If you want to generate returns through stocks, focus on companies that achieve a higher return on invested capital than it costs to raise that capital. This is the essence of value creation.
A company that cannot create a positive difference in this respect will, by definition, not generate positive returns for shareholders. If the difference is negative, the company is even destroying value for its shareholders. In the financial sector, return on equity is usually compared with the cost of equity.
The problem is that banks typically have a weak balance sheet. Therefore, the return on equity must be at least above 10%. However, regulators prefer that banks do not achieve a return on equity above 10%, as this would require less equity or riskier investments. This is one reason why bank stocks are generally not attractive investments. However, there is currently one exception, and that is Japanese banks.
For years, it was theoretically simple to outperform the Japanese stock market. If you bought all Japanese stocks minus the financial sector, outperformance was almost guaranteed. Japanese banks were major casualties of the burst of the twin bubbles in the early 1990s.
These bubbles in the stock- and real estate markets were largely funded by Japanese banks. When those bubbles burst, the banks were left with so many bad debts that they were effectively bankrupt on paper. Under the strategy of “extend and pretend,” Japanese banks barely managed to stay afloat. These once heavily weighted bank stocks in the MSCI World index, thanks to a valuation of 200 times the earnings, have since been decimated. Investors abandoned them.
What remains after more than 30 years of falling prices are typical value stocks: undervalued, under-researched, and under-owned. Today, there are more ETFs than individual stocks in the world, yet no one seems to have considered creating an ETF for Japanese banks.
When Ueda recently raised interest rates in Japan from 0.1% to 0.25%, he did not do so because of a robust Japanese economy or rising inflation. He did it because of the weak yen. The Japanese Ministry of Finance has been trying, unsuccessfully, to support the yen through interventions in the currency market.
It is uncommon for a central bank of a developed country to support its currency, so when Ueda took this step, it came as a big surprise. Japanese carry traders were alarmed. In Japan, these traders are typically represented by the archetype “Mrs Watanabe.”
In Japan, women generally manage household finances, and with no returns available at Japanese banks, the carry trade emerged. This group has benefited from the positive interest rate differential and a weakening yen. But now that the Bank of Japan is aiming for a stronger yen, the risks of such carry trades have increased while the returns have diminished.
Moreover, Ueda was not alone in adjusting rates. Around the same time, expectations for rate cuts in the US rose. This means a swift reduction in the interest rate differential, making the carry trade less appealing and potentially strengthening the yen further.
Many Japanese companies feel the impact of a stronger yen in their results. About 60% of the profits of these companies come from outside Japan. Due to the historically strong yen, much of their costs are now also incurred outside Japan, via factories in countries like Thailand and Vietnam. However, a strong yen still hurts large companies like Toyota Motor, Sony Group, and Hitachi.
The stronger yen also makes Japanese imports cheaper, which in turn suppresses inflation. Upcoming rate hikes could further moderate inflation and strengthen the yen. Rising interest rates benefit the financial sector, which also gains from increased demand for credit.
And there is still room for growth. At 120 yen against the dollar, the yen remains undervalued. Additionally, Japanese companies are raising wages for the first time in decades. Combined with rising prices, it is now more favourable to spend rather than save.
The interest margin for Japanese banks can only move upward. A major bank like Mitsubishi UFJ Financial Group (MUFG) has 107 trillion yen in reserves, earning no interest. In addition, there was another 80 trillion yen that, until recently, earned only 0.1% interest. The bulk of its loanbook consists of variable-rate loans. For MUFG alone, every 0.1% increase in rates adds up to 35 billion yen ($232 million).
Apart from interest income, about 40% of the largest Japanese banks’ revenue comes from fees and commissions. This could also rise if returning carry traders become interested in the stock market.
Keep in mind that 50% of Japanese household assets are still in cash. Saving without meaningful interest was attractive in times of deflation, but now there needs to be a shift towards higher-yielding investments. Altogether, this should lift the return on equity, which has been around 8% or 9%, to above 10% nowadays, making Japanese banks attractive to investors once again.
Han Dieperink is Chief Investment Officer at Auréus Vermogensbeheer. Previously, he was Chief Investment Officer at Rabobank and Schretlen & Co.