Markets

Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.

Is it time for investors to turn Japanese?

Morgan Stanley predicts that the country's stocks will outperform those of the U.S. next year. According to the bank, Japan will be “fueled by the prospect of fiscal expansion, rising earnings and a return of true animal spirits.” So much spirit, in fact, that Japan will apparently experience higher earnings-per-share growth than any other region.

All you have to do, according to Morgan Stanley, is dump those has-been U.S. stocks to make room for resurgent Japanese stocks.

But before you do, let’s take a closer look at some data. It turns out Japan may not be the value investors are looking for.   

The idea that Japan is on the verge of a renaissance is intuitively appealing. Japan was an economic and financial powerhouse in the 1980s. According to IMF data, Japan’s gross domestic product grew by an average of 6.2 percent a year from 1981 to 1990.

Unfortunately for Japan, however, that growth was accompanied by one of the great asset price bubbles in history. The collapse that followed in the early 1990s seriously battered Japan’s economy, and it has struggled to regain its 1980s-era mojo ever since. Japan’s GDP has grown by an average of just 0.4 percent annually since 1991.

The difference in the performance of Japan’s stock market before and after that collapse is just as astonishing. The MSCI Japan Index returned 22.3 percent a year in local currency, including dividends, from 1980 to 1989, but has declined by 1 percent a year from 1990 through November of this year.

Still, Japan remains one of the world’s most advanced economies more than two decades after that fateful collapse. It’s not unreasonable to expect that Japan will rise again.

Here’s the complication: Japan’s renaissance has already been underway for years. Its GDP has grown by an average of 1.4 percent a year since 2012. Granted, that’s a fraction of the growth the country achieved in the heady 1980s, but it’s also more than three times Japan’s long-term growth rate since 1991.

That growth has translated into higher profits for Japanese companies. The profit margin for the MSCI Japan Index averaged 1.8 percent from 1995 to 2012. But since then profit margins have soared to 4.8 percent, 4.9 percent and 5.1 percent in 2013, 2014 and 2015. Profit margins are expected to be similar this year.

High Life Again
Japan's companies are enjoying the highest profit margins in decades
Source: Bloomberg

And higher profits have translated into better-performing stocks. In fact, Japan’s stock market has quietly beaten the performance of U.S. stocks over the last five years, even though U.S. stocks have grabbed all the headlines. The MSCI Japan Index has returned 17.1 percent a year in local currency over the last five years through November, while the S&P 500 has returned 14.4 percent a year over the same period.

Laggard No More
Japan's stock market has quietly beaten the S&P 500 over the last five years
Source: Bloomberg

You can forgive U.S. investors if they haven’t noticed. While Japan’s economic growth, corporate earnings and stock prices have climbed in recent years, the yen has collapsed relative to the dollar.  

Yen Down
The yen has collapsed relative to U.S. the dollar in recent years
Source: Bloomberg

That’s crucial for many U.S. investors because their reward for investing in Japan is ultimately measured in dollars, not yen -- and a falling yen can take a real bite out of returns. The yen has declined 32.2 percent against the dollar over the last five years through November. That translated into a return for the MSCI Japan Index of just 8.4 percent a year in dollar terms -- a far cry from the 17.1 percent annual return in yen or the S&P 500’s annual return of 14.4 percent.

As a result of Japan's recent success, its stock market is no bargain, either. The price-to-earnings ratio for the MSCI Japan Index is 22, based on 10-year trailing average earnings. That’s modestly cheaper than the S&P 500’s 24 but far from the cheap valuation you would expect in the early stages of an economic or earnings recovery.

There are many good reasons to be a long-term investor in Japan. But if investors are looking to exploit Japan’s long-awaited turnaround, it looks as if they’re already several years too late.  

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Nir Kaissar in Washington at nkaissar1@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net