A quick glance at a chart of this year's performance of the Nikkei tells its own chastening tale. Ha...
A quick glance at a chart of this year's performance of the Nikkei tells its own chastening tale. Having peaked just shy of 21,000 in mid-April, the index has tracked a relentless downward path to its current levels of around 15,000, a fall of over 25%.
Behind the falls have been a catalogue of negative inputs which have dented investor sentiment.
These have included worries about the stability of the Japanese economic recovery, the high profile demise of retailer Sogo and, more recently, heightening concerns over prospects for Japan's exporters as global growth slows. Meanwhile, recent moves on Nasdaq and, in particular, profit warnings from a number of blue chip US technology names, have served only to further depress sentiment towards a Japanese equity market whose foundations are widely perceived as being built on technology stocks.
An interesting comparison between the equity market of 2000 and that of 1999 is the significant shift in attitude towards Japanese equities from overseas investors.
Attracted by the prospects of an economic recovery, large-scale restructuring and a significant improvement in corporate profitability, overseas investors were the driving force behind last year's strong performance in Japanese equities, in stark contrast to the more pronounced scepticism of domestic Japanese institutions. This situation has been largely reversed this year.
In the eyes of most western investors two major concerns exist: first, the strength of the Japanese economic recovery in an environment highlighted by a downturn in the technology cycle; and second, the perception that the pace of restructuring is actually slowing. By and large, foreigners' concerns are a result of their very concentrated ownership of the market.
For investors who are heavily overweight technology names, the durability of the high tech boom is particularly worrisome. Similarly, the lack of restructuring efforts within the foreign-owned high tech sector has led to a misconception that the rest of corporate Japan is not restructuring.
However, while the importance of restructuring as a theme may have faded within the equity market, in reality the physical process at companies around the country continues apace.
This is clearly shown in the data relating to capital expenditure, employment and labour productivity as well as in companies' earnings results. For example, although capital expenditure is one of the major drivers of the economic recovery, in particular IT investment, it has failed to accelerate as strongly as many had expected. This leads to the logical conclusion that management is imposing severe profitability checks on prospective investments and that talk of setting return on investment targets, for so long an anomalous concept to corporate Japan, is actually being translated into action.
Labour data tells a similar story. Although the headline unemployment rate has reached a plateau at 4.5%, if one were to reconstitute the index to include those workers that have effectively dropped out of the labour force, then the unemployment rate has continued to rise.
Although rising levels of unemployment are not traditionally a positive sign for the economy, or the equity market, we take this as clear evidence that Japanese corporate managers are taking the hard decisions regarding cutting labour forces. As a result labour productivity remains on a sharply rising path which has positive implications ultimately for corporate profits.
The principle reason for the misconception regarding restructuring has been the slowdown in announcements that peaked, in absolute terms, at the end of 1999. However, while the easy restructuring announcements, such as the sale of a corporate HQ or the introduction of an early retirement scheme have been made in a blaze of publicity, the more difficult decisions have not been getting the press column inches that perhaps they deserve.
Japanese business leaders, with the obvious exception of Carlos Ghosn, brought in by Renault to turn around Nissan, do not gain critical acclaim for the axe-cutting of factories or personnel.
However, although diminishing as a news story, the area where one would expect to see restructuring have the biggest impact would be in profitability.
There is no denying that over the last 12 months Japan has seen a rapid increase in corporate profits. According to the Ministry of Finance's corporate survey, economy-wide profits have been rising at over 40% year-on-year for the last three quarters.
This is the strongest performance for 20 years. This series is extremely cyclical, reflecting underlying trends in the Japanese economy. However, what is notable is that profit growth has been particularly strong, despite a growth background that has been much less supportive than has been the case historically.
Cause and effect
So what has caused this? Trends on the sales side or the cost side?
The evidence points very clearly to cost control being the main determinant of the profits recovery. Sales growth has failed to make an impact on profits. Even by the standards of the anaemic 1990s recent sales growth has been particularly disappointing, reflecting the deflationary trends in the economy. With regard to the cost side the two main components to focus on are cost of goods sold (Cogs) and sales, general and administration (SG&A).
The story on the first is relatively well known, in that there has been a long-term downward trend in Cogs relative to sales, which is expressed in a widening gross margin.
This reflects a varying combination of weak commodity prices, the squeezing of small company suppliers and the relocation of manufacturing plants to lower cost centres in Asia. Despite the recent rise in oil prices the likely trend of the gross margin is to widen further.
The more significant issue concerns SG&A expenses. There has been a long-term upw
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