Is Japan finally paying out to income investors?

When you think of overseas equity income, the chances are you won't think of Japan. Japanese companies have notoriously hoarded capital on their balance sheets instead of paying it out, and Japanese funds offering income have been few and far between.

Now companies have been urged to put return on equity at the top of their agendas as part of a new Stewardship Code, launched in June 2015. It is the third 'arrow' in a mammoth package of stimulus measures launched by prime minister Shinzo Abe in 2013. The first arrow was a major QE programme which succeeded in devaluing the yen and boosting equities. Now Mr Abe is focusing on corporate governance. The code is helping but possibly an even bigger boost came when the country's national pension fund - the largest in the world - announced it would hold half its assets in equities for the first time, making it a major purchaser of Japanese stocks. Companies have responded by ramping up dividends and buying back cheap shares, and managers say they are reaping the benefits.

Simon Somerville, manager of Jupiter Japan Income fund (GB00B6QC0Z69) says: "Pretty much every company we own is increasing dividends this year and according to consensus data we're getting 17 per cent dividend growth across our portfolio." JO Hambro Capital Management Japan Dividend Growth Fund (IE00BKS8NS44) co-manager Scott McGlashan says: "We're seeing a second year of double-digit dividend increases in the current fiscal year and we're only six months in. Share buybacks are also running way ahead of last year's levels."

According to Mr Somerville, Japanese dividends last year rose by 13 per cent and Nomura estimates total shareholder returns will rise 14 per cent this year. Jason Hollands, managing director at Tilney Bestinvest, says that last year "a record 55 per cent of companies in the Topix hiked their dividends with payouts rising from circa ¥6bn in 2010, to over ¥9bn last year. This year payouts are expected to surpass ¥10bn during 2015." Share buybacks were also up by 76 per cent, as companies made the most of a weaker yen to claw back shares, boosting the value of shareholders' stakes in Japanese stocks.

Those stocks include companies such as Amada (Jap:6113), which responded to being rejected from a new corporate governance-themed JPX-Nikkei 400 index, launched in 2013, by announcing it would pay out 100 per cent of its profit in dividends and share buybacks from 2014.

This means that investors will start to see income from their investments as well as capital growth. And it isn't just Japanese fund managers who believe that could be the case. Lucy Walker, manager of the Sarasin fund of funds range, says: "We started off owning a fund full of exporters as the yen weakened substantially and a lot of companies benefited. But in the past six to 12 months we've seen real signs that companies are starting to care about shareholders and dividends are a big part of that.

"We really do believe things are changing and it is that structural element of a reform story which gives you a lot more conviction at a time when there's a lot of uncertainty. Japan definitely could be a place for income in the future."

Funds focused on Japanese income

There are still few income-paying Japanese funds around and the yields on them remain small. But there is a large capacity for growth and several have delivered strong capital growth over the long term, too.

Jupiter Japan Income Fund (GB00B6QC0Z69) and its hedged share class (GB00B6496D90) have delivered solid returns over the long term, with the hedged share class returning 91.4 per cent over three years. sBoth also pay an income: according to Morningstar data both share classes have a historic yield of over 1.7 per cent.

Mr Somerville focuses on company cashflow rather than dividends, arguing that companies with more cash on the balance sheet will be in the strongest position to pay money back to shareholders. He likes domestic-focused companies which will not benefit from a weak yen but be able to withstand market volatility. Two of his favoured stocks - Suburu car maker Fuji Heavy Industries (Jap:7270) and tyre maker Bridgestone (Jap:5108) - are exporters however, focused on the US. According to Mr Somerville, Fugy Heavy's forecast dividend is estimated to go up by 69 per cent this year and its yield is set to rise to 2.6 per cent. "That is coming from a low base but it is exactly the kind of company we like," he says.

He also holds small-cap names such as TechnoPro (Jap:6029), which yields 3.5 per cent and has increased dividends at a compound rate of 10 per cent year on year, according to Mr Somerville.

But currency will eat away those benefits for UK investors and a hedged share class protects your capital returns but not your dividends. Although the fund is seeing an increase in dividends to investors in yen terms, when those are translated back to sterling, you will not see an increase in income. "When the yen weakens a lot the increase in dividend will get diluted," says Mr Somerville. "The dividend we have paid out in the last few years has been flat even though it has actually increased." The fund's unhedged share class pays two dividends per year and, according to Trustnet, its final dividend in February 2015, at 0.442p, was below that of 2015, at 0.507p. The hedged share class paid a higher final dividend of 0.563p, although it still fell below its 2014 final dividend.

JOHCM Dividend Growth Sterling Hedged (IE00BKS8NT50) is hedged back to sterling, but as a new share class has not yet paid a dividend. Unhedged share class JOHCM Japan Dividend Growth (IE00BKS8NS44) is also focused on harnessing the Japan income story and has just 39 holdings. Unlike Jupiter it tries to isolate a small group of companies that pay high dividends but which are also increasing that dividend by the most year on year.

Mr McGlashan says: "Our starting point is to rank stocks in terms of yield and in terms of dividend growth. Then we look at the 20 highest yielders and fastest dividend growers, and decide which we like fundamentally." Currently the fund's highest-yielding stock is Canon Electronics (Jap:7739), at 4.25 per cent, while the holding growing its dividend fastest is Mazda (Jap:7261).

He says stocks across the portfolio are paying more into the fund in dividends. Even textiles company Nisshinbo (Jap:3105) announced an unexpected increase in dividends last November and an 11 per cent share buyback despite profits taking a hit.

The unhedged share class is fairly new and its last dividend according to Trustnet was 0.104GBP in December 2014.

CF Mourant Nippon Yield (GB00B2R83B20) is another fund targeting dividend growth and carries a relatively high yield, at 2.39 per cent, according to Morningstar. It focuses on smaller companies and delivers both income and capital growth. In five years it has returned 66.1 per cent compared with 33 per cent for the Topix 100 index.

Mr Hollands says: "The Nippon Yield Fund has a value bias but it has a much greater exposure to smaller and mid cap companies than the others. It brings something different to the table."

The fund is managed by a boutique dedicated to Japanese funds. Its April dividend in 2015 was higher at 2.9372p than the first 2014 dividend, at 2.7196p.

Hold your horses

But don't sell up all your high-yield investments in favour of Japanese funds just yet. Juliet Schooling Latter, director at Chelsea Financial Services, says: "The Japanese index is yielding 1.8 per cent and even though Sony (Jap:6758) and Mazda (Jap:7261) are going to resume paying dividends they remain at a very low level. Meanwhile, poor companies with weak cash flow such as Toshiba aren't paying dividends at all."

Mr Hollands points out: "Toyota (Jap:7203) currently has a payout ratio of just 27 per cent, which would be considered derisory for a FTSE 100 company - so those needing income today will still find better opportunities elsewhere. payout ratios have hovered around 20 - 30 per cent of earnings for a painfully long time, and Japan remains far down the rankings of payout ratios on a global basis, but clearly there is plenty of headroom for further growth."

Compared with some of the highest-yielding stocks in the UK, even the best dividend growers in Japan still don't look too hot. For example, Wm Morrison (MRW) is currently yielding 7.31 per cent and the FTSE All-Share was yielding 3.6 per cent at the end of August.

And some managers are sceptical that change is even happening. David Jane, fund manager of Miton multi-asset fund, says: "You don't get much in the way of income even though you have seen a significant increase in the rate of dividend growth. I don't think there's enough evidence to say we're in a real turnaround in Japanese companies yet.

"We've seen some improvements but it is not compelling yet and income is not the reason why you would own Japan. You would own it for the weak yen export story and for good companies at low valuations. Maybe you will get a bit of upside if they genuinely reform and start improving distributions, but I would see that as icing on the cake."

Japan is also not without its risks, being vulnerable to a China slowdown and global shocks. Deflation is also continuing to dog the country.

Ms Schooling Latter says: "My slight concern is around global growth. Japan tends to be very dependent upon global growth and is hurt when that is weak."

But even if Japanese stocks fail to deliver double-digit yields in the near future, for the first time it looks like a place to find capital growth and income combined. That is good news for a region that is home to some of today's best value stocks.

Mr Somerville says: "We are talking about a market at 1.23 times price to book so you're not paying a massive premium for the market. Yes, yields are low but so is the overall valuation on the market."

"For years Japan has been incredibly cheap on a price-to-book basis but the problem was it was cheap for a good reason, because return on equity was so low." He says that under Mr Abe, return on equity has increased from 7 per cent to 9 per cent while valuations have remained good. That means good stocks with improving returns at good prices.

ETF investing via the JPX-Nikkei 400 BOX

ETF investors can also gain access to the newly launched JPX-Nikkei 400 index. Stocks are granted inclusion based on three-year average returns on equity (RoE), operating profit and market value in order to identify those expected to deliver the best shareholder value. It is seen as a badge of honour for Japanese companies and major institutions have already piled into it. However, the ETFs tracking the index are very new and as such, have a short track record.

Japan funds performance in cumulative total return (%)

Source: FE Trustnet, as at 25 September 2015

ETF JPX-Nikkei performance (% cumulative total return)

Japan funds and yields

*According to Morningstar the yield is 9.7 per cent due to an unusually high trade from a large shareholder. The fund provider has supplied the figure of 2.4 per cent as an average weighted 12-month yield.

Source: Morningstar, as at 25 September 2015