The rise of Japan Inc.

Japanese equities are booming. Despite slight downturns in June and July, due to concerns about the impact of a potential US rate hike and worries about the Chinese slowdown, the benchmark Nikkei 225 index has posted sustained, substantial gains since the end of 2013.

Indeed, although macroeconomic developments remain subdued and public debt is huge, there remain very good reasons to be positive on the country's equity markets - especially the corporate sector's increasing focus on profitability and shareholder value.

Within days of taking office in 2012, prime minister Shinzo Abe laid out his strategy for resuscitating the economy through three key actions: fiscal spending, monetary easing and structural reform.

Abenomics

Abe has so far only shot two of the three arrows in his landmark reform plan, known as "Abenomics", although more progress is being achieved on the third arrow - structural reform - than currently meets the eye.

Since 2012, Bank of Japan governor Haruhiko Kuroda has overseen a quantitative easing (QE) programme that is injecting ¥80 trillion (£413 billion) annually into the national economy. So the central bank is increasing QE by 15% of GDP.

Japanese QE is ostensibly aimed at staving off deflation and generating an annual inflation rate of 2%. Despite a strengthening labour market and improved manufacturing output, this remains an area of concern. In June 2015, the inflation rate remained low - at 0.4% on an annualised basis - on the back of soft oil prices and weak household spending both.

Meanwhile, the massive government pension investment fund - with assets of ¥137 trillion, nearly equal to the annual GDP of Mexico - is now pivoting firmly away from bonds in favor of riskier equities. The aim of this strategy, in place since the fourth quarter of 2014, is to stimulate the overall economy and finance ballooning pension payments.

Actions by Abe and Kuroda have helped bring down exchange rates, supporting significantly increased export levels. Indeed, the yen has fallen 30% against the dollar since the end of 2012, leading to a rise in exports, boosting corporate earnings.

Structural reform progress

Abe's third arrow has disappointed investors until now. However, progress is already taking place. The prime minister's reform package aims to liberalise the economy and labour markets and foster innovation, facilitating greater (local and foreign) entrepreneurship and overhauling corporate governance.

Japan's tourism sector, for example, is now extremely strong - with monthly visitor numbers reaching 1.64 million in May 2015 alone, up 50% compared to the same period in 2014.

The energy sector is also picking up, including through the imminent restarting of the country's nuclear power sector some four years after the disaster at the Fukushima Daiichi power plant, caused by a seismic tsunami. All of Japan's nuclear plants were shut down in the wake of that catastrophic event. Officials have now approved the resumption of operations, starting this summer.

Another key supporting factor is that corporate majors, such as Canon, Nissan and Panasonic, are increasingly "reshoring". Moving production back to Japan, partly as a consequence of the weak value of the yen and rising overseas labour costs, is a major plus for the country's export sector - and for overall employment.

Meanwhile, the prime minister has been especially successful in implementing market reforms. In 2014, the Abe government introduced the JPX-Nikkei 400, which weighs companies by operating profit and return on equity (ROE), in addition to market capitalisation - encouraging firms to reduce their large cash piles and return more cash to shareholders.

Hoarding cash

Indeed, the Japanese corporate sector is famous for hoarding cash: ROE in Japan is just 10% versus 17% in the US, while cash amounts to 47% of GDP versus 10% in the US.

This renewed focus on ROE and dividends has produced significant results: in 2014, shareholders received the highest level of returns ever, a record ¥12.8 trillion over the 12-month period, a 33% increase in dividend revisions and 93% increase in the value of share buybacks.

For 2015, profits are expected to grow by more than 20%. The Nikkei 400 will be reshuffled with a far higher RoE for the new members. The Toshiba scandal showed that CEOs are still far too loyal to their predecessors as they refused to write down the former CEOs' non-performing divisions.

Until now, Japan's equity rally has been based on earnings growth; by comparison, multiple expansion has been the driver in many other regions. The Topix has a 12-month price/earnings ratio (P/E) of 15.5 - below American P/Es - and a price-to-book ratio of less than 1.5. Dividend yields amount to only 1.8%, but are expected to increase.

Moving forward, earnings growth will accelerate, while valuations will remain attractive.

Japan Inc. is steadily moving in the right direction. With increasing earnings, decreased cash hoarding and a fundamental shift in corporate behavior, the outlook for the country's equity market is firmly positive.

Ineke Valke is senior investment strategist at Amsterdam-headquartered Theodoor Gilissen, a member of KBL European Private Bankers.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.