Value Investing

What Japan’s Troubling Economics Mean For AFLAC

What Japan’s Troubling Economics Mean For AFLAC by Sure Dividend

In the mid 1980’s economists believed Japan would surpass the United States to become the world’s largest economy. Japan did not grow as planned. The image below shows how the Nikkei 225 (Japan’s version of the S&P 500) is down about 50% since high’s around 1989.


Source: Wikimedia Commons

Japan’s economy has been stagnant for about 25 years. The country is facing 3 issues that threaten to further weaken the country’s economy.

Issue #1: Extreme Debt

Japan has the highest debt to GDP ratio of any country in the world. Japan is more indebted than both Zimbabwe and Greece. The country’s debt to GDP ratio is currently well over 200%. The image below shows Japan’s almost continuous rise in debt as a percentage of GDP over the last 35 years.


Source: Trading Economics

Japan’s debt is a looming problem for the country. Taking on debt is intergenerational borrowing. Citizens of Japan today are borrowing against future generations’ earnings power. This is not sustainable indefinitely.

High debt levels mean interest rates must be kept low. With low interest rates, current tax revenue can cover interest expenses on debt. If interest rates rise, Japanese bonds will lose value. The country will find it difficult to continue issuing debt at higher interest rates – interest expense will take up a greater share of the country’s tax revenue.

Issue #2: Declining Population

Japan’s birth rate is lower than its death rate. One million babies were born in Japan in 2014 while 1.27 million people died. For comparison in 2010 (the most recent year with data for both birth and death) 4 million babies were born in the United States and 2.468 million people died. The Japanese population is expected to decline from 127 million today to 97 million by 2050.

Population decline means less productive citizens generating fewer new ideas, businesses, scientific advances, products, and services. Population growth is a net positive for the economy. Population decline hurts economies.

Population declines by themselves are troublesome. Declining population coupled with rising debt is even more troublesome. As debt grows while the number of citizens shrink, each Japanese citizen will have a more onerous debt burden. The percentage of tax revenue from each citizen that goes to paying interest on debt will keep rising as the population decreases.

Issue#3: Currency Devaluation

The Bank of Japan has vowed to purchase about $664 billion (yes, that’s billion with a B) in Japanese treasury bonds each year (80 trillion yen a year). The Japanese money supply is around 900 trillion yen. Each year, the country is adding close to 9% to its money supply.

Japan’s radical money supply move is meant to foster growth in the country. The Bank of Japan is targeting 2% inflation. With the money supply growing by nearly 9% a year inflation could get out of control if the Bank of Japan does not ease off on its massive injection of cash into the economy at just the right time.

The Bank of Japan is now buying short-term Japanese government debt that has negative interest rates. The Bank of Japan’s massive bond purchases artificially sky-rockets the demand for Japanese government debt – reducing prices. Prices have fallen so low that short-term debt sometimes trades at a negative interest rate.

Where AFLAC Fits In

AFLAC (AFL) is a an accident and health insurer publicly traded on United States markets. The company generates about 75% of its premiums in Japan, with the remaining 25% coming from the United States. AFLAC is the global leader in Cancer insurance. AFLAC is a Dividend Aristocrat thanks to its 32 consecutive years of dividend increases.

Japan’s perilous economic condition could potentially impact AFLAC in two ways. First, negative population growth could slowly reduce the company’s customer count and premium income. Secondly, Japan’s quantitative easing and ultra-low interest rates are impacting the company’s interest income.

Japan’s Negative Population Growth & AFLAC

AFLAC’s annual premiums in Japan grew at an annualized rate of 5% a year from 2005 through 2014. Japan’s population declined by 0.1% a year over the same time. AFLAC managed to grow premium revenue at about 5 percentage points ahead of population growth in Japan in the last decade.

Japan’s population is projected to decline from 127 million today to 97 million in 2050. This comes to an annualized decline of about 0.8% a year. If AFLAC continues to grow its Japanese premium revenue at 5 percentage points ahead of inflation, the company will see Japanese premiums increase 4.2% a year over the long-run. Premium growth is not earnings-per-share growth (as will be discussed in the ‘AFLAC’s Future’ section of this article).

Premium growth of 4.2% a year does not take into account inflation. When AFLAC grew Japanese premiums by 5% a year from 2005 through 2014, the average inflation rate in Japan was 0.21% Removing inflation, AFLAC grew Japanese premiums by a real rate of 4.8% a year from 2005 to 2014. Adjusting again for negative population growth, AFLAC’s base long-term growth rate for real Japanese premiums is about 4%.

Japanese Quantitative Easing & AFLAC

Virtually all of AFLAC’s insurance float is invested into debt securities. AFLAC is heavily exposed to Japanese government bonds. Over 38% of the company’s debt securities are Japanese government bonds. The company’s second largest holding is Republic of South Africa bonds which make up 0.5% of the company’s total debt security holdings.

In the short-run, the Bank of Japan’s $660+ annual buying binge of Japanese government bonds will likely continue to push up the price of Japanese government bonds. This is good for AFLAC if it decides to liquidate government bonds.

In the long-run, The Bank of Japan’s actions are likely to create inflation and/or higher interest rates in Japan. Either of these occurrences is bad for bond holders. The Bank of Japan’s manic buying of Japanese government bonds is good for bond-holders in the short-run, but bad in the long-run.

AFLAC has slightly reduced the percentage of its holdings in Japanese bonds from 40% in 2010 to 38% today. The company had less than 20% of its debt portfolio in Japanese bonds in 2010. If AFLAC’s investment team decides to further reduce its position in Japanese government bonds, the company could benefit from the Bank of Japan’s bond buying without ‘holding the bag’ when inflation or rising interest rates occur in Japan and damage bond values.

When interest rates do rise (and they have to eventually), AFLAC stands to gain. Over the last 5 years the company’s invested asset base has grown at about 5% a year. Every year, the company can invest more funds into fixed income investments. When interest rates rise, AFLAC’s interest income will rise as well. AFLAC Japan’s investment yield is currently just 2.81% – down from 3.56% in 2010. For comparison, AFLAC US’ investment yield is currently 5.85% – more than double AFLAC Japan’s.

AFLAC’s Future

AFLAC has grown earnings-per-share at 10.3% a year over the last decade. The company’s 10% earnings-per-share growth is extremely impressive given the time period. Interest rates have fallen significantly over the last decade, and the Great Recession damaged many insurers.

AFLAC has achieved its growth by finding innovative new sales channels in Japan and repurchasing shares. The company sells insurance in banks and post offices in Japan, as well as through traditional agents. These new product distribution channels have helped AFLAC become the global leader in cancer insurance.

AFLAC has almost no equity securities in its investment portfolio. The company makes up for this by repurchasing a tremendous amount of its own stock. The company has reduced its share count by an average of 2.75% a year over the last 2 years. AFLAC’s share repurchases help boost earnings-per-share numbers.

AFLAC will grow significantly faster than premium revenue grows thanks to share repurchases. If the company’s combined ratio stays constant and premium revenue grows 4%, the company’s operating income before investments will grow 4%. AFLAC can and does use a sizeable portion of this income to repurchase shares, growing earnings-per-share faster than premium revenue.

Japan’s stagnant economy is no cause for concern for AFLAC investors. On paper, the company must translate its Japanese earnings into dollars. In practice, the company does not do this. In the long-run, underlying business growth will determine the value of AFLAC shares, not currency fluctuations.

AFLAC is a high quality business with a long history of rewarding shareholders. The stock ranks highly using The 8 Rules of Dividend Investing thanks to its solid growth over the last decade, above-average dividend yield of 2.4%, and long history of dividend increases.