Japan_Equity_Strategy

Paul M. Kitney, PhDBALLINGAL INVESTMENT [email protected]+852 2733 1000 (Main)+852 2733 1031 (Direct)+852 6975 8444 (Mobile)

The Animal Spirits Report - Asia Pacific Investment StrategySeptember 21, 2016

ANIMAL SPIRITS™ REPORT: Japan Equity Market Outlook - Escaping The Value TrapInvestment Conclusions1. We are currently "neutral" in our view on Japan in global developed market portfolios but "underweight" in our APAC portfolio outlook for Q4 2016, as our macro baseline scenario favors emerging markets2. The risks to our Japan view are skewed to the upside. Our baseline roadmap is to raise the Japan weighting sometime before year end when it becomes clear that inflation expectations are trending up, driven by the reversion in the oil market.3. For US dollar based macro investors or tactical asset allocation, we suggest hedging JPY. Two liquid ETFs that would be appropriate for implementation are Wisdomtree Japan Hedged Eq (DXJ US) and iShares Currency Hedged MSCI Japan ETF (HEWJ US).4. Our cautious positioning at an index level reflects short-term (Q4 2016) concerns (near term JPY strength) but our sector and stock selections are based on a longer horizon of 6 months at least, which reflects some "risk on" views presented in this note.5. We recommend overweighting information technology, financials, and materials sectors and underweighting telecom, utilities, and consumer staples.6. At a factor/"Smart Beta" level, we believe "value" will likely return to favor and "minimum volatility" will underperform over the next 3-6 months.7. Our Animal Spirits "Strategist Top Picks" include Keyence Corp (6861 JP) , Resona Holdings Inc (8308 JP) , Mizuho Financial Group Inc (8411 JP) , T&D Holdings Inc (8795 JP) and Toray Industries Inc (3402 JP)Summary of Our Investment Thesis• Valuation - Japan has potential but needs an earnings catalyst to escape the value trap• Earnings - Still dependent on international trade and JPY but there are some green shoots. Inflation is required to induce a domestic demand driven earnings profile in Japan.• Economic Policy - 2 Percent inflation target/NIRP to prevail. QQE may not taper but it might twist. Fiscal monetization should and will arrive but not this year.• Macro - Japan gets interesting from 2017 but beforehand JPY strength may be a headwind. Fed likely runs "hot" until year end with a rate hike in December or early Q1. JPY should then become a tailwind. The yield curve steepening is "pro-growth". Inflation is key to domestic growth.

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Valuation - Japan needs an earnings catalyst to escape the value trapThe valuation case for Japan is compelling, second only to Korea in our Animal Spirits APAC market universe. As a result, Japan scores well on this metric in our matrix based analysis. For details on the valuation methodology and a global/regional comparison see ANIMAL SPIRITS REPORT 2: APAC Valuation and Earnings Snapshot and for details on the matrix-based country evaluation, please refer to ANIMAL SPIRITS™ REPORT 3: APAC Country Outlook Summary . The highlights are the following:• Dividend yields are rising, are higher than the US and have a much higher coverage ratio at 2.71x versus 1.53x for the MSCI World and a worrisome 1.05x in Europe. Low leverage in Japan (12.32% net debt to equity) means that net cash on a plethora of Japanese company balance sheets is available for ongoing capital management events such as dividend hikes and share buybacks. (Table 1)• Beware dividend "bond proxies" in a rising yield environment! "Dividend growers" such as Japan will likely perform better if and when (we believe Q1 2017) bond yields rise. Stable high dividend stocks will likely behave like "bond proxies", especially if dividends are not well covered and the cost of capital is rising. Mature (slow/no growth) sectors with high dividends are to be avoided. The rising yield scenario is outlined in our macro piece ANIMAL SPIRITS REPORT 1: Macro Backdrop - Base Jumping the Fed with Oil and Inflation Expectations . At a Japanese sector level consequently we are underweight consumer staples, utilities, and telecom. Names should be selected with a clear dividend growth strategy or stock specific growth drivers. In aggregate, these three sectors fall into the "bond proxy" category in our opinion.• Relative to its developed market benchmark, Japan is trading at its biggest PER discount in 12 years (Figure 1).• The heat map in Table 2 demonstrates that Japan is trading both cheaply relative to its developed market peers (top half) and against its own history, according to the low percentile rankings on several valuation measures.• On a CPI-adjusted basis, Japan is the cheapest it has traded on the dividend yield-bond yield gap (Figure 2)• Figure 3 depicts a scatter plot of EBIT margins against EV/EBITDA multiples. Japan is cheap but it sits alongside the "Deflation Group" (largely European nations) and is fairly placed globally given the lower level of profitability. In order to earn a higher valuation multiple, it requires an earnings catalyst, which is currently lacking. This may change if inflation surprises (which we expect in early 2017) or the BOJ-MOF backflips and implements fiscal monetization. However, for the present and for much of Q4 2016, Japan is cheap for a reason and as such is a value trap. There will be more discussion on earnings in the next section treatment of earnings revisions.

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Table 1 - Selected Japanese Valuations and Financials with Global Developed Market Comps

Source: MSCI, Bloomberg, Ballingal Research. Note: Data as of 9/7/2016

Figure 1 - MSCI Japan Historical PER Premium/Discount to MSCI World

Source: MSCI, Bloomberg, Ballingal Research. Note: Data as of 9/7/2016. Note: Data measured in multiple points.


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Table 2 - Developed Market Valuation Heatmap - Multiples and Historical Percentiles

Source: MSCI, Bloomberg, Ballingal Research. Note: Valuation Multiple data as of 9/4/2016. Valuation Percentiles based on monthly data. Date ranges are from 08/2001 to 08/2016 except for Europe PER (from 03/2005), Hong Kong PER (from 12/2001).

Figure 2 - Japan Real Dividend-Bond Yield Spread



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Figure 3 - Japan Valuation Versus Profitability - Global Developed Market Comparison


Earnings - Still dependent on international trade and JPY but there are some green shoots. Inflation is required to induce a domestic demand driven earnings profile in Japan.• The exposure of Japanese corporate earnings to global sectors and the influence of the JPY is well understood. Japan has yet to break the nexus between JPY, earnings, and the equity market. Until the US resumes policy normalization the JPY is likely to be strong and will be a headwind for earnings. As can be seen in Figure 4, FY 2016 earnings revisions are recovering but still lag global peers.• Animal Spirits sees some "green shoots" for a domestic demand driven economy but it has yet to take hold. High corporate cash levels and an aging capital stock should call for robust CAPEX cycle. Loan applications by SMEs for CAPEX are rising but it is early days. The labor market is tight with the job offers to applicants ratio at 1.37 and an unemployment rate at 3 percent. The former is the highest since 1991 and latter indicate full employment in Japan. This should bode well for the next round of wage negotiations in spring, 2017 ("Shunto"). Household balance sheets (and those of corporations) are unleveraged so the scope for investment and consumption cycles is there but a catalyst is required. The Animal Spirits view is that inflation (and inflation expectations) is the key to unlocking the domestic demand potential in Japan, as argued in ANIMAL SPIRITS™ REPORT: BOJ “Comprehensive Assessment”: Tokyo Visit Takeaways.


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• The BOJ is squarely targeting real interest rates. It has done what it can with nominal rates. Now the key to lowering real rates is increasing inflation expectations. Our view is that the oil market is going to do that for Japan as the base effect kicks in in Q1 2017 and should shift inflation and inflation expectations up with it. The latent potential in consumption and investment in Japan could be unlocked next year if real rates get low enough. If so there is a possibility Japan will reach sufficient "escape velocity" to exit the value trap it has been languishing in for some time and re-rate meaningfully.• FY 2016 consensus earnings estimates of a 6.8 percent decline and an 8 percent recovery the following year (Table 1) seem reasonable to us. However, there is upside risk to 2017 earnings if the BOJ/MOF get the monetary-fiscal policy mix right and if our scenario on inflation expectations is correct. In ANIMAL SPIRITS™ REPORT: Fiscal-Monetary Policy Interaction: A Primer, we explore various policy options and advocate fiscal monetization as the fiscal multiplier is likely to be significant and Japan's risks (inflation) in adopting such a bold policy are low since it's starting point is deflation/disinflation and is a net creditor. There is clearly some opposition to fiscal monetization and it will require some legal reform but we don't think it is beyond the Abe Administration, which is a reformist government and has recently increased its house majority. As mentioned above, we have made the case for a shift up in inflation expectations in the November 2016-May 2017 period (Figure 6) based on a normalization in the oil market. Detailsare provided in ANIMAL SPIRITS REPORT 1: Macro Backdrop - Base Jumping the Fed with Oil and Inflation Expectations . Inflation is key to unlocking households and corporate spending power and breaking the JPY-earnings nexus in Japan.Figure 4 - Japan Earnings Revisions Versus Global Developed Market Peers

Source: MSCI, Bloomberg, Ballingal Research, Data as of 9/16/2016. Note: Earnings revisions are based on a 3 period moving average of monthly changes in FY 2016 net profit estimates.


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Economic Policy - 2 Percent inflation target/NIRP to prevail. QQE may not taper but it might twist. Fiscal monetization will likely be a tool but not yet.For the upcoming BOJ "Comprehensive Assessment" of monetary policy, we expect the following:1. NIRP is believed to have worked and in all probability will not be reversed at the September 21 BOJ meeting.2. QQE will not likely taper overall.3. But a "twist" will probably be attempted to steepen the yield curve to nullify the ill effects of NIRP on bank margins and insurance companies' embedded value.4. There is a possibility that corporate bond purchases will be included in QQE.5. Foreign bond purchases are a low probability event.6. Fiscal Monetization (Helicopter Money) is not possible yet.7. For a more detailed treatment of this topic, see ANIMAL SPIRITS™ REPORT: BOJ “Comprehensive Assessment”: Tokyo Visit Takeaways .One theme we would like to develop a little further is the potential for a "twist" in QQE and what this means for the yield curve. Below (Figure 5) is a chart of the yield curve defined as the spread between the 10 year JGB yield and 3-month rates and the change in the yield curve. There are some promising signs already that the yield curve is starting to steepen with the desirable positive slope. In the short-run, this is desirable for banks as it is a boost for NIMs as they fund short and lend long and it is a boost for insurance companies' embedded values. If the Animal Spirits macro scenario of an oil price induced an upward shift in inflation expectations correctly transpires in Q1 2017 then we would expect this to steepen the yield curve much further in Japan. Animal Spirits suggests an overweight position in financials, especially banks and insurers based on this theme. We argue that a steeper yield curve will be pro-growth and will coincide with the desired upward shift in profit margins required to enable Japanese equities to trade at higher valuation multiples.Figure 5 - A Steeper Yield Curve is Positive For Financial Sector Earnings and is Pro-Growth

Source: MSCI, Bloomberg, Ballingal Research


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Macro - Japan gets interesting from 2017. Fed runs "hot" until year end. JPY becomes a tailwind in Q1. The yield curve steeping is "pro-growth". Inflation is key to domestic growth.• Our baseline scenario is the Fed runs "hot" and holds off raising rates until at least December, thus keeping the JPY relatively strong in Q4 2016.• The JPY-corporate earnings nexus has not broken yet so the aforementioned scenario is not favorable for Japanese equities until Q1 2017.• The improving shape of the yield curve (possibly enhanced if the BOJ engages in "twist" tactics) is encouraging but will likely see more steepness from late 2016, once inflation expectations are shifted up by the oil price base effect (Figure 6).• Tight labor market conditions combined with healthy corporate and household balance sheets are indications of latent domestic demand that may be a growth driver in 2017 if inflation resurfaces.Figure 6 - Projected Base Effect (green) and EIA Estimates (purple) on WTI Oil YOY

Source: Federal Reserve Bank of St. Louis, University of Michigan, EIA, Historic Data as of 31/7/2016, Forward-looking YOY based on EIA estimates and fixed historic end-July data.


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Investment Conclusions• We are currently "neutral" in our view on Japan in global developed market portfolios but "underweight" in our APAC portfolio outlook for Q4 2016, as our macro baseline scenario favors emerging markets (Table 3).• The risks to our Japan view are skewed to the upside. Our baseline roadmap is to raise the Japan weighting sometime before year end when it becomes clear that inflation expectations are trending up, driven by the reversion in the oil market. We will be watching the yield curve very closely. Potential surprises include more vigorous fiscal policy or an earlier rate hike than we assume, which is December or Q1 2017.• For US dollar based macro investors or tactical asset allocation, we suggest hedging JPY. Two liquid ETFs that would be appropriate for implementation are Wisdomtree Japan Hedged Eq (DXJ US) and iShares Currency Hedged MSCI Japan ETF (HEWJ US).• Our cautious positioning at an index level reflects short-term (Q4 2016) concerns (near term JPY strength) but our sector and stock selections are based on a longer horizon of 6 months at least, which reflects some "risk on" views presented in this note.• We recommend overweighting information technology, financials, and materials sectors• We suggest underweighting telecom, utilities, and consumer staples.• At a factor/"Smart Beta" level, we believe "value" will likely return to favor and "minimum volatility" will underperform over the next 3-6 months.• Our Animal Spirits "Strategist Top Picks" include Keyence Corp (6861 JP) ,Resona Holdings Inc (8308 JP) , Mizuho Financial Group Inc (8411 JP) , T&D Holdings Inc (8795 JP) and Toray Industries Inc (3402 JP)• Keyence Corp (6861 JP) - Factory automation is a favored long-term theme for Animal Spirits. Keyence has the top global market share for sensors and vision solutions in this space, which yields the company an EBIT margin of 53 percent. With such pricing power, the company's earnings have been able to grow, despite the strong JPY. There are no market comps for this company so DCF is the only way to value it but we like it.


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Investment Conclusions (Continued)Resona Holdings Inc (8308 JP) - Either by a "twist" policy or by the re-emergence of higher inflation expectations later this year, we see the Japanese yield curve steepening, which is advantageous for bank net interest margins. Resona is our top pick among the Japanese banks. It has a clear strategy for focusing on retail banking (not diversifying away from its core competence like some of its competitors). Animal Spirits also likes the fact that it has reduced its JGB portfolio from Y2.151 trillion in 2015/3 to Y498 billion as of 2016/6 and importantly reduced bond duration from an average of 3.3 years to 2.1 years during that time (Source: Resona Holdings, September 2016). If we are right about the shift in the yield curve, we want to see a positive impact of higher NIMs not encumbered unnecessarily by mark to market losses on bond holdings owing to large holdings of JGBs with a long duration. A PER of 6.7x (FY17) and 3.9 percent dividend yield with over 3 times dividend coverage is attractive (Source: Bloomberg consensus estimates).Mizuho Financial Group Inc (8411 JP) - Mizuho will benefit from the improvement in NIMs should our macro call on Japanese yield curves be correct. The management plan is to accelerate the unwinding of cross-shareholdings. As of March 2015, cross-shareholdings stood at Y1.962 trillion and as of June 2016, these were Y1.832 trillion. Mizuho plans to reduce this by Y250 billion by March 2017 and Y550 billion by March 2019. The total JGB portfolio has reduced from Y17. 2 trillion to Y10.5 trillion and duration is averaging 2.6 years, which is acceptable. (Source: Mizuho Financial Group, September 2016). Average JGB duration at competitor MUFG, for example, is 4.2 years. The PER is currently 7.7x (FY17) and the dividend yield of 4.4 percent with over 3 times dividend coverage is hard to overlook (Source: Bloomberg consensus estimates).T&D Holdings Inc (8795 JP) - Our macro scenario of rising yields into early 2017 is a significant positive for life insurers' embedded value. Based on the company results for June 30, 2016, group embedded value was Y1.495 billion so given a current market capitalization of Y832.7 billion, T&D is trading at 44.3% discount to embedded value (Source: T&D Holdings, July 2016 and Bloomberg). Historically, as recent as 2006, T&D traded at a premium to embedded value. Granted, it is not as cheap as it was in July but if embedded value moves up with yields then there is potential upside.Toray Industries Inc (3402 JP) - As discussed in ANIMAL SPIRITS REPORT 2: APAC Valuation and Earnings Snapshot, the best performance of earnings revisions is in the materials sector, which leads us to this textiles and special materials company. Toray has a significant market share overall in carbon fiber for the aerospace industry and is the main supplier for Boeing, with particularly strong demand for the B787. The shares currently trade on a PER of 13.8x and EV/EBITDA of 8.8x (Source: Bloomberg consensus estimates).


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Table 3 - Animal Spirits APAC Equity Tactical Views (3-6 Months)

Source: Ballingal Research, MSCI, Bloomberg. Note: Benchmark used is MSCI AC Asia Pacific Index. Note on symbols in table: single green (positiveview) , double green (very positive view), red (negative view), double red (very negative view), blue (neutral)


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