Following three years of initiatives focused on reversing Japan’s slow growth and deflation, positive developments continue to be underway. Based in Tokyo, the portfolio management team of the Hennessy Japan Fund (Trades, Portfolio) and Hennessy Japan Small Cap Fund (Trades, Portfolio) provide a local “feet on the street” perspective and what could fuel growth over the next several years.
- Would you please provide an assessment of the macro environment in Japan?
Japan’s economy appears to be moving in the right direction, firmly but slowly, and corporate profits remain robust. Over the past two years, aggressive quantitative monetary easing has been a primary driver of improvement. Since November 2014, the Bank of Japan (BOJ) has purchased approximately $700 billion of government bonds, exchange-traded funds and real estate investment trusts annually. With the monetary base currently at an unprecedented $2.5 trillion, or 30% of outstanding government bonds, Japan has eliminated its output gap in the economy and is no longer in a deflationary environment. In addition, the Yen’s depreciation against the U.S. Dollar has lifted profits for companies involved in exporting to record highs, with cash flows being reinvested into core business activities.
While there appears to be ample liquidity due to the BOJ’s bond purchases, it has not yet circulated throughout the economy. Inflation has recently tapered off, but we believe it is due to a lack of confidence in the private sector. To achieve Prime Minister Shinzo Abe’s goal of long-term sustainable growth, the government needs to push for structural reforms and encourage wage growth, thereby creating a positive cycle throughout the economy going forward.
2. What has been the progress of wage increases so far?
To strengthen consumer spending and encourage economic growth, Japan plans to raise its minimum wage by 3% in 2016. In 2015, Japan’s base salary increased 2.4%, resulting in a positive real wage gain for the first time in two years. In the past, wage increases generally came from large companies such as Toyota, which recently offered its largest pay increase in more than a decade. Over the next few years, smaller companies may have to follow suit as the labor market becomes tighter. The number of job openings compared to job seekers has been rising over the past several years with the jobs-to-applicant ratio at 1.25 as of the end of November 2015.
3. What significant structural reforms have been implemented?
Several corporate governance, tax and job market initiatives collectively illustrate Japan’s improving economic and business environment. A few examples include:
- Continuation of corporate tax reform. The government recently accelerated its plan to reduce the corporate tax rate from the current 32% to below 30%. The cut, which is the third in as many years, will go into effect in April 2016 and is intended to encourage companies to spend their cash coffers on wage increases and corporate investment.
- Increased taxation of unprofitable companies. The government is considering imposing higher taxes on “zombie companies” that do not pay taxes or are taxed at a low rate, which may result in a healthier turnover of companies.
4. Looking ahead, what are your thoughts regarding market valuations?
We believe Japanese stocks are not expensive, as stock prices generally kept pace with corporate earnings in 2015. In addition, price-to-earnings in Japan appear favorable to those in the U.S., Europe and other Asian markets. The market’s consensus is that Japanese companies’ earnings per share (EPS) growth will be 7% in 2016, but we believe it may be higher. Factors that may lead to higher EPS growth include the lower corporate tax rate, potentially stronger-than-expected domestic growth, strong share repurchase activity by Japanese firms as well as the innate conservative nature of Japanese firms when providing guidance.
The slowdown in the Chinese economy may be a headwind for Japanese stocks in 2016 due to their exposure to the global markets. While China is major trading partner, the U.S. remains Japan’s largest market for exports.
5. Japan’s tourism has increased significantly in 2015. What drove the larger number of people to visit Japan?
Encouraging tourism has been a key part of Japan’s economic program, with Prime Minister Abe setting a target of 20 million annual visitors to Japan by 2020. Due to a weaker Yen and relaxation of visa requirements, Japan achieved this goal in 2015. Overall tourism increased 40% from 2014 to 2015, with the largest number of tourists traveling from China. With each tourist estimated to spend $1,000 to $1,500, tourism provides a boost of approximately $20 to $30 billion annually to the economy.
Tourism is expected to remain strong over the next several years as the country prepares to host the Olympics in 2020. In December 2015, the Bank of Japan estimated the impact of the Olympics over the next five years to be about $250 billion, which represents approximately 1% of GDP.
6. Where are you finding opportunities for the Funds?
For the Japan Fund, we are patient investors focused on high-quality, globally oriented companies protected by high barriers to entry and run by smart management. In addition, we prefer companies that have high return-on-equity, consistent, sustainable and predictable earnings growth and strong cash flows. Currently, we have found considerable opportunities in consumer franchises that provide personal care goods, cosmetics, diapers and leisure goods, as well as factory automation companies.
The Japan Small Cap Fund seeks smaller Japanese companies that could be beneficiaries of the economic recovery and increasing domestic demand. In addition, with robust capital spending continuing, we remain positive on the manufacturing and machinery sectors. With our “feet on the street” research, we believe our local perspective provides a competitive advantage for our investors.
