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Land of the rising income

Japan and income are two words not often used in the same sentence. This is hardly surprising given that, for the past 15 years, Japanese equities have been in a state of turmoil. As a measure of the extent of Japan’s derating, the Topix is still 55 per cent below its peak at the end of 1989.

Rather than dwell on the reasons for Japan’s fall from grace in the 1990s, investors should focus on how Japan has reacted to it. In the more recent past, we have seen painful but necessary change take place that is finally redeeming Japan in the eyes of the investment community.

The cosy arrangement of cross-shareholdings that characterised the boom has been effectively unwound. Merrill Lynch estimates that cross-shareholdings and stable shareholdings amounted to about 50 per cent of total market cap in the 1980s but will have dwindled to under 20 per cent by next year.

Companies have reduced gearing, the banking industry has been recapitalised and deflation is finally ending.

Profits and margins are now at record levels, by some distance, and are expected to keep rising. Net cash levels are also at record highs.

Japan is more than just an export-led story, as domestic demand is also improving, with employment levels rising after seven years of falls. Household earnings are beginning to improve and land prices have stabilised.

Yet valuation multiples for Japanese equities are still low and have been falling. In terms of price/earnings, Japan looks a little cheaper than the US and, in terms of price/book, it is substantially cheaper.

For an equity investor, Japan looks a good bet. So why income when, on the face of it, growth might be a better bet? First, there are a few fallacies which need to be put straight. Japan is thought of as a low-yield market, which it clearly was in the 1990s. But if you look back to the post-war era, when Japan was the first of the so-called tiger economies, the dividend yield reached as high as 8.5 per cent, according to Credit Lyonnais.

Though yields are unlikely to return anywhere near those levels, they are expected to rise as earnings and payout ratios increase. UBS’s estimate at the current market price is for a yield of 1.7 per cent in 2006, on a payout ratio of 30 per cent of earnings, rising to 2.7 per cent by 2008.

Nor is it true that there is no dividend culture in Japan. Nomura recently raised over 200bn yen ($1.8bn) in a high-dividend Nippon fund. Japanese companies need to attract stable shareholders and pension funds need income.

The corporate sector needs to charm shareholders for various reasons, the key one being that, in the new era, foreign and domestic predators, including vulture funds, are building stakes. At 24 per cent of total value, foreign ownership of Japanese equities has never been higher and Japanese companies no longer have the protection of cross-shareholdings.

There are many examples of firms looking to woo share- holders and protect themselves from rivals. Toyota has started to raise its dividends and has been increasing stakes in its group companies to buf- fer it from unwanted bids.

Pension funds need income because yield is hard to come by in Japan. Dividends are an attractive source of income because they offer the lure of growth and, not least, because the yield is higher than for 10-year government bonds. The yield on 10-year governments is about 1.3 per cent while mobile giant NTT DoCoMo has a prospective dividend yield of 2.2 per cent for the year to March 2006, rising above 3 per cent in 2007 at current prices.

The incentive to pay divi- dends is there and Japanese firms are in a better position – and are increasingly willing – to pay them than at any point in the past 15 years.

The combination of low valuations, strong domestic demand for income and the need to lure long-term shareholders suggest Japan and income should not be considered such strange bedfellows.

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