tokyo signals, noise & strategy

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Japan Equity Research03 July 2014

Tokyo Signals, Noise & Strategy- Vol 23Risky Business

Strategy

Patrick Rial, CFAAC

(81-3) 6736-8649

[email protected]

JPMorgan Securities Japan Co., Ltd.

Jesper J Koll

(81-3) 6736-8600

[email protected]

JPMorgan Securities Japan Co., Ltd.

Rajiv Batra

(91-22) 6157-3568

[email protected]

J.P. Morgan India Private Limited

See page 17 for analyst certification and important disclosures, including non-US analyst disclosures.J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that tfirm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factormaking their investment decision.

Risk is the permanent loss of capital, never a number James Montier, #5 of theSeven Immutable Laws of Investing.

The decline in volatility has captured headlines in recent weeks and coincidedwith continued steady gains by equity markets, including Japan.

And yet, Japan still cannot match the US for volatility-adjusted returns. Thus, itbecomes a market that global investors tend to loathe most of the time therisk-reward outlook has been inferior to other markets, yet periodic violentrallies can cause bouts of underperformance for those who are underweight.

While we do not have a particular outlook on overall volatility levels in Japan,which are being driven by global circumstances, in this report we explore thereasons for Japans consistent excess volatility relative to the US market.

We identify three factors that we believe are the primary culprits: 1) lack ofparticipation in the market by domestic institutions; 2) underlying instability ofearnings due to a high fixed cost structure and low margins; and 3) lowdividend payouts, which creates significant downside when the market shiftsaway from earnings-based valuation metrics.

We believe the latter two factors are undergoing a permanent structuralimprovement trend, while our expectations remain low for more active domestic

participation in the market.

From the business weeklies: Toyo Keizai highlights conflicts of interest in

Japans fund management industry. Diamond Weekly issues a special report onthe logistics industry in Japan, noting how a labor shortage is forcing companiesto rethink their business models.

New insights from our analysts: Hirokazu Anai reiterates a bullish stance onDaiwa House with property sales set to generate substantial profit over the next2-3 years. Toru Nakahashi downgrades Okuma to Underweight withexpectations that the machine tool cycle will enter a downtrend in 2H. HisashiMoriyama raised estimates on Mitsubishi Electric, with the electronic devicessegment set to overshoot company plans.

TIJ: Researchers have identified a number of quick fixes that could slash thecost of doing business in Japan, although they want to eliminate the belovedcompany seal.

ContentsStrategy InsightsNoise & Signals f rom the Local PressTactical View NeutralNew Insights from Our AnalystsJ.P. Morgan Japan Top-Down ThesisWhat Were Watching Key Drivers of OurThesisThis is JapanTokyo Signals, Noise & Strategy Backlog


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Japan Equity Research

03 July 2014Patrick Rial, CFA(81-3) [email protected]

Strategy Insights

Japan's Excess Volatility

Performance is picking up once again in the Japanese market, while volatility hascollapsed across all asset classes globally. Our global asset allocation team succinctlydefines volatility as the product of the supply of surprises (news) and thevulnerability of markets to these surprises (leverage). For a more in-depth read onthe current global trend in vol, please seeFlows & Liquidity: Where do we findleverage?

Japan is no exception, with realized 90-day equity volatility now at 16%, a seven-month low. Still, the decline has been even more dramatic in the US (not to mentionother asset classes).

Figure 1: 90-day Annualized Volatility - TOPIX and S&P 500

Source: Bloomberg, J.P. Morgan

We find that Japan consistently exhibits a higher level of volatility compared withthe US: 90-day vol has for the TOPIX has been higher than the S&P 500 75% of thetime since 1990. Examples of recent periods when Japan volatility undershot wasduring the 2008 global financial crisis and in 2011 amid a flare-up in Europes debtcrisis.

0%

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2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014TPX S&P
https://jpmm.com/research/content/GPS-1428233-0https://jpmm.com/research/content/GPS-1428233-0https://jpmm.com/research/content/GPS-1428233-0https://jpmm.com/research/content/GPS-1428233-0https://jpmm.com/research/content/GPS-1428233-0


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Figure 2: %pt Spread Between TOPIX and S&P 500 Volatility%pt


Based on Sharpe ratios for annual returns of the S&P 500 and Topix index in USDterms, we find that Japan has produced lower volatility-adjusted returns for each ofthe past five years, despite comparable percentage gains in two of those years.

Figure 3: Sharpe Ratios and Annual Returns - S&P 500 + TOPIX (USD)


We recognize that volatility is not the same as risk, and thus we also derived SortinoRatios, which look specifically at downside volatility, as investors should in factwelcome upside volatility. Based on annual returns back to 1988, not only has theS&P 500 provided less downside volatility, but so has the MSCI Emerging Marketsindex, this in spite of the large draw-downs during the Asian Financial Crisis.

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S&P 500 Sharpe (LHS) TPX $ Sharpe (LHS) S&P Return TPX $ Return


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Figure 4: Sortino Ratio Based on Annual Returns 1988-2013


One factor that serves to boost Japan volatility is the absence of a counterbalance tooverseas investor trading flow from the domestic asset management community. Inthe US, it would appear that the equity ownership culture has created a strongappetite among individuals investors to use minor pullbacks as opportunities forlong-term accumulation. By contrast, we view the active individual participants inthe Japanese market as more momentum-driven and hesitant to buy on small declines,

but more apt to position for reversals on larger drops.

Thus, there appears to be an opportunity to counterweigh such momentum strategies,but domestic institutions either lack the desire or the available funds to do so.

Figure 5 shows the combined share of Japanese equity value traded by insurers,investment trusts and banks on an inverted scale. When trading share by these groupsis high, it appears to reduce or reverse the excess volatility of the TOPIX relative to

the S&P. We note that domestic institutional share of trading has hovered between 6-8% since April 2013.

Figure 5: Domestic Asset Manager Trading Share and TOPIX / S&P Volatility Spread%


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Spread of TPX/S&P 90d Vol (LHS)

Japan Domestic Institution Trading Share (Inverted) (RHS)


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Profitability of Japanese companies has also historically been much more volatilerelative to US peers. We believe this is in part due to the post-bubble economic

decline resulting from deleveraging and asset price deflation. However, there is alsoan underlying vulnerability of profits to sales shocks due to a high fixed coststructure and low margins.

In contrast, we believe US corporate management is more focused on responding tosales growth disappointments with fixed cost reductions (i.e. layoffs), while the lesscapital intensive structure of the US economy provides a naturally lower ratio offixed to variable costs.

Figure 6: S&P 500 and TOPIX T12m Operating Margin%


As might be expected, the market has rewarded periods of stability with highervaluations in Japan. The annualized volatility of operating margins shows that

periods of stable margins coincided with higher P/B ratios, particularly 2005-2007.

Figure 7: TOPIX Price Book Ratio and Volatility of Operating Margins


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S&P-TOPIX OPM Spread TOPIX T12m OPM S&P 500 T12m OPM

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Still, even though margins have been stable and are now approaching historic highsreached in 2006, valuations remain depressed on a P/B basis.

The reduction in debt relative to equity should also aid in stabilizing earnings asfixed interest and debt repayment expenses decline. Topix net debt/equity hasdeclined 40% from 2009 levels, and now stands at the lowest level since data isavailable from Bloomberg. This impressive feat pales compared to the deleveragingof the US, but still represents a dramatic change, in our view.

Figure 8: TOPIX and S&P500 Net D/E Ratio


The impact of deleveraging is further aided by the ongoing decline in interest rates inJapan. While we dont have aggregate data on interest expense, Toyota Motor

provides one example of the reduced ability of debt to negatively impact earnings.Despite rising overall debt levels as the company has grown, Toyotas interestexpense has trended steadily lower, so that now the company pays only 0.13%annually in interest relative to its total debt burden.

Figure 9: Toyota Motor Interest Expense and Total Debt bi llion


Lastly, we look at the impact of returns to shareholders on share price volatility. Webelieve that the majority of the time, the market will value shares using and estimateof future cash flows.

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Interest Expens e (LHS) T ot al Debt (RHS)


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However, in periods where the earnings outlook is particularly unclear or poor, thereshould be a tendency to use more defensive valuation metrics including dividend

yield and asset valuations such as P/B.

The problem for Japan derives from the fact that companies have traditionally paidout relatively little in dividends and buybacks, leaving a large gap between areasonable earnings-based multiple and a reasonable dividend or asset multiple.

Over the last 10 years, the TOPIX has found support at about a 2.7% forecastdividend yield, both during the global financial crisis and in 2012.

Figure 10: Topix and Forecast Dividend Yield


In the following table, we show how the dividend yield and payout ratio can be usedto derive a P/E ratio. Thus, if a growth stock is priced at 25x P/E and only pays out25% of earnings in dividends (and buybacks), in an environment where the marketdemands a 3% dividend yield to compensate for perceived risk, the P/E would needto decline to 8x.

However, if the payout ratio were much higher, at 50%, a 25x P/E stock could findsupport at 17x P/E assuming a 3% yield is required by the market.

Table 1: P/E Derived From Payout Ratio and Dividend Yield

Payout Ratio

20% 25% 30% 35% 40% 45% 50% 55% 60%

Dividend Yield 1.0% 20 25 30 35 40 45 50 55 60

1.5% 13 17 20 23 27 30 33 37 402.0% 10 13 15 18 20 23 25 28 30

2.5% 8 10 12 14 16 18 20 22 24

3.0% 7 8 10 12 13 15 17 18 20

3.5% 6 7 9 10 11 13 14 16 17

4.0% 5 6 8 9 10 11 13 14 15

Source: J.P. Morgan

We believe that payout ratios (dividends and buybacks combined) are on a structuraluptrend in Japan due to factors including an end to the deleveraging phase, bettermargins as management reorients toward a focus on profitability, and ongoing

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pressure from minority shareholders. In the latest fiscal year the total payout ratiowas approximately 37%. We expect this can rise to 50% in the next few years (which

would still trail the 70-100% recent range for the US).

In conclusion, many of the sources of Japanese excess volatility are starting tounwind and that should have positive implications for valuations going forward.


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Noise & Signals from the Local Press

Japans Fund Industry Riddled with Conflicts of Interest

While the rest of the world has experienced an explosion of the asset managementbusiness, Toyo Keizai delves into why Japans industry has barely grown. At theheart of the problem, according to the report, is the keiretsu" relationships between

brokerages and asset managers, with the parent bank overseeing it all. One formerfund manager says he keeps all his money in money market funds, instead of anyinvestment products because hes seen how the sausage is made.

One problem asset managers face is that banks transfer people into senior fundmanagement positions, but they have no experience managing money and tend to dohigh-cost day trading. Another is that because the sales arm brokerages and assetmanagers are so closely linked, fund companies are forced to supply new products to

satisfy the sales force, but which arent in the best interest of customers. The result isthat the number of zombie funds is huge, where investors have largely pulled out, butthe statutory life of the fund has yet to expire and all the relevant back-office coststhat come along with a fund must keep being paid.

Even worse is the situation of Bansei Securities and Bansei Asset management,which were recently cited by the FSA. Bansei Securities was found to unload someloss-making bonds to its fund investors over a number of years, but transferred themat prices higher than their true value, forcing the investment funds to eventually takethe losses. (Weekly Toyo Keizai, p. 46, July 5 edition)

Transformation in Japans Logistics IndustryA shortage of drivers is causing major disruptions to the logistics industry, and nowas the summertime gifting season approaches, delays may become the rule ratherthan the exception. Consumers have gotten used to the idea of overnight deliverywhen they order on the Internet, but they will now find wait times extendingdramatically.

55% of trucking companies report a shortage of drivers according to a recent survey,with the remainder saying conditions are unchanged, and no one seeing an excess ofworkers. This is leading to an increased utilization of rail and ships for transport overmedium and long distances within Japan.

Recognizing the increasing importance of logistics to growth in e-commerce,

Rakuten attempted to copy the Amazon model of centralized warehouse andnationwide shipping. However, inventory management proved more difficult thanexpected, and the company is now exiting. Yahoo Japan is testing a different model routing orders made on its shops to local outlets, thereby decreasing the time anddistance between shop and customer, and thus lowering logistics costs. Askul,meanwhile, is using state-of-the-art packaging equipment imported from France togain an edge. (Diamond Weekly,p. 28, July 5 edition)


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Tactical View Neutral

Summary of Key Market Directional Indicators

Indicator 6m Ago 3m Ago CurrentFwd 3m

(Est)

OECD G7 LI 6 Mos % Chg - - - +

Consensus EBITDA & DividendRevision Trend

+ + Neutral +

Topix Blended ValuationIndicator

- Neutral Neutral

Overseas Investor Net Buying -12m Trend

- - - Neutral

Leveraged Fund Positioning - + Neutral

Bear / Bull Ratio in Leveraged Index Funds


OECD G-7 Leading Indicator 6M % Change Rate


Blended Valuation Score and Topix Index


Next FY Consensus Topix EBITDA & Dividend 5 Week Rate of Change


12-Month Net Foreign Buying of Japanese Stocks trillion


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New Insights from Our Analysts

Daiwa House Industry (1925): Raising Price Target: Sustainable Growth via CapitalRecycling

Hirokazu Anai

6/26/2014

- Amid record-high operating profit, we think factors such as gains from the sale of investment properties positionthe company for profit growth for the next 2-3 years.

- We expect building contracting to drive profit growth in FY2014, and look for property sales to J-REITs and profitgrowth at acquisitions (subsidiaries Fujita and Cosmos Initia) to support overall profit growth from FY2015 through

FY2018.

- The company also had 278.5 billion worth of rental property (rental housing, commercial facilities, logisticsfacilities) planned for sale at end-FY2013. We think it will very likely sell investment properties with stableoccupancy to J-REITs, and expect gains from the sale of such properties to drive overall profit growth from FY2015.

Okuma (6103): Risk-Reward Tradeoff Worsens Again on Poor 1Q Start; Downgrading to

Underweight

Toru Nakahashi

6/20/2014

- Expectations about capital investment activity remain high thanks to Abenomics policies and improving business

confidence, but new orders are currently trending flat and still lack momentum. Reflecting our view that the machinetool cycle will decelerate in FY2015, we downgrade our rating from Neutral to Underweight.

- We expect the machine tool cycle to enter a downtrend from 2H FY2014, and in FY2015 we therefore expectsales to decline 8.6% YoY to 132.8 billion and operating profit to fall 26.0% to 9.7 billion.

Shiseido (4911): Cautiously OptimisticEarnings Outlook Bright, Though Merits

Vigilance

Ritsuko Tsunoda

6/27/2014

- Shiseido has begun its drive towards more precise operational management under the leadership of new CEOMasahiko Uotani. Its margins should also change if it can clarify accountability and results by making domestic

sales visible and by managing earnings by brand.

- Investors have high hopes of medium-term margin improvement, but there is also near-term selling pressure fromsome investors, triggered by sales momentum in Japan and China. We think the share price range will be markedup, though with a tug-of-war between sales momentum and improving margins as these are priced in. In light of the

current earnings profile, characterized by thin margins and high operating leverage, we believe Shiseido's shareprice carries the greatest upside potential within the toiletry industry.

Mitsubishi Electric (6503): Raising Our Estimates for the Electronic Devices Segment Hisashi Moriyama

7/2/2014

- Electronic devices segment poised to beat full-term guidance by 11 billion: Full-term guidance calls for sales inthe electronic devices segment to rise 65.3 billion YoY to 260.0 billion. Assuming a marginal operating margin of50%, this translates to 32.6 billion YoY growth in segment operating profit. However, because we also factor in

higher fixed costs, we look for segment operating profit to rise 17 billion YoY to 27 billion. This topsmanagements 16 billion profit target for the segment by 11 billion. Based on this outlook, we also raise ourFY2015 consolidated operating profit forecast to reflect an upward revision to our profit estimate for the electronic

devices segment.

- In FY2014 we expect steady growth in the social infrastructure business, a recovery in the industrial automationsystems business, and earnings growth in defense-related business.
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J.P. Morgan Japan Top-Down Thesis

We believe Japan remains on track for a multi-year bull-market in Yen riskassets, equities and real estate. In 12-15 months we forecast TOPIX at 1450.

While Japan's inherent high level of volatility leaves structural bulls exposed tohigh risk of tactical missteps, we maintain our call for a strategic peak-cycletarget of 1600.

Earnings are the most important fundamental driver of equity markets, and forlisted companies both the quantity and quality of earnings are only at the very

beginning of a multi-year structural up-shift. We forecast peak-cycle EPS at 118likely to be achieved by FY3/16E. This is significantly above the previoushistoric record of 101, and the current consensus 99.5 for FY3/16E. Our bullishtarget is driven by a combination of both top-line growth and productivity-ledmargin expansion.

Against our thesis of positive structural change, tactical calls have been a force offrustration. This is because immediate policy-induced positive catalysts have notmaterialized: nuclear power re-starts have been postponed; Bank of Japan policy

priorities have switched from pro-active to re-active; and, most recently, thechances of Abenomics re-kindling the imagination of global investors by

presenting a concrete corporate tax cut proposal appear to have been pushed backuntil the autumn.

From here, we think the markets directional dynamics thus have to bedetermined primarily by "orthodox factors valuations, earnings momentumand the business cycle; rather than a top-down policy induced boost to price-earnings multiples. The good news is that orthodox" factors are poised set toturn into concrete positive drivers. The market has priced out any "Abenomics"

premium, and now trades on both absolute and relative valuations that areattractive.


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Japan TOPIX outlook JPM versus consensus

FY3/13 FY3/14FY3/15

EstFY3/16

Est10Y

Peak

EPS

Cons. 51 84 89 99 101

JPM 100 118

Sales

(tn) Cons. 416 460 450 463 550

JPM 480 500

Margin

(%) Cons. 2.6% 4.0% 4.3% 4.7% 5.1%

JPM 4.9% 5.4%Source: DataStream, IBES, Bloomberg and J.P. Morgan estimates

TOPIX forward EPS

Source: : DataStream, Bloomberg and J.P. Morgan calculations

ROE Back toward 11%

Source: DataStream, Bloomberg and J.P. Morgan calculations

TOPIX companies Net margin (EPS) %


TOPIX companies Sales (JPY, trillion)


TOPIX earnings % share of GDP


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Forward EPS

12-month moving average

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What Were Watching Key Drivers of Our

Thesis Credit Cycle Monthly bank loan data we expect continued confirmation of a

sustained pickup in the credit cycle. Revision of the money lending law to easerestrictions on consumer lending would also be an important catalyst.

Fall: The most immediate catalyst is bound to be the next round of consensusupward revisions. In our view, the run-up to the mid-year results season -August/September - is thus likely to mark the next up-leg in Japan. The majordownside risk would be unexpected Yen strength or a spike in JGB yieldsundermining confidence in the stability of the banks.

Mid-Year: TPP: Progress on Trans Pacific Partnership free trade negotiationscontinues to be slow. Successful navigation by Abe will be key to maintaining

investor confidence in reform momentum.

March 2015: Additional BOJ Easing: We have pushed back our call for earliereasing as the central bank appears content that the current inflation trend willcontinue. We now expect March 2015 to be the likely timing of additional easing,or an extension of the current QQE program.


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This is Japan

As part of PM Abe's growth strategy he has named improving Japans ranking in theWorld Banks ease of doing business survey from the current #15 to #3 (among high-income OECD countries.)

Rather than just dismissing this as sloganeering, researchers Jamal Haidar at the ParisSchool of Economics and Takeo Hoshi at Stanford University identified in a newwhite paper concrete yet simple steps the country can take to propel itself up therankings in short order.

By and large, the recommendations center around reducing the amount of paperworkneeded to open a business or conduct new operations, as now entrepreneurs need tovisit multiple government offices and file multiple applications for just about anystep they want to take.

Such streamlining efforts should be readily adopted, but we wonder if they will gainany support with their recommendation to eliminate company seals used to stamp alldocuments of importance, a medieval holdover that has shown remarkable staying

power.

The researchers assert that adopting all of their recommendations would catapultJapan to #9, while they caution that a move to #3 doesnt seem particularly realisticat the moment.


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Tokyo Signals, Noise & Strategy Backlog

Date English Japanese

6/26/14 Vol 22: From Good to Great Vol 22:

6/19/14 Vol 21: Waking up from History Vol 21:

6/12/14 Vol 20: Are You Paying Attention? Vol 20:

6/5/14 Vol 19: Times They Are a-Changin' Vol 19:

5/29/14 Vol 18: A Shareholder Yield Enigma Vol 18:

5/21/14 Vol 17: Winning the Loser's Game Vol 17:

5/8/14 Vol 16: In Search of Guidance Vol 16:

4/23/14 Vol 15: Sutton's Law Vol 15:

4/16/14 Vol 14: Seeing Through A Glass Darkly Vol 14:

4/9/14 Vol 13: The Truth Will Out Vol 13:

4/2/14 Vol 12: Skating on Thin Ice Vol 12:

3/26/14 Vol 11: Bye Japan or Buy Japan? Vol 11: Bye Buy

3/19/14 Vol 10: Payback Time Vol 10:

3/12/14 Vol 9: The Pendulum Swings Back Vol 9:

3/5/14 Vol 8: Death and Taxes Vol 8:

2/26/14 Vol 7: The Existentialism of Corporate Japan Vol 7:

2/19/14 Vol 6: Other People's Money Vol 6:

2/12/14 Vol 5: Waiting for Mrs. Watanabe Vol 5:

2/5/14 Vol 4: The Element of Surprise Vol 4:

1/29/14 Vol 3: Death of a Grizzly Bear Vol 3:

1/22/14 Vol 2: What You Pay & What You Get Vol 2:

1/15/14 Vol 1: Feed the Birdies Vol 1:
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