2021 Outlook on Japan

In this article, we will analyze the investment opportunities in the two Northeast Asian equity markets—Japan. We believe that the new economic sector in Japan will deliver a potential upside. iFAST Research Team Published on Dec 31, 2020, 10:10 AM Research Market Update , Equity , Small to Medium Companies , Market Analysis , Equity Funds , General

Photo by Su San on Unsplash

Japanese Equity Market • The auto industry will bounce back strongly next year and contribute to the upside earning growth. • The six major constituents in the Nikkei 225 come from different sub-sectors, accounting for 32% of the index. These sectors are predicted to rebound strongly in the next two years. • We believe that the earnings prospects of Japanese stocks in the next two years are bullish without serious fundamental problems. However, the problem lies in their high valuations. • The Nikkei 225 is expected to reach 30,000 by the end of 2022. It can be seen that even if the earnings outlook is still healthy, the increase will be limited by its high valuation.

Nikkei 225 Index will focus on new economic sector

As to Japanese market, Nikki 225 is a price-weighted index like the Dow Jones Industrial Average, but it focuses more on new economy sector evidenced by technology stocks taking up more than 46% of the index. The top 10 constituents are dominated by companies with fast earnings growth, such the Uniqlo's parent company, Fast Retailing, SoftBank, the third largest semiconductor equipment manufacturer, Tokyo Electronics, a mechanical equipment manufacturer, FANUC, and the telemedicine service provider, M3. Unlike KOSPI, Nikki 225 is more diverse without being dominated by a single industry or stock.

On the contrary, the cap-weighted TPOX is dominated by large old economy sector, including Toyota, Sony, Nippon Telegraph, Mitsubishi UFJ, Takeda Pharmaceuticals, etc., which is totally different from Nikki 225 in concepts. In fact, the holdings of Japanese equity funds are closer to the allocation of Nikkei 225.

The six major holdings are likely to support earnings growth

The overall earnings performance of Japanese stock market this year has been dragged down by multiple sectors, such as consumer discretionary, consumer staples, financial and industrial sectors. Even so, these sectors are expected to welcome a sharp rebound in the years to come. Similar to South Korean market, Japan's consumer discretionary sector contains many automakers. This sector is estimated to make a comeback next year and contribute to the index's earnings growth.

Table 3: Six major constituents in the Nikkei 225 Index

Index 2020 2021 Est 2022 Est 2020 Est 2021 Est Company Sector Weighting Est EG EG EG PE PE

Fast Retailing Co 11.72% Retail 91.25% 19.83% 12.80% 49.38 41.21 Ltd

SoftBank Group 5.95% Telecommunications N.M -50.20% 14.86% 8.17 16.41 Corp

Tokyo Electron 4.84% Tokyo Electron Ltd 18.99% 17.78% 10.68% 25.12 21.33 Ltd

FANUC Corp 3.46% Machinery-Diversified -2.40% 50.17% 22.87% 69.21 46.09

Daikin Industries 3.23% Building Materials -14.79% 39.42% 18.51% 48.36 34.68 Ltd

M3 Inc 3.15% Internet 47.67% 33.13% 28.45% 189.56 142.38

Source: Source: Bloomberg and iFAST Compilations The six major constituents in Nikkei 225 come from different sub-sectors, accounting for 32% of the index. These sectors are predicted to rebound strongly in the next two years, with the only exception being SoftBank. The company recorded a loss of USD 12.7 billion in 2019 due to the decline in the fair value of its Vision Fund’s investments (such as in Uber and WeWork). Yet in the first half of this year, the company recorded earnings of USD 18 billion, which made up for the loss in 2019 and was close to the level of the whole year of 2018. We believe that the current market’s forecast of a 50% drop in earnings for 2021 is mainly due to analysts’ belief that the Vision Fund cannot repeat its strong performance in the year to come. On the whole, the market believes that Japanese stocks will have an earnings growth of 30% next year. We believe that this goal is not aggressive but achievable.

Good earnings prospects expected for Japanese stock market, but high valuations limit its growth

Chart 4: Earnings and P/E History of the Nikkei 225 Index

The earnings growth of Nikki 225 has been rather strong over the past decade, which is different from what people might be thinking. It recorded negative growth only in 2011 (suffering from 311 Tohoku Earthquake and Tsunami), last year and this year. Supported by the rising earnings growth, the P/E of Japanese market has declined from 20x above in 2011 to 15x in 2019, even though the stock prices went high. The P/E rose again due to the negative earnings growth in the recent two years.

Historically, Nikkei 225 has a high correlation with its earnings per share. On the whole, we believe that the earnings prospects of Japanese stocks in the next two years are bullish without serious fundamental problems. However, the problem lies in their high valuations. Nikkei 225 is one of the best-performing markets year to date, with an increase of more than 13%, accompanied by a forecast of a 10% decline in earnings, causing its valuation to look quite expensive.

Chart 5: Target price of Nikkei 225 by end-2022

However, similar to the Hang Seng Index, Nikkei 225 is more dynamic than TOPIX, and it consists of a higher proportion of fast-growing industries in recent years. Therefore, based on a fair P/E of 20x revalued upward, Nikkei 225 is expected to reach 30,000 points by the end of 2022. It can be seen that even though the earnings outlook is still healthy, the increase will be limited by its high valuation.