Shinzo Abe’s recent election win clearly signals a firm nod of approval from the Japanese electorate. But, there’s another important constituent out there that also seems to be a fan – the stock market. Since he took power in late 2012, the Nikkei 225, one of the main indexes of Japanese stocks, has more than doubled. That looks like an economic vote of some clout, and arguably vindicates the policies that Abe put in place with his eponymous Abenomics program – an ambitious combined salvo of monetary, fiscal, and structural reforms intended to wrest Japan from its decades of economic malaise.
If we put the focus on that latter policy, structural reform, there were some fairly interesting initiatives packaged under a “Corporate Governance” label. We won’t go into all of them here, they are pretty wide reaching, but two initiatives that seem to have come to fruition are; the returning of excess cash to shareholders, and more focus on corporate profitability.
Figure One shows some evidence of the former. The idea was that Japanese firms were being overly conservative by retaining cash on their balance sheets that might be better off in the hands of shareholders (a well-known corporate finance phenomenon, if you don’t have a productive use for cash, then give it back to your investors). The chart shows that both share buybacks, and dividend revisions, have been moving higher over the last several years, evidence in our view that companies are taking this reform seriously.
Figure One: Buybacks and Dividends are on the rise
The other aspect of this is corporate profitability, and here, amongst other things, there has been a renewed focus on return on equity (ROE). And, indeed ROE does seem to have been trending higher in Japan over the last five years. Figure Two shows this, but we have also put on the chart, the three components of ROE (from the DuPont Model if you remember that) – profit margin, asset turnover, and leverage. It’s a nice way of breaking down the ROE to get under the hood and identify the main drivers.
What the model is essentially saying is that a higher return on equity depends on three factors - first, the amount of a dollar of sales that the firm is actually able to retain (margin), second, the amount of sales that the asset base can sustain (asset turnover), and, third, the ratio of those assets to equity (leverage). Presumably investors prefer high ROEs that are generated by selling a greater volume of more profitable goods as opposed to the potentially more risky approach of levering up thin margins.
What Figure Two shows, in our view, is that Japan has managed to increase its ROE, not through higher asset turnover, nor leverage (both of these seem relatively stable), but rather through higher profitability. After all, it’s the net margin line that most closely mirrors the trend higher in ROE that the graph shows. One last point on this chart is that the scales are a little tricky - some are percentages, and some multiples. The net margin and the ROE are in percentages, and are on the left hand scale. But that scale hasn’t been labelled in percentages because it is also being used for leverage which is a multiple. The right hand scale is also a percentage (for the asset turnover number) but is shown separately because of the different magnitudes. However, the bottom line remains - there are upward trends in margins, and ROE, while asset turnover and leverage remain relatively flat.
Explaining the increase in net margins is not easy. Clearly Japanese firms have found a way to increase their profits, and we could posit plenty of reasons why that might be so, from an improving macroeconomic picture, to increased consumer spending, to a weakening yen. But that’s a topic for another blog. For now, let’s just welcome what looks like an improvement in ROE, and one that’s coming from the “right” driver. It would have been a savvy Japanese voter that plucked for Abe on that basis.
Figure Two: The DuPont Model in Japan, ROE broken into margins, asset turnover, and leverage (10/12-10/17)