May 13, 2014 7:00 pm JST

Capital productivity key to pushing Nikkei index over 30,000

CHIAKI KITAZAWA, Nikkei senior staff writer

TOKYO -- What are the prerequisites for the Nikkei stock average to return to the 30,000 level?

     Suppose price earnings ratios remain at more or less the same level as now; in other words, excessive, bubble-like expectations for higher stocks will not take place in stock markets, simple arithmetic shows the 30,000 level would be reasonably achievable if per-share earnings of companies adopting the Nikkei average more than doubled from current levels.

     Recently, the Nikkei index has been hovering at levels well below 20,000. However, "in the most bullish scenario, the index could top 30,000 in five years," said Naoki Kamiyama, chief strategist at Merrill Lynch Japan Securities.

     To double profit per share in five years, annual growth of about 15% will be necessary. To achieve a two-fold increase in profit despite a cycle of boom and bust in the global economy, Japanese companies must take unconventional steps to boost their overall profitability. That's what Kamiyama calls a "return revolution."

     As Japanese companies have the lowest capital productivity among businesses of major industrialized nations, Kamiyama said, they have the potential to dramatically improve their profitability.

     However, the questions arise here: Why has that potential been dormant for so long, resulting in Japanese stocks losing their attractiveness as a target of long-term investment? The Ministry of Economy, Trade and Industry has examined this issue from various angles through its project called "Building favorable relationships between companies and investors." The project is chaired by Hitotsubashi University Professor Kunio Ito. The project team recently issued an interim report.

     The report addresses a number of issues facing Japanese companies on both company and investor fronts; Japanese businesses engage in a short-term management cycle in which they replace their top executives often; there is a lack of investors who can assess companies on a long-term basis, among other things. But most importantly, the report puts emphasis on the issue of capital efficiency.

     Long-term investors expect companies to achieve profit growth by using internal reserves to reinvest in capital spending, and hope companies will achieve return on equity higher than shareholders' equity cost (expected rate of return).

     Nevertheless, many Japanese executives don't consider ROE to be one of their management objectives and don't pay much attention to shareholders' equity cost. Thus, the interim report notes, Japanese firms' disregard for capital efficiency is one major reason for their low profitability.

     The report also urges Japanese business leaders to set ROE as one of their key goals and shoulder the responsibility to achieve a higher ROE. It describes 8% or higher as the minimum ROE standard surpassing shareholders' equity cost, in a rare move by the ministry to make such a specific argument.

     In June, the ministry is set to compile a final report. Many observers will be watching carefully what kind of policy proposals are included in the final report. That will likely reignite debate on the issue of capital efficiency among Japanese businesses.

     The Japanese version of the stewardship code -- principles for responsible institutional investors -- encourages dialogue between companies and their investors. "The central theme (of such dialogue) is how to handle shareholders' equity cost and internal reserves," noted Yasunori Nakagami, president of Misaki Capital.

     In January this year, the Tokyo Stock Exchange launched a new index, the JPX-Nikkei Index 400, which uses ROE to score selected issues. Such a development indicates that Japanese companies come under mounting pressure for boosting their capital productivity.

     Does this all mean that the Japanese market is now on the threshold of a "return revolution?" Kamiyama of Merrill Lynch Japan Securities said there is a 25% chance of the Nikkei average hitting 30,000 in five years.

     It all comes down to how serious Japanese companies and investors will be about raising that probability.