The rapid increase in dividends paid by Japanese companies, at a 21% annualised growth rate since 2003, has been a great achievement. Although this strong growth still leaves the payout ratio at an unacceptably low level, Nikko Asset Management expects a steady increase in dividends over the next few years to arrive at a more appropriate payout level of 30%.

Japanese companies should not cut their dividends even if earnings decline (unless the payout ratio exceeds 100%), as such would cause serious problems, not only hitting the companyÆs share price, but also hurting sentiment for the entire equity market.

Structural changes

The profitability of Japanese companies has improved since 2003, after the long economic downturn during the 1990s and early-2000s. The effort to reduce costs and new, rapidly growing businesses in emerging economies enhanced the capability of Japanese corporations to generate cash and profits.

CorporationsÆ cash flows have started to pile up on their balance sheets since the early 2000s. Structurally changed Japanese corporations are now entering a new phase in which they need to find effective ways to use their cash flows. Capex, mergers and acquisitions, dividends and share buyback are all constructive choices to improve shareholdersÆ value. However, as M&A opportunities do not always exist and companies also should not invest in capex beyond optimal levels, increasing dividends or share buybacks are currently the most important options. Increasing dividends, in our opinion, is more appealing than share buybacks, given domestic investorsÆ strong interest in current income.

Excess equity capital is an obstacle to increasing returns on equity. If earnings stay constant, accumulating equity capital reduces RoE. As low RoE usually causes a low equity valuation, companies with such face the risk of becoming an M&A target. Possessing too much cash in balance sheets also brings companies serious risk of becoming such a target, as acquirers require less money to buy their targets, because they can use the targetÆs cash to fund their purchase.

Surprisingly, 6% of listed companies in Japan are now trading below the net cash on their balance sheet, and 21% trade below two times their net cash. Considering the increased deregulation of M&A rules during the past two years in Japan, many companies now face very serious risk to becoming an M&A target. Such companies have to take their situation seriously and study optimal ways to use their cash to raise their shareholdersÆ value, rather than introducing defensive measures like poison pills.

JapanÆs dividend-payout gap

JapanÆs equity market has experienced valuation convergence, as its price-to-equity ratio has fallen to international norms. As financial flows became international, valuations of the same asset class in respective regions have converged.

However, there is a large gap in dividend-payout ratios between Japan and other developed countries. The current dividend-payout ratio is approximately 30% in the US and 40%-50% in Europe (which also reflects their five-year averages) and 40%-50% in Asia-Pacific ex-Japan, versus 25% in Japan.

International investors, which now account for more than half of equity trading in Japan, will very likely continue to put pressure upon companies to raise dividends to international levels. Japanese corporations are, indeed, finding it difficult to ignore the demands from their major shareholders. Domestic individual investors should also continue focusing on dividends due to their conservative attitude to investments and their strong association with high yield-type investments.

Some may question why Japanese dividends matter. The current Topix dividend yield, at 1.75%, does not look impressive from a global standpoint, but it is the highest in Japan since the mid-1980s (which is attractive to domestic investors) and now exceeds the 10-year Japanese government bond yield; it is the highest real dividend yield in the G3 economies. A dividend yield higher than the sovereign bond yield has been very rare in international developed markets in the past two decades, because dividends have long-term growth potential while bond coupons do not. Topix has experienced this occurrence three times in the past and each of them coincided with an excellent buying opportunity.

John Vail is head of global macro strategy and asset allocation at Nikko Asset Management in Tokyo.