Improving the number of independent directors and other governance issues are very important in the intermediate term for Japan, but it is crucial for investors to understand that much of the profitability message has already been understood by Japanese corporate for nearly a decade.
Indeed, the 2Q data on overall corporate profits (not just of listed companies) showed that the pretax profit margin’s four-quarter average hit a new high of 4.8%. We expect that profit margins will expand further in coming quarters, which should further prove that Japan’s structural profitability trend continues upward. It is also worth mentioning that forex related profits are not the main driver of improvement, as the profit margin of services industries also surged to a new record high in virtually parabolic fashion.
Four-quarter Average of Pretax Profit Margin vs. Japanese Nominal GDP YoY Growth
(for all non-financial companies, not just listed ones)
Sources: Japan Ministry of Finance, Bloomberg, data through 2Q14,
Indeed, as the chart to the right shows, service sector (only non-financials are included in the survey) profitability has been even more impressive than manufacturing. Bottom-up investors have known this for a long time, but macro-based investors are much less aware of it.
This is but one reason why investors should ignore the macro-based strategists who say that Japanese equities can only rise if the Yen weakens further. If valuations were high, this might be true, but not at their presently low levels and as large corporate tax cuts are likely to be enacted soon.
...and for Non-manufacturers excluding Non-financials
Sources: Japan Ministry of Finance, Bloomberg, data through 2Q14
1. Years of restructuring’s progress was hidden (due to successive crises and the gradual nature of Japan’s redundancy programs).
2. “Show me the Money!” corporate governance: Japanese companies do care about corporate profitability.
3. The dividend paid by TOPIX is surging upward again, and we expect such to double over the next five years.
4. Abenomics is having a strongly positive effect on profits due to the normalized Yen and further deregulation will gradually push profit margins higher.
5. Poor demographics are linked with GDP growth to some degree, but countries with strong automation and efficiency capabilities can offset such.
6. As these charts show, even if GDP is flat, corporate profits can rise sharply in Japan due to productivity increases and gearing to global growth via multinationalization.
7. We are now at the stage where domestic macrofactors (including the Yen) are less important to the stock market than the bottom–up increases in corporate profits. Indeed, we still believe equities can continue rise even if the Yen stabilizes at 108-109, although, of course, external factors will also be critically important.