The Land of the Rising Yen (and equities?)

Japan has been in the headlines in recent months.  The stories have been centred around wild movements in the Japanese Yen.  Until the middle of July, the yen had been depreciating remorselessly, especially against the US dollar.  The USDJPY rate moved from around 141 at the beginning of the year to 162 at its peak in July (a rising USDJPY indicates a strengthening US dollar, weakening yen and vice versa).  The weakness in the Yen had been reinforced by the so-called Yen carry trade, where traders would borrow in yen at ultra-low rates, sell the Yen for other currencies and invest in assets in those currencies at higher rates of return.  The weakness in the yen boosted returns to this trade even more.  In July, the Bank of Japan hinted at a minor tightening shift in interest rate policy.  This caught many leveraged investors off guard.  The Yen rallied causing losses for these investors, who scrambled to cover their positions, exacerbating the moves.  Trading was wild for a few days while this played out.  Japanese equities were hit hard in yen terms, although much less so when measured in dollars or sterling.  After bouncing in August, the yen has continued to strengthen into September to the extent that it has now reversed all the weakness of the first half of the year.  Much of the continued momentum has come from the US side of the equation, with the Federal Reserve looking to start to cut rates.

USDJPY

Tokyo Stock Exchange - TOPIX

While in the short-term, Japanese stocks have been whipsawed by the volatility in the yen, this should not distract investors from the opportunities in Japanese equities.  Firstly, Japanese corporate profits have benefited from a prolonged deleveraging of Japanese companies.  For example, the Topix Index as a whole, has negative net debt.  While total debt has risen in the past decade, total cash on balance sheets has risen faster.  The near removal of interest cost has boosted profitability, and paradoxically Bank of Japan rate hikes would be a positive for profits.

In 2023, the Tokyo Stock Exchange issued a directive asking all companies with price-to-book ratios below 1x (around half of all listed companies) to issue a plan to improve this number.  The directive is a clear signal that the authorities are taking active steps to address the reputation of Japan as a graveyard for shareholder value.  The responses have been varied but most include a combination of increased dividends, share buybacks and sales of cross holdings and those companies that have enacted these policies have started to see their share price performance improve.

However, from a rating perspective the Japanese market remains modestly valued.  The chart below compares the Enterprise Value (EV) to EBITDA of the Japanese and US markets.

EV/EBITDA - TOPIX (blue), S&P 500 (orange)

The multiples, which were comparable until around 2015 began to diverge as US equities, driven by technology shares, powered ahead.  What is most noticeable however is that while the US rating has surged in the past two years to a lofty 15.5x while Japan has continued to derate to around 6.6x.  There is no question, that even accounting for the difference in the make up of the two indices, Japanese stocks are materially cheaper.  The question for investors is whether the continued push towards more shareholder friendly policies will eventually act as a catalyst to close this gap.