In a recent series of blog posts on FT, Andrew Smithers has been arguing that CAPE isn’t reliable outside the US (and possibly the UK) because profit margins don’t revert to the mean over a reasonable period of time. He’s on his way to explaining how he thinks investors should view Japanese equities, but his most recent article hit on something pretty striking: depreciation in Japan is nearly twice as high as it is in the US.
“US depreciation amounts to 39 per cent of operating profits, while the ratio for Japan is 68 per cent,” he writes. “This might be justified if depreciation should be higher in Japan for non-financial companies in general, or because listed companies in either Japan or the US are unrepresentative of the wider economy.”
Japan, US depreciation seems like it should be comparable
The first thing to check is whether Japan has simply been investing more in equipment than the US (relative to operating profits) and therefore has more laying around getting worn out. Investment relative to output is higher in Japan if you go back to 2000, but only by a couple percentage points, hardly enough to explain such a large jump depreciation. More recently the US has passed Japan in investment, but depreciation is affected by a decade or more of previous investments depending on the industry (nb Smithers lists an ‘old’ measure for the US that is more comparable with Japanese accounting standards because it counts research as an intermediate output). Either way, both economies are in the same investment range, so you would depreciation to follow suit.
Smithers is comparing 400 non-financials from the S&P 500 with another 400 from the Nikkei 500, but even if the industry mix isn’t exactly the same it doesn’t seem like that should be enough to account for such a large difference either.
Low US depreciation costs could be a problem in the future
Smithers is mostly interested in what this means for investors analyzing Japan, but you could just as easily ask what this means when looking at US stock prices. For his part, Smithers “profit figures published by US companies should not be considered to be a reliable reflection of the “true” profits they make. This is equally true of their balance sheets and any ratios derived from them.”
If US companies are making overly aggressive assumptions about how long their equipment will last, and those assumptions are showing up as low depreciation, it could be a sign of trouble down the line.
