Japan: There’s a Reason Why its Cheap?   

• A New Yorker article claims Japan can offer few lessons to the US. The author, citing old data, insists that Japanese companies are not well run in terms of shareholder return on equity, profitability, growth and managing cash flow.
• One problem is the cost of capital mis-match between foreign investors and Japanese companies. Returns on invested capital in Japan are lower because the weighted average cost of capital (WACC) is much lower in Japan, whereas foreign investor required returns (which are based on their home market WACC) and the ROIC of Japanese companies. An indication of this is the spread between the market average earnings yield (1/PER) and the 10-yr government bond (riskless rate of return). On trailing earnings, the Nikkei 225’s earnings yield is currently around 9.6% versus a 10-yr JGB yield of 1.52%, resulting in a yield gap of 815bps. Moreover, the dividend yield gap is 89bps.
• We would submit that Japanese equities now offer shareholders very competitive returns. The trailing P/E multiple for the Nikkei 225 is 10.5X versus 18.9X for the S&P 500, the earnings yield is 9.6% versus 5.3%, dividend yield is 2.4% versus 2.8%, and ROE is 10.1% versus 9.7%. Moreover, the very same features that previously created relatively lower returns, such as minimal balance sheet leverage and abundant cash on hand, are the very features that will stand Japanese companies in good stead in surviving the global financial crisis and economic recession.
• At the start of the Heisei Malaise, Japanese were confident they would not catch “the developed country disease”. Now, their US peers are still too confident that the US will never catch the “Japanese disease”. The apparently juicy returns available heretofore in the US and Europe substantially above “riskless” rates of return had a big catch, and the catch was substantial balance sheet risk that went ignored for too long. It is the unleveraging of this excessive balance sheet risk that created the worst financial crisis in our lifetime and very well could result in the worst recession in our lifetime.
• Japan will survive this crisis better than others simply because it is Japan’s individuals and companies who now have the savings to weather the storm.

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