We continue to monitor the improvement in Japanese corporate governance by concentrating on the structural shift towards higher profitability. While increasing the number of independent directors and other governance issues are very important in the intermediate term for Japan, it is crucial for investors to understand that much of the profitability message has already been understood by Japanese corporates for a decade. This is shown by the divergence in the profit margins from the trend in GDP growth in the chart below, showing that even though GDP growth has remained quite subdued, profit margins have surged.

Since the Koizumi era, Japan has embarked on major rationalizations in many industries, with the number of players often reduced from upwards of 10 players in each industry down to a few stronger and more profitable leaders. The fruits of this restructuring were slower to ripen than in Western world examples, and they were hidden by a series of crises (the Lehman shock, the turbulence in China, the strong Yen and of course, the Tohoku crisis), but since Abenomics began, the global backdrop for Japan has been stable and there have been no domestic crises, thus allowing the fruits to ripen.

The CY1Q15 data on overall corporate profits (not just of listed companies) announced on Monday continues this upward trend, showing that the pretax profit margin's four-quarter average hit a new high of 4.96%. We expect that profit margins will expand further in coming quarters, driven by a large corporate tax cut and continued industry rationalizations that further prove that Japan's structural profitability trend continues upward. It is also worth mentioning that forex related profits are not the only driver of this improvement, as the profit margin of services industries also surged to a new record high, as shown in the second chart below.

Four-quarter Average of Pretax Profit Margin vs. Japanese Nominal GDP YoY Growth
(for all non-financial companies, not just listed ones)

Source: Japan Ministry of Finance, Bloomberg, data through 1Q15

...and for Non-manufacturers excluding Financials

Source: Japan Ministry of Finance, Bloomberg, data through CY1Q15

Of course, this improving structural profitability trend has become more fully realized by global investors, who should ignore the few remaining macro-based strategists who say that Japanese equities can only rise if the Yen weakens further. The market has proven that the latter statement is untrue by outperforming major global markets this year.

Conclusions

  1. Years of corporate restructuring's progress was hidden due to successive global and domestic crises.
  2. “Show me the Money!” corporate governance: Japanese companies do care about corporate profitability.
  3. The dividend paid by TOPIX is surging upward and we expect it to double in the five years from 2013-2018.
  4. On top of the corporate tax cut in April, Abenomics is having a strongly positive effect on profits due to the normalized Yen and further deregulation should gradually push profit margins higher.
  5. Poor demographics are linked with GDP growth, but countries with strong automation and efficiency capabilities can completely offset such (see our report on Debunking Demographics). As these charts show, even if Nominal GDP growth is fairly flat, corporate profits can rise sharply in Japan due to productivity increases and gearing to global growth via multinationalization.