“In Japan…nothing makes any sense. They’re very polite, but you feel like a joke is being played on you the entire time.” Bill Murray, Actor and Comedian
It could be plausible that Bill Murray’s quote is attributed to investing in Japan. It has been a graveyard for many an investor over the years, with many false dawns and lost hope, lending itself to the moniker of the proverbial value trap.
However, at times of elevated global economic, political, and monetary policy uncertainty, investing using valuations as a starting reference is as strong a guide to future returns as one may have. With that in mind, one cannot help but recognise the current valuation of the Japanese financial sector.
If we consider three of the largest banks in Japan, Sumitomo Mitsui, Mizuho Financial and Mitsubishi UFJ, the valuations are quite something. The price earnings ratios are no higher than 7.8x and the price to book ratios no greater than 0.53x.
These valuations are largely lower than at any time through the 2008-09 financial crisis which perhaps brings context to the severe stress, or perceived stress in the sector. If we drill down on the numbers and consider Q3 2008 as a period of extreme stress for the global financial sector, Sumitomo Mitsui was trading at 12.8x price earnings and 1.55x price to book on 30 September 2008, and today trades at 6.55x and 0.53x respectively (as at 20/04/16; source Bloomberg).
The MSCI Japan Financials Index has fallen some 22% over 1 year (to 20/04/16) with much of that negative performance coming in January and February 2016 as the Bank of Japan introduced a Negative Interest Rate Policy. This policy clearly puts downward pressure on bank profits, so it is very reasonable that the sector deserves this moribund rating attributed to its stock.
However, taking a step back, these valuations do appear to price in a rather apocalyptic scenario.
The three banks in question generate around 50% or less of their gross profit from net interest income, with the balance from other sources. This universal model of banking lends itself to a broader revenue base, not necessarily linked directly to Tokyo Interbank Offered Rate (TIBOR).
Japanese bank balance sheets are incredibly strong and perhaps more so today than they ever have been due to the conservative approach adopted post the Asian banking crisis. Bankruptcies are low and exposure to the resources sector is limited. Yields are healthy (and pay-out ratios modest) – Sumitomo is currently yielding 4.2%, Mizuho 4.5% and Mitsubishi 3.5%. This is not only enticing for foreign investors, but increasingly so for domestic investors considering the Japanese Government Bond 10 year yield is negative 0.13%.
Investing in Japan can at times make little ‘sense’ considering the demographic, the debt burden and the strength of the currency; but perhaps with a value led approach, allocating to the region, and specifically to the beaten up financial sector, may actually be quite sensible. The yields on offer are noteworthy compensation for being too early, with the valuations offering longer term upside potential.