zero. What can be seen is that other than utilities and transport, there was no decline in prices for other categories. For items such as food, clothing, recreation and education, price increases were approaching or exceeding 2%. Falling energy prices resulted in headline deflation The sharp decreases in utility and transportation costs are driven by falling energy costs. In fact, within transportation we only see cost declines for private transport (travel by car, -4% yoy) whereas public transport costs are unchanged. page 4 of 47

5 Chart 5: Inflation (%YoY) by sub-category. Headline inflation was the same in 2012 as it is in 2016, i.e. becoming slightly negative. However, other than falling utility and transportation costs due to the collapse in energy prices, inflation is alive and kicking in Food prices inflation moderated in April which also helped push the overall index into negative territory (2) Jan 2016 Feb 2016 Mar 2016 Apr (4) (6) (8) (10) Clothing Recreation Education Food Misc. Medical Furniture Housing Transportation Utilities Source: Ministry of Internal Affairs and Communications We therefore conclude that were it not for falling energy prices, the underlying inflation dynamics would be very clear for all to see. The other issue that is now coming in to play is the strong Yen. This is offsetting dollar energy price increases and could also result in weaker prices for other imported goods. The question then is, how do we see these dynamics playing out over the coming year? YoY change in energy prices should turn positive at the end of 2016 If we assume $50 per barrel for oil prices and that the Yen remains at 100/$, then Chart 6 below shows the YoY change in energy prices remains negative until almost the end of The YoY change in energy prices then spikes up briefly before returning to around zero by spring Chart 6: Oil Price in (YoY % Change). The period after June 2016 assumes the oil price remains $50 per barrel and the FX rate is 100/$ Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Dec-14 Jun-15 Dec-15 Jun-16 Dec-16 Jun-17 Oil Price (% YoY), Jefferies estimates In Table 1, we assume that the underlying inflation dynamics for all other categories remains at the average level seen during the first four months of 2016, and that energy price related deflation for transportation and utilities goes to zero by year end. We see that the total CPI would come to 1% YoY around early next year. page 5 of 47

6 Table 1: Forecast CPI inflation assuming transportation and utilities deflation goes away and all else remains the same. Weight YoY % Change Clothing 25.3% 2.2 Recreation 4.1% 2.0 Education 11.5% 1.6 Food 3.3% 2.1 Misc. 5.7% 0.8 Medical 3.5% 0.7 Furniture 4.3% 0.5 Housing 21.2% - Transportation 14.2% - Utilities 7.0% - Total 100.0% 1.0 Source: Ministry of Internal Affairs and Communications, Jefferies estimates 0.5% to 1% inflation expected in spring 2017 if we remain at 100/$ The BOJ probably did not want to encourage belief in the existence of a Kuroda Put This 1% CPI inflation estimate is probably an over estimate as we have not factored in the impact of the strong Yen on the price of goods such as clothing, food and furniture. If we look at the change in inflation on these goods between 2013 and 2015, i.e. when the Yen went from around 100/$ to 120/$, we find that inflation in these goods accelerated between 1 to 2 percentage points. This excludes the period where inflation was affected by the consumption tax hike. If we assume that the Yen returning back from 120/$ to 100/$ reduces inflation in each of these 3 categories by 1 percentage point, we estimate inflation would decline to 0.6% (see Table 2). Although this would fall well short of the BOJ s 2% inflation target, it would remain in positive territory. These estimates would indicate that the CPI index is likely to be in positive territory early next year. This may partly explain the BOJ s reluctance to provide more stimulus at the April monetary policy meetings. Another factor was probably its belief that the market must not get into the habit of assuming monetary stimulus from the central bank every time stock prices fall or there is a bit of market turmoil. Kuroda probably did not want to create a belief that a Kuroda Put existed. At the June monetary policy meeting it probably also wanted to keep some dry powder due to the global market risk from the Brexit vote which was one week later. Hence the BOJ took no action in June. Table 2: Forecast CPI inflation assuming transportation and utilities deflation goes away and the strong Yen reduces inflation by 1 percentage points for clothing, food and furniture. Weight YoY Change Clothing 25.3% 1.2 Recreation 4.1% 2.0 Education 11.5% 1.6 Food 3.3% 1.1 Misc. 5.7% 0.8 Medical 3.5% 0.7 Furniture 4.3% (0.5) Housing 21.2% - Transportation 14.2% - Utilities 7.0% - Total 100.0% 0.6 Source: Jefferies estimates Headline inflation during the spring Shunto negotiation is critical to getting meaningful wage increases for full-time employees Even if we assume that the ese economy does not suffer from a downturn due to Brexit, the problem that exists for the BOJ is that 1% inflation is not enough. This is for two reasons. The first and most obvious one is that it is well short of its 2% target and shows the BOJ as failing to achieve its goals. The second and more important reason is that most full time wages in are negotiated in the spring during the annual Shunto wage negotiations. What the BOJ realized this year was that the labour unions pay attention to the headline inflation numbers, not the BOJ s core-core metric that excludes food and page 6 of 47

7 energy prices. If headline CPI inflation is below 1% next spring, full-time wage increases are unlikely to be significant, and certainly not the 3% wage increases that the BOJ needs in order for inflation to move to a sustainable 2% level. If we believe the global economy slows down as a result of the uncertainty created by the Brexit Leave vote, then there is even more need and urgency for the BOJ to act. Central banks always have to appear calm and avoid looking like they are reacting in panic. That said, we believe the market turmoil after the Brexit Leave vote is sufficient excuse for the BOJ to claim it is acting due to global events rather than to a specific deterioration in the ese economy. It can claim to simply acting prudently in the face of global market uncertainty and potential negative impacts of a decline in global investment and trade. The yield curve goes more negative The Brexit Leave vote has pushed the ese yield curve even further into negative territory. The short end of the curve did not move much, but the medium to long end did. 15 year interest rates are now -5bp, while long-term yields for years halved from 30bp to 15bp. Might the BOJ be setting conditions for launching a perpetual zero coupon bond? This may be assisting the BOJ in setting up conditions for issuing perpetual zero coupon bonds in order to consolidate government debt. See Sean Darby s April 6 th report It's Time To Launch A Zero Coupon Perpetual JGB! This plan could be combined with large fiscal stimulus by the government, which given the already tight labour market, could help to boost wages and thus inflation up to the 2% target. Chart 7: Yield Curve : Negative out to 15 years M 6M 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 15Y 20Y 30Y 40Y 2013 Jan 2013 May 2014 Nov 2016 Jan 2016 Apr 2016 June Risk asset bazooka in July/September? As we have shown above, Abenomics and the BOJ have actually been quite successful in getting the economy to have a tight labour market and engineering the necessary underlying inflation dynamics. What has happened in 2016 is not the result of policy mistakes by the government or because NIRP was a mistake and backfired. Both the BOJ and the government understand that their hard won battle to achieve a tight labour market where wage increases are inevitable has suffered a big setback. The weak negotiating stance taken by labour unions during this year s spring Shunto in the face of a falling stock market and appreciating Yen means no significant full-time wage increases at page 7 of 47

8 least until next year. Monetary and fiscal policies now need to keep the labour market strong for another year. They also need to weaken the Yen despite the large current account surplus and the risk-off trade as a result of the Brexit Leave vote. The only way to achieve both of the above is for a combination of fiscal stimulus by the government and a bazooka by the BOJ. Brexit, the resultant turmoil in the global markets and a hiatus on many corporate investment plans may provide the government with an excuse for more fiscal stimulus. There are already statements from the government to that effect. NIRP has been unpopular 100/$ may be a key level The BOJ bazooka has to be a lot more than just more NIRP. In fact, NIRP is very unpopular and is seen as a failure. It has created more of a backlash from financial institutions than the BOJ probably expected and doing more of the same would likely see a negative reaction from the market. There already appears to be some backtracking by the BOJ in terms showing more concern about the profitability of the financial sector. We therefore believe that the probability is increasing that the BOJ will announce a significant increase in monetary easing, focused on risk asset purchases. We believe that this decision will depend partly on the trajectory of the Yen over the coming month. If the Yen strengthens sharply, the BOJ may act in July. If the Yen remains weaker than 100/$, the BOJ may postpone its actions until September to give it more time to observe developments in the UK and globally. Sector selection post Brexit When we look at the fall in the market on Friday, June 24 th, upon the Brexit Leave vote being announced, we find that there is relatively little differentiation across sectors. Indiscriminate selling The obvious, expected candidate sectors for the biggest falls were the interest rate and market sensitive insurance and securities sectors; as well as export sectors such as transport equipment (autos) and electrical appliances. The smallest falls were for domestic sectors such as retail, agriculture and construction. However, the largest fall of % for the insurance sector was not that much more than for the best performing retail sector that was down -5.2%. Taking out the worst 2 and best 2 sectors in terms of performance, we find a total spread of only 2.7% between the mining (-8.8%) and construction (-6.1%) sectors. We consider this to be a sign of general indiscriminate selling across the whole market. On Monday, the market started to discriminate more between the various sectors. Some sectors such as pulp & paper, land transport and pharmaceuticals rose over 5%, while others such as mining and securities fell by more than 3%. We review the Topix 33 sectors to identify risks and evaluate which sectors appear the most and least attractive. Performance in 2013 when the FX rate was 100/$ may help evaluate sectors today In evaluating each sector, we look back at earnings levels since 2013 when the FX rate was last at 100/$ for an extended period to provide some guidance on the potential impact on the different sectors. We have to keep in mind when doing this analysis that many other factors were very different at that time. For example, oil prices were over $100/barrel then compared to under $50/barrel currently. One of the purposes of this analysis is to identify and evaluate risk factors for each sector. This includes factors such as the revenue growth and operating margin expectations, the level of debt and free cash flow generation. We also look at valuation metrics such as PER, PBR and dividend yield in order to judge what may or may not be priced in. High expectations for some sectors may result in disappointment, while the bad news may be priced in for other sectors Our conclusion is that investors may be selecting sectors too simplistically. Although some of the domestic sectors may be best positioned to weather the strong Yen and global market turmoil, however, the expectations for those sectors may already be relatively too high and at risk of disappointing. On the flip side, some of the sectors that are likely to be page 8 of 47

9 negatively affected may already be pricing in all the bad news and hence may be relatively more attractive. We categorize the Topix 33 sectors into 6 categories as below: Attractive: air transport, banks, construction, glass, insurance (P&C), metal products, rubber products, Somewhat Attractive: machinery, non-ferrous metals, oil & coal, other products, transport equipment, Neutral: real estate, warehousing, wholesale trade, May not have bottomed: insurance (life), iron & steel, mining, pulp & paper, securities, High expectations could lead to disappointment: chemicals, electric appliances, finance, food, information & communication, pharmaceuticals, precision instruments, retail, service, textile, Highly indebted: electric power & gas, fishing/agriculture/forestry, land transport, marine transport. Table 3: The 1-Day Return shows across the board, indiscriminate selling on Friday, 24 th June Ticker Name Weight Volatility 120 Day Volatility 162 Week 1 Day Return 1 Month Return 3 Months Return 6 Months Return 1 Year Return TPX TOPIX TPINSU TOPIX INSURANCE TPSECR TOPIX SEC&CMDTY FUTR TPMINN TOPIX MINING TPFINC TOPIX OTHER FINC BUS TPTRAN TOPIX TRANSPORT EQUIP TPRUBB TOPIX RUBBER PRODUCTS TPELMH TOPIX ELECTRIC APPL TPGLAS TOPIX GLSS & CRMC PRD TPIRON TOPIX IRON & STEEL TPNBNK TOPIX BANKS TPMACH TOPIX MACHINERY TPMART TOPIX MARINE TRAN TPNMET TOPIX NONFER METAL TPMETL TOPIX METAL PRODUCTS TPPAPR TOPIX PULP & PAPER TPPHRM TOPIX PHARMACEUTICAL TPPREC TOPIX PREC INSTRUMENT TPTEXT TOPIX TXTL & APPRL TPWARE TOPIX WARE&HARB TRNS TPREAL TOPIX REAL ESTATE TPPROD TOPIX OTHER PRODUCTS TPAIR TOPIX AIR TRANSPORT TPNCHM TOPIX CHEMICALS TPSERV TOPIX SERVICES TPLAND TOPIX LAND TRANSPRT TPWSAL TOPIX WHOLESALE TRD TPFOOD TOPIX FOODS TPCOMM TOPIX INFO & COMM TPELEC TOPIX ELEC POWR & GAS TPOIL TOPIX OIL & COAL PROD TPCONT TOPIX CONSTRUCTION TPFISH TOPIX FISH/AGR/FRST TPRETL TOPIX RETAIL TRADE page 9 of 47

10 Air Transport Sector Attractive Support factors: This sector is a beneficiary of falling oil prices and the strong Yen. The expectation is for a high operating margin compared to The debt level is low with only a small net debt position. Net debt to EBITDA is low and falling sharply. Risk factors: One risk factor is that the free cash flow yield is low due to high capex estimates. The expected growth in dividends could be at risk. Valuation: The valuation is reasonable and attractive at CY2017 PBR of 1.0x, PER of 7.7x and 3.5% estimated dividend yield, if forecast earnings are achieved. Table 4: Topix Air Transport Sector Sales growth EBIT growth EBITDA Earnings growth Earnings, Positive Book Value Cash & Equivalents Total Debt Cash From Operations Capital Expenditures Free Cash Flow Dividends Operating Margin Return on Assets Return on Common Equity Dividend Payout Ratio Dividend Yield Free Cash Flow Yield Net Debt to EBITDA Total Debt to Total Assets Price/Earnings Price/Book Value page 10 of 47

11 Banks Sector Attractive Support factors: This sector is hurt by negative interest rates, but it appears that much of the potential damage is already in forecasts. Risk factors: A rise in credit costs or trading losses caused market turmoil could impact earnings, but is unlikely to be of a magnitude to hurt the book value. Valuation: The valuation is at attractive levels with a CY2017 PBR of 0.4x, PER of 7x and 4.3% estimated dividend yield. Table 5: Topix Banks Sector Sales growth EBIT growth Earnings growth Earnings, Positive Book Value Total Assets 5, , ,926.4 Cash & Equivalents ,021.5 Total Debt 1, , ,177.4 Dividends Operating Margin Return on Assets Return on Common Equity Dividend Payout Ratio Dividend Yield Total Debt to Total Equity Total Debt to Total Assets Price/Earnings Price/Book Value page 11 of 47

12 Chemicals Sector High expectations could lead to disappointment Support factors: The expectation is for strong earnings growth driven by high operating margins. The debt level is falling, with only a modest net debt position. Net debt to EBITDA is low and falling. Risk factors: Any shortfall relative to the high operating margin expectations. Valuation: The valuation, at a CY2017 PBR of 1.0x, PER of 13x and 2.3% dividend yield, is not particularly attractive unless the forecast growth in earnings is achieved. Table 6: Topix Chemicals Sector Sales 1, , , , ,753.0 growth EBIT growth EBITDA Earnings growth Earnings, Positive Book Value , , ,096.4 Cash & Equivalents Total Debt Cash From Operations Capital Expenditures Free Cash Flow Dividends Operating Margin Return on Assets Return on Common Equity Dividend Payout Ratio Dividend Yield Free Cash Flow Yield Net Debt to EBITDA Total Debt to Total Assets Price/Earnings Price/Book Value Source: Baseline page 12 of 47

13 Construction Sector Attractive Support factors: The expectation is for stable earnings driven by a strong order backlog ahead of the Olympics. The debt level is falling, with only a modest net debt position. Net debt to EBITDA is low and falling. Risk factors: Barring some major disruptions by global markets, things should be steady. Rising costs could be a risk, but that is unlikely if the macro environment deteriorates. Valuation: The valuation, at a CY2017 PBR of 1.1x, PER of 10x and 2.8% dividend yield, seems attractive. Table 7: Topix Construction Sector Sales 1, , , , ,183.6 growth EBIT growth EBITDA Earnings growth Earnings, Positive Book Value Cash & Equivalents Total Debt Cash From Operations Capital Expenditures Free Cash Flow Dividends Operating Margin Return on Assets Return on Common Equity Dividend Payout Ratio Dividend Yield Free Cash Flow Yield Net Debt to EBITDA Total Debt to Total Assets Price/Earnings Price/Book Value page 13 of 47

14 Electric Power & Gas Sector Highly indebted Support factors: The expectation is for a return to modest but stable earnings after years of turmoil. Risk factors: High debt levels and negative free cash flows. Valuation: The valuation, at a CY2017 PBR of 0.7x PER of 10x and 2.4% dividend yield, does not seem attractive given the debt burden and negative free cash flow. Table 8: Topix Electric Power & Gas Sector Sales 1, , , , ,147.1 growth EBIT growth , EBITDA Earnings growth , Earnings, Positive Book Value Cash & Equivalents Total Debt 1, , ,380.9 Cash From Operations Capital Expenditures Free Cash Flow Dividends Operating Margin Return on Assets Return on Common Equity Dividend Payout Ratio Dividend Yield Free Cash Flow Yield Net Debt to EBITDA 1, Total Debt to Total Assets Price/Earnings Price/Book Value page 14 of 47

15 Electrical Appliances Sector High expectations could lead to disappointment Support factors: The expectation is for strong earnings growth driven by improving operating margins and the end of asset write-offs. The aggregate debt level is low, with only a modest net debt position. Net debt to EBITDA is low and falling. Risk factors: Any shortfall relative to the high bottom line earnings expectations. The strong Yen could be a problem here. Valuation: The valuation, at a CY2017 PBR of 1.2x, PER of 13x and 2.4% dividend yield, is not particularly attractive unless the forecast growth in earnings is achieved. Table 9: Topix Electrical Appliances Sector Sales 2, , , , ,731.3 growth EBIT growth EBITDA Earnings growth Earnings, Positive Book Value 1, , , , ,286.4 Cash & Equivalents Total Debt Cash From Operations Capital Expenditures Free Cash Flow Dividends Operating Margin Return on Assets Return on Common Equity Dividend Payout Ratio Dividend Yield Free Cash Flow Yield Net Debt to EBITDA Total Debt to Total Assets Price/Earnings Price/Book Value page 15 of 47

16 Finance Sector High expectations could lead to disappointment Support factors: The expectation is for strong earnings growth driven by top line growth. With the two heaviest weights in this sector represented by Orix and Exchange, we find this expectation surprising. Risk factors: Any shortfall relative to the high bottom line earnings expectations. Valuation: The superficially attractive valuation, at a CY2017 PBR of 0.8x, PER of 8x and 3.5% dividend yield, depends on the high forecast growth in earnings being achieved. Table 10: Topix Finance Sector Sales growth EBIT growth Earnings growth Earnings, Positive Book Value Total Assets 3, , ,444.5 Cash & Equivalents Total Debt 1, , ,967.3 Dividends Operating Margin Return on Assets Return on Common Equity Dividend Payout Ratio Dividend Yield Total Debt to Total Equity Total Debt to Total Assets Price/Earnings Price/Book Value page 16 of 47

17 Fishing, Agriculture & Forestry Sector Highly indebted Support factors: The expectation is for strong earnings growth with unclear drivers (limited sell side coverage makes the consensus numbers suspect). Risk factors: High debt levels and high net debt to EBITDA. Valuation: The valuation, at a CY2017 PBR of 1.1x, PER of 11x and modest dividend yield, does not look attractive. Table 11: Topix Fishing, Agriculture & Forestry Sector Sales 1, , , , ,389.6 growth EBIT growth EBITDA Earnings growth Earnings, Positive Book Value Cash & Equivalents Total Debt Cash From Operations Capital Expenditures Free Cash Flow Dividends Operating Margin Return on Assets Return on Common Equity Dividend Payout Ratio Dividend Yield Free Cash Flow Yield Net Debt to EBITDA Total Debt to Total Assets Price/Earnings Price/Book Value page 17 of 47

18 Food Sector High expectations could lead to disappointment Support factors: The expectation is for strong earnings growth driven by high and rising operating margins. The net debt level is declining. Net debt to EBITDA is reasonable. Risk factors: Any shortfall relative to the high operating margin expectations. Valuation: The valuation, at a CY2017 PBR of 1.9x, PER of 19x and 2.1% dividend yield, is not particularly attractive unless the forecast growth in earnings is achieved. Table 12: Topix Food Sector Sales 1, , , , ,703.3 growth EBIT growth EBITDA Earnings growth Earnings, Positive Book Value Cash & Equivalents Total Debt Cash From Operations Capital Expenditures Free Cash Flow Dividends Operating Margin Return on Assets Return on Common Equity Dividend Payout Ratio Dividend Yield Free Cash Flow Yield Net Debt to EBITDA Total Debt to Total Assets Price/Earnings Price/Book Value page 18 of 47

19 Glass Sector Attractive Support factors: The expectation is for moderate earnings growth driven by high and improving operating margins. The net debt level is falling and seems to be at an appropriate level. Risk factors: Any shortfall relative to the high operating margin expectations. Valuation: The valuation, at a CY2017 PBR of 0.9x, PER of 11.7x and 2.5% dividend yield, seems attractive unless the forecast growth in earnings is missed by a large margin. Table 13: Topix Glass Sector Sales 1, , , , ,321.2 growth EBIT growth EBITDA Earnings growth Earnings, Positive Book Value Cash & Equivalents Total Debt Cash From Operations Capital Expenditures Free Cash Flow Dividends Operating Margin Return on Assets Return on Common Equity Dividend Payout Ratio Dividend Yield Free Cash Flow Yield Net Debt to EBITDA Total Debt to Total Assets Price/Earnings Price/Book Value page 19 of 47

20 Information & Communications Sector High expectations could lead to disappointment Support factors: The expectation is for strong earnings growth driven by high operating margins. Risk factors: Any shortfall relative to the high operating margin expectations. The debt level is high, but is supported by a high free cash flow yield. Valuation: The valuation, at a CY2017 PBR of 1.3x, PER of 12x and 2.4% dividend yield, is not particularly attractive unless the forecast growth in earnings is achieved. Table 14: Topix Information & Communications Sector Sales 2, , , , ,751.4 growth EBIT growth EBITDA Earnings growth Earnings, Positive Book Value 1, , , , ,028.9 Cash & Equivalents Total Debt 1, , ,480.5 Cash From Operations Capital Expenditures Free Cash Flow Dividends Operating Margin Return on Assets Return on Common Equity Dividend Payout Ratio Dividend Yield Free Cash Flow Yield Net Debt to EBITDA Total Debt to Total Assets Price/Earnings Price/Book Value page 20 of 47

21 Insurance Sector Attractive (P&C), May not have bottomed (Life) Support factors: Non-life sector is not significantly impacted by negative interest rates. Risk factors: The life insurance sector is a hurt by negative interest rates, but it appears that much of the potential damage is already in forecasts. Valuation: The valuation is at attractive levels with a CY2017 PBR of 0.5x, PER of 7.3x and 4.3% estimated dividend yield. Table 15: Topix Insurance Sector Sales 1, , , , ,994.7 growth EBIT growth Earnings growth Earnings, Positive Book Value , , , ,216.8 Total Assets 8, , ,941.8 Cash & Equivalents Total Debt Dividends Operating Margin Return on Assets Return on Common Equity Dividend Payout Ratio Dividend Yield Total Debt to Total Equity Total Debt to Total Assets Price/Earnings Price/Book Value page 21 of 47

22 Iron & Steel Sector May not have bottomed Support factors: The expectation is for a return to solid earnings in CY2017 based on margin improvement. Risk factors: High debt levels and modest free cash flows given an expected increase in capex. Net debt to EBITDA is rather high. Valuation: The valuation, at a CY2017 PBR of 0.5x, PER of 9x and 3.0% dividend yield, does not seem attractive given the debt burden and risk to free cash flow. Table 16: Topix Iron & Steel Sector Sales 1, , , , ,260.1 growth EBIT growth 1, EBITDA Earnings growth Earnings, Positive Book Value Cash & Equivalents Total Debt Cash From Operations Capital Expenditures Free Cash Flow Dividends Operating Margin Return on Assets Return on Common Equity Dividend Payout Ratio Dividend Yield Free Cash Flow Yield Net Debt to EBITDA Total Debt to Total Assets Price/Earnings Price/Book Value page 22 of 47

23 Land Transport Sector Highly indebted Support factors: The expectation is for solid earnings based on margin improvement. Risk factors: High debt levels and modest free cash flows given an expected increase in capex. Net debt to EBITDA is rather high. Valuation: The valuation, at a CY2017 PBR of 1.2x, PER of 13x and 1.3% dividend yield, is unattractive given the debt burden and risk to free cash flow. Table 17: Topix Land Transport Sector Sales 1, , , , ,964.4 growth EBIT growth EBITDA Earnings growth Earnings, Positive Book Value 1, , , , ,455.3 Cash & Equivalents Total Debt 1, , ,580.9 Cash From Operations Capital Expenditures Free Cash Flow Dividends Operating Margin Return on Assets Return on Common Equity Dividend Payout Ratio Dividend Yield Free Cash Flow Yield Net Debt to EBITDA Total Debt to Total Assets Price/Earnings Price/Book Value page 23 of 47

24 Machinery Sector Somewhat attractive Support factors: The expectation is for remaining stable at current levels. Net debt levels are modest and net debt to EBITDA is low. Risk factors: A strong Yen and global market turmoil causing delays in global capex spending are risk factors. Valuation: The valuation, at a CY2017 PBR of 1.1x, PER of 12x and 2.6% dividend yield, seems reasonable given the balance of support and risk factors. Table 18: Topix Machinery Sector Sales 1, , , , ,795.6 growth EBIT growth EBITDA Earnings growth Earnings, Positive Book Value , , , ,154.3 Cash & Equivalents Total Debt Cash From Operations Capital Expenditures Free Cash Flow Dividends Operating Margin Return on Assets Return on Common Equity Dividend Payout Ratio Dividend Yield Free Cash Flow Yield Net Debt to EBITDA Total Debt to Total Assets Price/Earnings Price/Book Value page 24 of 47

25 Marine Transport Sector Highly indebted Support factors: Little that is fundamentally supportive. Risk factors: High debt levels and negative free cash flows despite the decrease in capex. Net debt to EBITDA is rather high. Earnings could easily go into losses given the potential downside risk to global trade. Valuation: The valuation, at a CY2017 PBR of 0.5x, PER of 18x and 2.1% dividend yield, does not seem to be a bottom given the debt burden, negative free cash flow and risk to dividends. Table 19: Topix Marine Transport Sector Sales 1, , , , ,663.4 growth EBIT growth EBITDA Earnings growth Earnings, Positive Book Value Cash & Equivalents Total Debt 1, Cash From Operations Capital Expenditures Free Cash Flow Dividends Operating Margin Return on Assets Return on Common Equity Dividend Payout Ratio Dividend Yield Free Cash Flow Yield Net Debt to EBITDA Total Debt to Total Assets Price/Earnings Price/Book Value page 25 of 47

26 Metal Products Sector Attractive Support factors: The expectation is for moderate earnings improvement driven by recovering operating margins. The net debt level is stable and seems to be at an appropriate level. Risk factors: Operating margin recovery does not materialize. Valuation: The valuation, at a CY2017 PBR of 0.8x, PER of 11.9x and 2.4% dividend yield, seems attractive unless the forecast recovery in earnings is missed by a significant margin. Table 20: Topix Metal Products Sector Sales 1, , , , ,320.9 growth EBIT growth EBITDA Earnings growth Earnings, Positive Book Value 1, , , , ,118.5 Cash & Equivalents Total Debt Cash From Operations Capital Expenditures Free Cash Flow Dividends Operating Margin Return on Assets Return on Common Equity Dividend Payout Ratio Dividend Yield Free Cash Flow Yield Net Debt to EBITDA Total Debt to Total Assets Price/Earnings Price/Book Value page 26 of 47

27 Mining Sector May not have bottomed Support factors: The net cash position is the main supporting factor. Risk factors: The failure of operating margins to recover in CY2017 as well as the risk of asset write-downs are key concerns. Negative free cash flows due to low operating cash flow generation. Valuation: The valuation, at a CY2017 PBR of 0.4x, PER of 15.8x and 2.5% dividend yield, may not provide a floor if there are asset impairments. Table 21: Topix Mining Sector Sales growth EBIT growth EBITDA Earnings growth Earnings, Positive Book Value Cash & Equivalents Total Debt Cash From Operations Capital Expenditures Free Cash Flow Dividends Operating Margin Return on Assets Return on Common Equity Dividend Payout Ratio Dividend Yield Free Cash Flow Yield Net Debt to EBITDA Total Debt to Total Assets Price/Earnings Price/Book Value page 27 of 47