Fastest inflation in 30 years is driving the next leg of transformation
In 2015, expectations for corporate changes were rising sharply with "Abenomics"- economic policies implemented by the government of Japan in 2012. They faded due to flatlining profits in 2018-19 before excitement returned again over the past year. Mirroring Germany’s transitions in the 1990s, we believe that corporate governance reform in Japan has been steadily progressing underneath the surface all along. Many things are supporting this, including the introduction of the Corporate Governance Code in 2015, the Tokyo Stock Exchange (TSE) proposals on value creation and – especially – rising inflation expectations. As a result, there has been a notable change in management attempts to enhance corporate value. We expect this to continue with the potential to boost peak Return on Equity (ROE) by 300 basis points.
Change is real and coming from multiple drivers
Many Japanese companies have low ROE, and low price-to-book ratios (PBRs) because of excess capital accumulated during deflation. But shareholder returns are expanding alongside the highest inflation since the bubble burst in 1990 and the highest corporate inflation expectations since 2004. Other drivers such as the Tokyo Stock Exchange’s (TSE's) initiatives on value realisation and the increasing role of activists (a sevenfold increase in funds since 2016) are helping catalyse greater buybacks – annualising at 2.0% of market cap year to date (up 50 basis points since 2016), the highest of any major market globally right now – and unwinding of cross-shareholdings (up 2X since 2016). Beyond optimisation of balance sheets, more important is whether corporate efficiency and productivity will continue to improve with better management awareness of the cost of capital. From this viewpoint, we think divestitures, mergers & acquisitions (M&A) (up 1.5X since 2016) and management buyouts (MBOs) are likely to continue to increase and support business enhancement.
We think ROEs could go as high as 12%
Valuations are at post global financial crisis (GFC) highs on a PBR basis, signaling that investors are already pricing in some ROE improvement. And the recent flurry in corporate activity has also pushed up our proprietary measure of shareholder value optimism, to three-year highs. While we believe there is plenty of change still to come and ROEs can increase from last-cycle highs of almost 9% to almost 12%, we also recognise that improvements are non-linear, excitement can come and go (as it did in 2018-19), and predicting the next stock to engage in reform is challenging.
