World Gaining Faith in Japan as Topix Index Gets Cheaper

Japanese shares are getting cheaper faster than any developed market as global investors regain faith in the world's third-largest economy, with valuations declining even as the benchmark Topix index rallies.

The price-earnings ratio for the nation's companies dropped to 14.6 times estimated profits from 17.1 at the start of 2013 because the Topix's 36 percent surge, the biggest among 24 developed countries tracked by Bloomberg, has failed to keep up with analyst forecasts for 60 percent income growth. Nowhere have valuations contracted faster than in Japan. Multiples have increased in the U.S., France and the U.K.

Bears say the best of the rally that began in November is already over because earnings have failed to translate into stock gains for much of the past decade. Bulls say profit estimates are returning to pre-financial crisis levels as the yen weakens amid confidence in Prime Minister Shinzo Abe's policies to end 15 years of deflation and the central bank's promise to double the amount of currency in circulation. Earnings estimates by analysts and companies are based on an even stronger yen.

"This time is for real," Sergi Martin Amoros, who helps oversee $4 billion as chief executive officer of Credit Andorra Asset Management in Andorra, said in a Sept. 6 phone interview. "Their previous efforts were never accompanied by such a decisive monetary policy and the government's willingness to commit to structural reforms is also something we haven't seen before. This is the real one."

Credit Andorra made its first Japanese investments in "many years" this quarter, he said.

Topix Diverges

Earnings growth did little to lift equities after the financial crisis. The Topix ended last year at 859.80, less than a point above its 2008 close. During the four years in between, earnings doubled, while the index never rose more than 16 percent above its starting level, data compiled by Bloomberg show. The yen soared to a post-World War II record in 2011.

Stocks rose today after Tokyo won the right to host the 2020 Olympics and data showed the economy grew more than initially estimated in the second quarter. The Topix climbed 2.2 percent to 1,173, the highest close since Aug. 6, extending last week's 3.8 percent advance. The benchmark gauge for Japanese shares has gained 36 percent in 2013 and its 62 percent rise since mid-November is the biggest advance in a quarter century.

More Revisions

"We're positive on Japanese equities," Stephen Corry, Hong Kong-based chief investment strategist at LGT Group, a private banking and asset-management firm that oversees about $115 billion, said in a phone interview Sept. 6. "We'll continue to see more positive earnings revisions. Abe wants to leave a legacy in Japanese politics as the man who altered the economy and that's encouraging."

Foreigners speculating that Abe will succeed in stimulating economic growth and halting deflation have been pouring money into the Tokyo stock market. They added $93 billion to holdings this year, Finance Ministry data show.

Topix companies will earn a combined 80.43 yen a share this year, up from 50.29 yen in 2012 and 38.05 yen in 2011, when Japan had its biggest earthquake and nuclear disaster, according to more than 6,000 analyst estimates compiled by Bloomberg. Fifteen of 18 strategists surveyed by Bloomberg expect the gauge to rise by year-end, with the median forecast for an 8.3 percent increase to 1,270. Nomura Holdings Inc. is the most bullish, projecting a 28 percent jump to 1,500.

"Japanese stocks still have big upside," said Miyuki Kashima, head of Japanese equity investment at BNY Mellon Asset Management Japan Ltd., which oversees about $13 billion. "The correlation with the currency will weaken and the market will become more linked to earnings, like it was in the past."

The index's ratio of 14.6 times estimated earnings compares with the average valuation of 28.7 over the last decade, based on historical earnings, data compiled by Bloomberg show.

World Valuations

The 2.5-percentage-point narrowing in the ratio comes as multiples expand in developed countries. In the U.S., where a four-year bull market lifted the Standard & Poor's 500 Index (SPX) more than 145 percent to a record high, stocks trade for 15 times forecast 2013 earnings, up from 13.1 in January. Valuations rose 17 percent to 12.9 for France's CAC-40 Index and 13 percent to 12.8 for the U.K's FTSE 100 on Sept. 6, according to data compiled by Bloomberg.

Optimism about Abe's policies has prompted analysts to push profit projections up 16 percent in 2013, leaving them within 6 percent of their level in February 2007, the year before the collapse of Lehman Brothers Holdings Inc., when the Topix reached a 16-year high of 1,816.97. Even though more than $650 billion has been restored to Japanese share values since December, the gauge remains 35 percent below the 2007 level.

Earnings Influence

The yen's 19 percent decline against the dollar since elections were announced in November has been behind much of the profit gain.

The currency still isn't weak compared with its level of 108 per dollar before the collapse of Lehman Brothers Holdings Inc. in 2008, Finance Minister Taro Aso said at a Sept. 6 press briefing in St. Petersburg, Russia, after a Group of 20 nations summit. The yen traded at 99.63 as of 3:30 p.m. in Tokyo.

Nissan Motor Co., which gets more than 80 percent of its revenue outside of its home market, said in May that a one-yen drop against the dollar boosts operating income by 15 billion yen ($150 million).

The currency has distorted typical relationships between share prices and earnings growth, according to Takashi Miyazaki, general manager of strategic research and investment at Mitsubishi UFJ Asset Management Co., a unit of the nation's biggest bank.

Catching Up

"Share prices should depend on company profits, but stocks in Japan haven't followed the recovery in earnings after the Lehman shock primarily because of the strong yen," Miyazaki said in an Aug. 28 phone interview from Tokyo. "That said, the BOJ's unprecedented easing caused a change in the currency level and because of this we expect shares to catch up."

Analysts boosted annual profit estimates for Japanese companies about 9 percent during the last five months, according to data compiled by Bloomberg. The yen weakened 0.7 percent over that period, falling to its lowest point of 103.74 per dollar on May 22 and trading as high as 93.79 on June 13.

That's a shift from the same period in the last two years, when analysts cut earnings projections as the yen strengthened. A 4.2 percent appreciation against the dollar from April 9, 2012 to Sept. 9 of that year coincided with an 7.8 percent decline in forecasts. Profit estimates fell 14 percent in that part of 2011, when the yen strengthened 9.2 percent.

'Still Attractive'

"Earnings momentum is strong and valuations are still attractive," said Toshiyuki Miwa, head of money management for Japanese equity at the local unit of Invesco Ltd., which oversees $729 billion of assets globally. "Cyclically, Japan is recovering. That's why the market should be higher."

One reason for caution is heightened volatility. Investors in Japanese shares have endured the biggest swings since the financial crisis. The Topix has risen or fallen by an average of 1.32 percent a day this year through Sept. 6, compared with the 10-year average of 1 percent and 1.95 percent in 2008, according to data compiled by Bloomberg.

The index tumbled more than 18 percent from May 22 to June 13, about four times the drop in the MSCI All-Country World Index, on speculation that reduced stimulus for the U.S. economy would slow the rate of global growth.

Overvalued Japan

Japan remains overvalued and will suffer steeper losses should Abe decide to allow a national sales tax to increase, according to Shinkin Asset Management Co., the biggest bear among 18 Japanese strategists surveyed by Bloomberg. It predicts a 32 percent drop for the measure to 800.

"Earnings are already near their peak and likely to start falling soon," said Hiroshi Fujimoto, a fund manager for Shinkin, which manages the equivalent of about $6.4 billion, in a phone interview from Tokyo on Sept. 4. "Expectations for Abenomics, which have been driving the market forward, will fall off, and if the government decides to raise the sales tax, a negative impact on the economy will be unavoidable."

A law enacted last year allows Abe to permit the sales tax to rise to 8 percent in April and 10 percent in 2015 from 5 percent today, or to hold off if he concludes Japan's economy isn't strong enough. Raising the levy would reduce gross domestic product 1.42 percentage points in the fiscal year to March 2015, according to a Sept. 3 report by Daiwa Institute of Research Ltd.

Profit Outlook

Sony Corp., the country's No. 1 consumer-electronics exporter, lifted its revenue outlook by 5.3 percent after first-quarter profit topped estimates. The Tokyo-based manufacturer said in May it's assuming an exchange rate of 90 yen to the dollar for the fiscal year. Its price-earnings ratio has fallen 45 percent to 29.8 since May.

Honda Motor Co. and Fuji Heavy Industries Ltd.'s Subaru led U.S. sales gains in August as auto demand beat projections and Asia-based carmakers, buoyed by Toyota Motor Corp., combined for their best month ever. Honda's deliveries jumped 27 percent, topping analysts' estimates, and Toyota outsold Ford Motor Co. for a second month in a row.

Net income at Toyota will climb to a six-year high for the year through March 2014, Japan's largest company by market value said in August, when it raised its forecast by 8 percent. The automaker's shares trade for 16.1 times reported profit, compared with about 22 just over three months ago.

Auto Companies

The nation's six biggest carmakers reported total net income of about 848 billion yen for the three months ended June, beating analyst estimates by 14 percent.

Exporters in the Topix generally use a yen value of 93.5 per dollar for forecast earnings, according to Okasan Securities Co. The currency hasn't been stronger than that level since April, giving companies a boost for beating estimates, data compiled by Bloomberg show.

Earnings at financial companies, which account for about 19 percent of the Topix index, are also surging. Net income at Japan's three biggest banks climbed 63 percent in the first fiscal quarter from a year earlier on higher fee income and equity investments, according to their earnings statements.

First-quarter profit at Nomura, the country's largest securities firm, soared to 65.9 billion yen from 1.9 billion yen, as the stock rally spurred brokerage commissions and fees from managing share sales.

Abe's Arrows

The yen slumped as Abe's Liberal Democratic Party reclaimed power, promising "three arrows" of monetary easing, fiscal stimulus and reforms to boost the economy. The government will spend 10.3 trillion yen to spur growth and encourage private investment, officials said in January, before the Bank of Japan on April 4 pledged to double the monetary base in two years to reach a 2 percent inflation goal.

Profit at Topix companies this reporting season jumped 93 percent from the previous quarter, compared to a 3.3 percent gain for companies in the S&P 500. Japanese output expanded an annualized 3.8 percent in the three months through June from the first quarter, higher than an initial estimate of 2.6 percent, reflecting stronger private capital investment, the Cabinet Office said in Tokyo today.

"Monetary easing has driven stocks upward and reversed the yen trend, but its impact has only been factored in to a small extent," said BNY Mellon's Kashima. "The other two arrows of Abe's policy program, fiscal stimulus and growth strategy, can also be expected to have a positive effect in the medium to long term. Earnings per share are likely to return to pre-Lehman levels and the Topix will probably do the same."