Japan Quantitative Strategy - Home - NOMURA Quantitative Strategy pg gy Nomura Securities Co ... ・ Jittfdf dttiftJapanese equity quant fund performance and representative ... Trading

Post-ROE-P/B curve steepening strategy

Japan Quantitative Strategyp g gy

Nomura Securities Co., Ltd.

Akihiro MurakamiSee Appendix A-1 for analyst

certification, important disclosures and the status of non-US analysts.

Any authors named on this report

Akihiro Murakami Chief Quantitative Strategist, JapanNomura Securities Co., Ltd.+81 (0)3 6703 1746akihiro murakami@nomura com Any authors named on this report

are research analysts unless otherwise indicated.

May, 2013

[email protected]

Summary

Current investment environment in the Japanese equity market :J it t f d f d t ti f t・ Japanese equity quant fund performance and representative factors

・ Who are buying Japanese stocks?

Our investment strategy :(a) Major buyers of Japanese equities are nonresident investors( ) j y p q・ Strategy utilizing non-resident investors’ stock selection skills

(b) Reliability of analyst forecasts improving・ Earnings revisions focusing on the ROE-P/B curve

(c) The BOJ continues to be a major buyer of ETFs

1

・ Contrarian to the passive fund trading

Who are buying Japanese stocks?

Trading by trust banks, insurance and nonresident investors

TOPIX(b Y )

1,250 1,500 1,750

30 35 40 End-2010/12 = 0% (bn Yen)

250500 750

1,000

10 15 20 25 Nonresidents (rhs)

-500 -250

0 250

15-10 -5 0 5

-1,500-1,250

-1,000 -750

35-30 -25 -20 -15

Great East Japan European Resurgence of Change of Government

Trust banks & Insurance (rhs)TOPIX (lhs)

-2,000 -1,750 1,500

-45 -40 -35

10/1

2

011/

3

011/

6

011/

9

11/1

2

012/

3

012/

6

012/

9

12/1

2

013/

3

(yyyy/m)

2011 Q1 Q2 Q3 Q4 Q22012 Q1 Q3

pEarthquake

pFinancial crisis

gEuropean

Financial crisisQ4 2013 Q1 Q2

g&

Abenomics-Driven Rally

2Note: Shows trust banks‘, insurance cos’ and nonresident investors' (bottom graph) trading value, taken from equity purchases by investor category data (right axis) and TOPIX return(left axis). Sample

period is January 2011 through 10.May.2013 . Source: Nomura, from TSE's equity trading value by investor category data

20 20 20 20 20 2 0 20 20 20 20

As part of monetary easing, the BOJ also keeps buying Japanese ETFs

BOJ's ETF purchases and the TOPIX

TOPIXEnd-2010/12 = 0% (bn Yen)

30

40

2530 35 40 End 2010/12 0% ( )

BOJ's ETF purchases (rhs)

10

20

510 15 20 25

-10

0

-10 -5 0 5

-30

-20

-30 -25 -20 -15

Great East JapanEarthquake

EuropeanFinancial crisis

Resurgence of European

TOPIX (lhs)

Change of Government&

-40 -40 -35

2010

/12

2011

/3

2011

/6

2011

/9

2011

/12

2012

/3

2012

/6

2012

/9

2012

/12

2013

/3

(yyyy/m)

2011 Q1 Q2 Q3 Q4 Q22012 Q1 Q3

Earthquake Financial crisis European Financial crisis

Q4

&Abenomics-Driven Rally

Q22013 Q1

3Note: Shows the actual amount of ETFs purchased by BOJ (right axis) and TOPIX return(left axis). Sample period is January 2011 through 10.May.2013 . Source: Nomura, based on BOJ and other data

2 2 2

Japanese equity quant funds started to recover since the change of government

End-2010/12 = 0% Cumulative return

Average performance of Japanese equity quant funds

5

10

-5

0

15

-10 Quant FundChange of Government

-20

-15

2011 Q1 Q2 Q3 Q4 Q22012 Q1 Q3




Q4 2013 Q1 Q2

Abenomics-DrivenRally

Government16th. Dec. 2012

-25

2010

/12

2011

/3

2011

/6

2011

/9

2011

/12

2012

/3

2012

/6

2012

/9

2012

/12

2013

/3

(yyyy/m)


Abenomics Driven Rally

4

Note: Shows daily average return (Jensen's alpha), on an indexed basis, on 23 funds (domestic publicly offered investment trusts and nonresident investor funds) that invest in Japanese equities using a quant-based approach. Sample includes long-only, individual stock long-short, and market-neutral (long on individual stocks, short on index futures, for example) funds. Sample period is January 2011 through 10.May.2013 .

Source: Nomura

Mimic portfolio’s performance of quant funds

Average performance of Mimic portfolio and Quant funds


5

10

Mimic Quant Portfolio ( E/P + Revision + B/P + Reversal)

-5

0

15

-10 Quant Fund

-20

-15



Resurgence of European Abenomics-Driven Rally

2011 Q1 Q2 Q3 Q4 Q22012 Q1 Q3 Q4 2013 Q1 Q2

-25

2010

/12

2011

/3

2011

/6

2011

/9

2011

/12

2012

/3

2012

/6

2012

/9

2012

/12

2013

/3

(yyyy/m)


y

5

Note: Shows daily return of mimic portfolio (the composite factor of E/P, B/P, Revision and reversal(past 3month return)) and daily average return (Jensen's alpha), on an indexed basis, on 23 funds (domestic publicly offered investment trusts and nonresident investor funds) that invest in Japanese equities using a quant-based approach. Sample includes long-only, individual stock long-short, and market-neutral (long on individual stocks, short on index futures, for example) funds. Sample period is January 2011 through 10.May.2013 .

Source: Nomura

Value factors worked as the main driver for the Q4 quant recovery But…..

Daily performance of E/P and B/P


15

20Cumulative return

0

5

10 E/P

-10

-5

0

-20

-15B/P

2011 Q1 Q2 Q3 Q4 Q22012 Q1 Q3Great East Japan

E h kEuropean Resurgence of

E

Q4 2013Q1 Q2

Abenomics-DrivenRally

-25

2010

/12

2011

/3

2011

/6

2011

/9

2011

/12

2012

/3

2012

/6

2012

/9

2012

/12

2013

/3

Earthquake financial crisis European financial crisis

(yyyy/m)

Abenomics Driven Rally

6

Note: Universe of TOPIX500 stocks is divided into 5 quintiles, with an equal number of stocks in each quintile, by factor value. Portfolios are rebalanced at the beginning of each month. Cumulative spread return (#5 – #1) is calculated on a daily basis (end-Dec. 2010 = 0). We did not take transaction costs into account. Analysis is based on historical share prices and does not guarantee future performance. Sample period is 4 Jan. 2011 – 10.May.2013.

Source: Nomura

2 2 2 (yyyy/ )

B/P factors were driven by credit risk factor

Factor performance for B/P and 5-year CDS spreads

E d 2010/12 0%

10

20End-2010/12 = 0% Cumulative return

B/P

0

B/P

-20

-10CDS5Y

-302011 Q1 Q2 Q3 Q4 Q22012 Q1 Q3


Europeanfinancial crisis


Q4 2013Q1 Q2


-40

2010

/12

2011

/3

2011

/6

2011

/9

2011

/12

2012

/3

2012

/6

2012

/9

2012

/12

2013

/3

(yyyy/m)

financial crisis

7

Note: We divided the universe of TOPIX 500 stocks into five groups in terms of both B/P and 5-year CDS spreads at the beginning of each month. Figure shows cumulative monthly returns on a strategy of going long on the group of stocks with the highest factor values and short on the group of stocks with the lowest factor values, for each factor. We did not take transaction costs into account. Analysis is based on historical share prices and does not guarantee future performance. Sample period is January 2011 through 10.May.2013.

Source: Nomura

2 2 2

Credit risk factor may no longer be a driver for B/P factors

CDS spreads for high-B/P and low-B/P stocks

(bp) CDS spreads for high‐B/P and low‐B/P stocks

350

400

( p) p g / /

High B/P

250

300

150

200

Low B/P

50

1002011 Q1 Q2 Q3 Q4 Q22012 Q1 Q3


Europeanfinancial crisis


Q4 2013Q1 Q2


0

2010

/12

2011

/3

2011

/6

2011

/9

2011

/12

2012

/3

2012

/6

2012

/9

2012

/12

2013

/3


8Note: Universe is TOPIX 500 stocks for which 5-year CDS spread data were available. We divided the universe into five groups on the basis of B/P factor values at the beginning of each month, and

calculated the median 5-year CDS spread for the groups of stocks with the highest and lowest B/P, respectively. Sample period is January 2011 through 10.May.2013 . Source: Nomura

2 2 2

We expect profit-based factors to emerge as the next main driver


Daily performance of ROE, revision and recurring profit growth

20

30

End 2010/12 0% Cumulative return

Revision

0

10 ROE

-20

-10

Recurringf

-40

-30 2011 Q1 Q2 Q3 Q4 Q22012 Q1 Q3Great East Japan

EarthquakeEuropean

financial crisisResurgence of

European financial crisis

Q4 2013Q1 Q2


profit growth

-50

2010

/12

2011

/3

2011

/6

2011

/9

2011

/12

2012

/3

2012

/6

2012

/9

2012

/12

2013

/3

(yyyy/m)

financial crisis

2 2 2 (yyyy/m)

9

Note: Universe of TOPIX500 stocks is divided into 5 quintiles, with an equal number of stocks in each quintile, by factor value. Portfolios are rebalanced at the beginning of each month. Cumulative spread return (#5 – #1) is calculated on a daily basis (end-Dec. 2010 = 0). Sample period is 4 Jan. 2011 – 10 May.2013. We did not take transaction costs into account. Analysis is based on historical share prices and does not guarantee future performance.

Source: Nomura

Nonresident investor purchases likely to work more positively for profit-based factors than value factors

Comparison of risk characteristics: Stocks overweighted by domestic pension funds vs. Stocks overweighted by nonresident investors

0 000.10 0.20

Size

B/PSensitivity to dollar

0 30-0.20 -0.10 0.00

E/PHistorical volatility(60 months)

-0.40 -0.30

Forecast dividend yieldHistorical beta(60 months)

Sales growthDebt ratio

ROE

Past 3-month return

Past 1 year return

Domestic pension funds #5-#1 Non-resident #5-#1 TOPIX

10

Note: we calculated risk characteristics of each portfolio and plotted the historical average of each risk characteristic. We conducted a cross-sectional normalization of each set of data so that weighted average market cap was 0 and variance was 1 at the beginning of each month, adjusting standard deviation to ±3σ if it exceeded that level, and repeated this process three times. Sample period is June 1995 through March 2013.

Source: Nomura

Idea 1: Learning from non-resident investors’ stock selection skills

Performance of stocks overweighted by domestic pension funds and nonresident investors

(End-1995/6 = 0%) Cumulative return

80

100Active weight factorof Nonresident investors

40

60Active weight factorof Domestic Pension

20

40

‐20

0

ROE factor

‐40

1995

0619

9512

1996

0619

9612

1997

0619

9712

1998

0619

9812

1999

0619

9912

2000

0620

0012

2001

0620

0112

2002

0620

0212

2003

0620

0312

2004

0620

0412

2005

0620

0512

2006

0620

0612

2007

0620

0712

2008

0620

0812

2009

0620

0912

2010

0620

1012

2011

0620

1112

2012

0620

1212

11

1 1 1 1 1 1 1 1 1 1 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2

Note: We divided the universe of TSE-1 stocks into five groups based on their active weightings in the portfolios of nonresident investors at the start of each month. Figure shows cumulative monthly returns on a strategy combining long positions on stocks in the highest group (overweighted stocks) with short positions on stocks in the lowest group (underweighted stocks). We did not take transaction costs into account. Analysis is based on historical share prices and does not guarantee future performance. Sample period is June 1995 through April 2013.

Source: Nomura

Company valuation and profitability closely associated

∞ A simple residual income model gives the relationship between future ROE and P/B ratio.

, , 11

1

The ROE-P/B curve: the cross sectional relationship between ROE and valuation (P/B)p ( )

6 0

7.0 Jan 2009Apr 2013

P/B (x) Relationship between ROE and P/B

4.0

5.0

6.0 Fitted curve (Jan 2009)Fitted curve (Apr 2013)

2.0

3.0

4.0

0.0

1.0

15 0 10 0 5 0 0 0 5 0 10 0 15 0 20 0 25 0 30 0 35 0

12

Note: We plotted each stock's expected ROE (next-FY forecast where available, otherwise current-FY forecast) on the x-axis and its P/B on the y-axis, in a two-dimensional scatter plot. Universes were TSE-1 stocks as at the beginning of April 2013 and the beginning of January 2009, respectively. To remove outliers, we excluded stocks in the top 1% and bottom 1% of the universe in terms of ROE from our analysis.

Source: Nomura

-15.0 -10.0 -5.0 0.0 5.0 10.0 15.0 20.0 25.0 30.0 35.0

ROE (%)

The ROE-P/B curve fitted by converted model

Relationship between ROE and valuation (log P/B)

Th t d d l

3.0 Converted relationship between ROE and P/B (Apr 2013)ln (P/B)

,

,_ , , The converted model :

5.0

6.0

7.0

Apr 2013

Fitted curve (Apr 2013)

P/B (x) Relationship between ROE and P/B

1 0

2.0

2.0

3.0

4.0

y = 0.4556x + 0.0781 0

0.0

1.0

0.0

1.0

2.0

-15.0 -10.0 -5.0 0.0 5.0 10.0 15.0 20.0 25.0 30.0 35.0

ROE (%)

y

-2.0

-1.0

( )-3.0

-3.0 -2.0 -1.0 0.0 1.0 2.0 3.0

Standardized ROE (high)(low)

13

Note: We plotted each stock‘s standardized expected ROE on the x-axis and its log P/B on the y-axis, in a two-dimensional scatter plot. Universe was TSE-1 stocks at the beginning of April 2013. We estimated the best fit line using model , where ln(*) is the natural log of *, δt and βt are the intercept and regression coefficient, respectively, at time t, and εi,t is the residual. To estimate the regression coefficient, we standardized ROE, the explanatory variable, so that the average was 0 and the standard deviation was 1, and rounded any values beyond ±3σ to ±3σ. To remove outliers, we excluded stocks in the top 1% and bottom 1% of the universe in terms or ROE from our analysis.

Source: Nomura

,

,_ , ,

The ROE-P/B curve has recently steepened rapidly

Ti i β ffi i t f ROE P/B

The slope of the curve (β coefficient) has recovered to the level prior to Lehman collapse.

Time series β coefficient for ROE-P/B curve

0.7coefficient

0.5

0.6

Steep

The association between expected ROE and P/B is strong.

0.3

0.4

0.1

0.2 FlatThe association is weak.

0.0

1987

01

1988

01

1989

01

1990

01

1991

01

1992

01

1993

01

1994

01

1995

01

1996

01

1997

01

1998

01

1999

01

2000

01

2001

01

2002

01

2003

01

2004

01

2005

01

2006

01

2007

01

2008

01

2009

01

2010

01

2011

01

2012

01

2013

01

(yyy

ymm

)

14

Note: Universe was TSE-1 stocks. We carried out a cross-sectional regression analysis using expected ROE and P/B ratios at the beginning of each month, and the model ,where ln(*) is the natural log of *, δt and βt are the intercept and regression coefficient, respectively, at time t, and εi,t is the residual. Sample period was January 1987 through April 2013. To estimate the regression coefficient, we standardized ROE, the explanatory variable, so that the average was 0 and the standard deviation was 1, and rounded any values beyond ±3σ to ±3σ. To remove outliers, we excluded stocks in the top 1% and bottom 1% of the universe in terms or ROE from our analysis. We used a low-pass filter to determine phases of the coefficient.

Source: Nomura

,

, _ , ,

What does the steepening of the curve indicate?

S h ti f h h l f ROE P/B i hi h ( t ) d l (fl t)

We hypothesize that the slope of the curve indicates the effectiveness of revision strategy.

Schematic for phases when slope of ROE-P/B curve is high (steep) and low (flat)

3 0

Converted relationship between ROE and P/B (schematic)ln (P/B) (2) Steep(High)

2.0

3.0 (2) Steep(High)

A

A’

0 0

1.0 (1) Flat A

BB’

-1.0

0.0

Upward revisions

-3 0

-2.0

(Low)

15Source: Nomura

3.0 -3.0 -2.0 -1.0 0.0 1.0 2.0 3.0

Standardized ROE (High)(Low)

Revision factors are certainly effective when the curve becomes steep

Effectiveness of revision factor when the curve is steep / flat

0.80 Return/risk Performance of revision factor by phase

0.20

0.40

0.60

-0.20

0.00

-0.80

-0.60

-0.40

Note: Universe was TSE-1 stocks. We investigated the effectiveness of the earnings forecast revision factor in high, medium, and low phases of regression coefficient βt , estimated using model

0.80 Low Medium High

(flat) (steep)Slope of curve

16

. To calculate factor returns, we divided the universe into five groups based on the revision factor, then calculated statistical data for monthly returns on a strategy of going long on the top group and short on the bottom group. We did not take transaction costs into account. Analysis is based on historical share prices and does not guarantee future performance. We divided the entire sample period into three groups based on coefficient value. We defined periods with coefficient values above the level that divides the top third from the middle third as high phases and periods with coefficient values below the level that divides the top third from the middle third as low phases.

Source: Nomura

,

, _ , ,

In steep phase, profit-based factors perform well

Difference in factor performance between ”Steep” and ”Flat" phases

Difference in factor performance between “Steep” and “Flat” phases

P/E

P/B

Dividend yield

ROE

Profit margin

Sales turnover ratio

High financial leverage

High revision

Hi h l tilitHigh volatility

Large cap

High default probability

Historical 6-month return

Historical 3-month returnHistorical 3 month return

Herding

Equity finance

Earnings surprise (progress)

Earnings surprise (share price response)

-1.50 -1.00 -0.50 0.00 0.50 1.00 1.50 2.00

Earnings surprise (company earnings estimate)

High return in "Steep" phasesHigh return in "Flat" phases

Note: Universe was TSE-1 stocks. We investigated the effectiveness of a key factors in high, medium, and low phases of regression coefficient βt , model (*) ( ). , _ , ,

17

g y g , , p g βt , ( ) ( )To calculate factor returns, we divided the universe into five groups in terms of each factor, and calculated statistical data for monthly returns on a strategy of going long on the top group and short on the bottom group for each factor (but long on the bottom group and short on the top group in the case of P/E and P/B). Figure shows difference between time series average/standard deviation (annualized) in high and low phases. We did not take transaction costs into account. Analysis is based on historical share prices and does not guarantee future performance. We divided the entire sample period into three groups based on coefficient value. We defined periods with coefficient values above the level that divides the top third from the middle third as high phases and periods with coefficient values below the level that divides the top third from the middle third as low phases. Source: Nomura

,

The curve for high-ROE stocks has tended to steepen more than others

Relationship between ROE and valuation (log P/B) varies with level of ROE

β coefficient of ROE-P/B curve for different levels of expected ROE

y = 0.8278x - 0.22943.0

Converted relationship between ROE and P/B (April 2013)ln (P/B)

0.8

1.0 coefficient

High ROEMedium ROEL ROE

0.0

1.0

2.0

0.2

0.4

0.6 Low ROE

Steep

y = 0.1847x - 0.1768-2.0

-1.0

-0.4

-0.2

0.0

1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 mm

)

Flat

N t W l tt d h t k' t d di d t d ROE th i d it l P/B

-3.0 -3.0 -2.0 -1.0 0.0 1.0 2.0 3.0

Standardized ROE (high)(low)19

8701

1988

01

1989

01

1990

01

1991

01

1992

01

1993

01

1994

01

1995

01

1996

01

1997

01

1998

01

1999

01

2000

01

2001

01

2002

01

2003

01

2004

01

2005

01

2006

01

2007

01

2008

01

2009

01

2010

01

2011

01

2012

01

2013

01

(yyy

ym

Note: We plotted each stock's standardized expected ROE on the x-axis and its log P/B on the y-axis, in a two-dimensional scatter plot. Universe was TSE-1 stocks at the beginning of April 2013. We divided the universe into three groups in terms of expected ROE at the beginning of each month and estimated the best fit line for each group using model , where ln(*) is the natural log of *, δt and βt are the intercept and regression coefficient, respectively, at time t, and εi,t is

,

, _ , ,

Note: Universe was TSE-1 stocks. We divided the universe into three groups based on

18

,

the residual. To estimate the regression coefficient, we standardized ROE, the explanatory variable, so that the average was 0 and the standard deviation was 1, and rounded any values beyond ±3σ to ±3σ. To remove outliers, we excluded stocks in the top 1% and bottom 1% of the universe in terms or ROE from our analysis.

Source: Nomura

expected ROE at the beginning of each month, and carried out a regression analysis for each group using model . Shows time series data for regression coefficient βt . Sample period was January 1987 through April 2013.

Source: Nomura

,

,_ , ,

Idea 2: revision factor is most effective for the high-ROE group

Revision factor performance by expected ROE

400

450

High ROE

(End-Dec 1986 = 0%) Cumulative return

250

300

350

400 g

Medium ROE

Low ROE

100

150

200

250

0

50

100

-50

1986

1219

8712

1988

1219

8912

1990

1219

9112

1992

1219

9312

1994

1219

9512

1996

1219

9712

1998

1219

9912

2000

1220

0112

2002

1220

0312

2004

1220

0512

2006

1220

0712

2008

1220

0912

2010

1220

1112

2012

12(y

yyym

m)

19

Note: Universe was TSE-1 stocks. Sample period was January 1987 through 12 April 2013. We divided the universe into three groups based on expected ROE at the beginning of each month, divided these three groups into a further five groups each based on our earnings forecast revision factor, and calculated monthly returns on a strategy of going long on the top group and short on the bottom group in terms of the earnings forecast revision factor, for each ROE group. Figure shows cumulative monthly returns. We did not take transaction costs into account. Analysis is based on historical share prices and does not guarantee future performance.

Source: Nomura

Earnings revisions were larger (smaller) for the (low) high-ROE group

The absolute value of revisions factor by expected ROE

8.0%

Revision factor by expected ROE (absolute value)(large)

5.0%

6.0%

7.0%

acto

r al

ue)

3.0%

4.0%

Rev

isio

n fa

abso

lute

va

0 0%

1.0%

2.0%

R (a

(small)0.0%

Low Medium High

Expected ROE

20

Note: Universe was TSE-1 stocks. Sample period was January 1987 through April 2013. We divided the universe into three groups based on expected ROE at the beginning of each month. Figure shows time series averages of the absolute value of the revision factor for each group.

Source: Nomura

Passive funds have shown growing presence in the Japanese equity market

AUM for passive Japanese equity ETFs has grown remarkably and became double in the last 3 years. The BOJ is expected to keep buying Japanese stocks.

AUM growth for passive Japanese equity ETFs

2.5

AUM growth for passive Japanese equity ETFs(end-Jan.2005 = 1.0)

AUM growth – TOPIX return

AUM growth : 67 044 mil USD

2.02

1.82 2

AUM growth : 67,044 mil USD

1.5

0.5

1

0

0501

0601

0701

0801

0901

1001

1101

1201

1301

21

200

200

200

200

200

201

201

201

201

Note: Shows growth in AUM (assets under management) for passive ETFs (excluding leveraged and inverse ETFs) that track Japanese equities and are listed on major markets in the US and Asia, including Japan. The red line shows cumulative monthly growth in AUM from the beginning of 2005 (AUM at beginning of 2005 = 1). The blue line shows the cumulative spread between monthly AUM growth and monthly TOPIX return. Sample period is February 2005 through March 2013.

Source: Nomura

Jan, Apr, Jul and Oct are periodical index rebalance season Anomalies might be seen around index events

Typical trading pattern of TOPIX-tracking fundAnnouncement Date Rebalance Date

5th business day in Jan / Apr / Jul /Oct

Day before last business day in Jan / Apr / Jul /Oct

(a) Stocks about to see a relative increase in FFW → Buy

(b) Stocks about to see a relative decrease in FFW → Sell

Trading by passive funds

Trading in typical event-driven strategy

( )

Announcement Date5th business day in October

in Jan / Apr / Jul /Oct

Rebalance DateDay before last business day


Reverse trades to lock in profits(a) Stocks expected to see a relative increase in FFW → LongInvestments carried out in advance on basis of forecasts

22

(b) Stocks expected to see a relative decrease in FFW → Short

Typical event-driven strategy

Announcement Date5th business day




Investments carried out in advance on basis of forecasts Reverse trades to lock in profits

(a) Stocks expected to see a relative increase in FFW → Long

(b) Stocks expected to see a relative decrease in FFW → Short

p

2 0

3.0

Announcement date = 0% Cumulative return (vs TOPIX)

Top 10% in terms of weighting change

Announcement date

0 0

1.0

2.0

(b)

-2 0

-1.0

0.0

Bottom 10% in terms of weighting change(a)Note: In this event, all constituent stocks, including stocks unchanged in FFW,

see a change in their TOPIX weighting. We compare TOPIX weightings based on post FFW and new FFW. Covering periodic reviews of FFW in every October from 2006 through 2011. Sample size for each groups is around 400 stocks. Average cumulative excess return relative to TOPIX from 20 trading days before announcement/date to 20 days after

-3.0

2.0

-20 -15 -10 -5 0 5 10 15 20(days) 23

from 20 trading days before announcement/date to 20 days after announcement/rebalance date. We did not take transaction costs into account. Analysis is based on historical share prices and does not guarantee future performance.

Source: Nomura

After the rebalances of passive funds, return reversal is expected

Announcement Date5th business day




Trading by passive funds(a) Stocks about to see a relative increase in FFW → Buy

(b) Stocks about to see a relative decrease in FFW → Sell

2.0

3.0

Rebalance date = 0% Cumulative return (vs TOPIX)

Bottom 10% in terms of weighting change

Rebalance date

0.0

1.0 (b)

-2.0

-1.0 Top 10% in terms of weighting change

(a)

Note: In this event, all constituent stocks, including stocks unchanged in FFW, see a change in their TOPIX weighting. We compare TOPIX weightings based on post FFW and new FFW. Covering periodic reviews of FFW in every October from 2006 through 2011. Sample size for each groups is around 400 stocks. Average cumulative excess return relative to TOPIX from 20 trading days before effective date to 20 days after

-3.0 -20 -15 -10 -5 0 5 10 15 20

(days)24

(a)from 20 trading days before effective date to 20 days after announcement/rebalance date. We did not take transaction costs into account. Analysis is based on historical share prices and does not guarantee future performance.

Source: Nomura

Effect of FFW change on valuations

B/P value spread of the stocks for which FFWs are increased and decreased is expanded more than 3%. Then, the spread is eliminated gradually.

2.00%Value spred of stocks with incresing/ decreasing FFWs

Effect of FFW change on valuations

1.00%

1.50%(a) Stocks for which FFWs are to be increased (Buy) → relatively overvalued

0.00%

0.50%

‐1.50%

‐1.00%

‐0.50%

Expanded value spread more than 3％

‐2.00%

1.50%

Sep Oct Beginning of Nov Dec Jan Feb

(b) Stocks for which FFWs are to be decreased (Sell) → relatively undervalued

Trading period by passive fundsAnnouncement

25

Note: Taking TSE-1 stocks as our universe, we calculated the average P/B of stocks for which the FFW (free-float weight) was increased or decreased, respectively, in the periodic FFW review for the TOPIX carried out in October each year from 2006 through 2011. We then calculated the spread between these two averages, respectively, and the average P/B for the universe (the value spread). We rebased the data so that the value spread in the month preceding the announcement of the October FFW review each year = 0%.

Source: Nomura

Idea 3: investment strategy based on change in FFW

Start investment at the beginning of the next month when passive funds are rebalanced. Short the stocks for which FFWs increased (overvalued), and long the stocks

f ( )for which FFWs decreased (undervalued).

Strategy utilizing FFW change

Jan 2002 = 0% Cumulative return

60

70

80

Jan. 2002 0% Cumulative return

Composite:TOPIX + R/N + Passive Fund Buy/Sell

30

40

50

TOPIX FFW revision (3M)

0

10

20

( )

‐10

2002

01

2003

01

2004

01

2005

01

2006

01

2007

01

2008

01

2009

01

2010

01

2011

01

2012

01

2013

01

26

Note: We divided our universe of TSE-1 stocks into five groups on the basis of composite factor (TOPIX, R/N and Passive Fund Buy/Sell) at the beginning of each month. We then calculated the monthly return on a strategy combining long positions on the group of stocks with the lowest factor values (#1) and short positions on the group of stocks with the highest factor values (#5). Chart shows cumulative monthly return. We did not take transaction costs into account. Analysis is based on historical share prices and does not guarantee future performance. Sample period is January 2002 through April 2013.

Source: Nomura

Conclusion

We have seen more favorable investment environment in the Japanese equity market for profit-based factors to perform wellmarket for profit-based factors to perform well.

We propose the following three investment ideasWe propose the following three investment ideas (1) Strategy utilizing non-resident investors’ stock selection skills(2) Revision strategy in the phase when the ROE-P/B curve becomes steep( ) gy p p(3) Contrarian strategies based on passive fund trading

27

Appendix (1): definitions of factors

Definitions of factorsFactor Factor definition

1 P/E #1 (undervalued) - #5 (overvalued) Market cap / earnings forecast( f / / /S f f )

/ # (u de a ued) #5 (o e a ued)(next-FY forecast w here available; I/B/E/S consensus forecast > Toyo Keizai forecast)

2 P/B #1 (undervalued) - #5 (overvalued) Market cap / actual shareholders’ equity

3 Dividend yield #5 (high) - #1 (low ) Calculated from Nikkei estimated dividends

4 ROE #5 (high) - #1 (low ) Earnings forecast / actual shareholders’ equity(next-FY forecast w here available; IFIS consensus forecast > Toyo Keizai forecast)(next FY forecast w here available; IFIS consensus forecast Toyo Keizai forecast)

5 Profit margin #5 (high) - #1 (low ) Earnings forecast / sales forecast(next-FY forecast w here available; IFIS consensus forecast > Toyo Keizai forecast)

6 Sales turnover ratio #5 (high) - #1 (low ) Sales forecast / total assets(next-FY forecast w here available; IFIS consensus forecast > Toyo Keizai forecast)

7 High f inancial leverage #5 (high) - #1 (low ) Total assets / Net Equity

8 High revision #5 (high) - #1 (low ) Recurring profit forecast / past 3-month average recurring profit forecast – 1(IFIS consensus forecast w here available, otherw ise Toyo Keizai forecast)

9 High volatility #5 (high) - #1 (low ) Standard deviation of daily share price return (past 60 days)

10 Large cap #5 (large cap) - #1 (small cap) Log market cap

11 High default probability #5 (high) - #1 (low ) Estimated using Merton options theory

12 Historical 6-month return #5 (high) - #1 (low )

13 Historical 3-month return #5 (high) - #1 (low )

Active fund ow nership as % of total shares out14 Herding #5 (high) - #1 (low ) * Active funds defined as all the active (long-only) funds in the Japanese equities category, as

categorized by The Investment Trusts Association, Japan

15 Equity f inance #5 (high) - #1 (low ) Change in no. of shares out compared to 24 months previously

16 Earnings surprise (progress) #5 (high) - #1 (low ) Calculated from cumulative recurring profits (from Q1 through most recent quarter) as % of consensusrecurring profit forecast (FY1)

28Source: Nomura

17 Earnings surprise (share price response) #5 (high) - #1 (low ) Cumulative return versus TOPIX from most recent results announcement date to tw o trading days after

18 Earnings surprise (company earnings estimate) #5 (high) - #1 (low ) Company estimate versus consensus recurring profit forecast (FYU1) (IFIS consensus forecast > ToyoKeizai forecast)

Appendix (2) performance of Japanese fundamental-based active funds

Average performance of Japanese fundamental-based active funds


5

10 End-2010/12 = 0% Cumulative return

Fundamental Based Active Fund

0

5 Fundamental Based Active Fund

-5

Mimic Active Fund Portfolio (E/P + Revision)

-10

Mimic Active Fund Portfolio (E/P + Revision)

2011 Q1 Q2 Q3 Q4 Q22012 Q1 Q3

Great East JapanE th k

Europeanfi i l i i


Q4 2013 Q1 Q2Change of Government

&

-15

2010

/12

2011

/3

2011

/6

2011

/9

2011

/12

2012

/3

2012

/6

2012

/9

2012

/12

2013

/3

(yyyy/m)


&Abenomics-driven rally

29Note: Shows average daily return (Jensen‘s alpha), on an indexed basis, for all long-only active domestic publicly offered investment trusts (based on Investment Trusts Association, Japan categories).

Sample period is January 2011 through 10.May.2013 . Source: Nomura

2 2 2

Appendix (3): transition in shareholding at market value by investor category

700 Shareholding at Market Value(trillion yen) Shareholding at Market Value(trillion yen) Shareholding at Market Value(trillion yen) Shareholding at Market Value(trillion yen)

Transition in shareholding at market value by investor category

500

600

00

I di id l 63 Business corporations, 67

200

300

400 Survey year 2011 ( as of Mar. 2012)

Financial Institutions, 90

Foreign corporations, 81

Individuals, 63

0

100

200

0 5 0 5 0 5 0 5 0

1970

1975

1980

1985

1990

1995

2000

2005

2010

(Survey year)(Survey year)(Survey year)(Survey year)Note: All domestic stock exchanges(Tokyo, Osaka, Nagoya, Fukuoka and Sapporo)in Japan. The market value of public pension funds is not included in that of Annuity Trusts.

- Business corporations: All companies incorporated in Japan (ex “Financial institutions” and “Securities companies”).- Individuals and others: Individuals and non-incorporated groups with Japanese nationality, regardless of their place of residence.- Foreign corporations: Corporations that were established based on foreign laws; foreign and municipal governments, and entities that are not incorporated; and individuals whose nationalities are other than Japanese, regardless of their place of residence.p , g p- Financial institutions> City, regional banks, etc.: Regular Japanese banks licensed under the Banking Act and the Long-Term Credit Bank Act (There have been no regular Japanese banks licensed under the Long-

Term Credit Bank Act since the 2006 Shareownership Survey)> Trust banks: Trust banks that are members of the Trust Companies Association of Japan> Investment trusts: Trust assets of trustors that are stipulated in the Investment Trust Act (Act on Investment Trusts and Investment Corporations), and whose nominees (trustees) are banks that

conduct trust business> Annuity trusts: Employees’ pension funds that are stipulated in the Employees’ Pension Insurance Act, and corporate pensions stipulated in the Defined-Benefit Corporate Pension Act or the

30

y p y p p p y , p p p pDefined Contribution Pension Act, whose nominees (trustees) are banks that conduct trust business. (excluding public pensions under management)> Life insurance companies: Life insurance companies that are stipulated in the Insurance Business Act> Non-life insurance companies: Non-life insurance companies that are stipulated in the Insurance Business Act> Other financial institutions: Financial institutions other than those stipulated above, including credit unions (shinkin banks), credit associations, agriculture-related financial institutions, mutual aid

associations, and government-related financial institutions, etc.Source: Shareownership Survey (TSE), Nomura

Appendix (4): outline regarding periodic review of FFW

Outline of calculating FFW Definitions of free-float shares and non-free-float shares

Outline Estimation of non-free-float shares

(1) Estimate the amount of non-free-float shares using publicly available documents released by listed companies.

(2) Calculate non-FFW. (Non-free-float shares / listed shares)

Shares held by the top 10 major shareholders, treasury stocks, shares held by the board of directors, and other shares TSE seems not available for trading in the market.

TSE t t h h ld b th t 10 j h h ld(3) Obtain the FFW by removing the non-free-float factor from

1. (1 – Non-FFW)※TSE multiply the FFW by 0.75x for stocks recognized as having low liquidity and newly listed stocks

TSE may treat shares held by the top 10 major shareholders as free-float shares in the following case.

Condition Major shareholder

As a general rule, shares considered as Securities finance

Periodic Review

Settlement Term

Announcement Date

EffectiveDate

Source: Nomura based on Tokyo Stock Exchange Index Guidebook published 9 February 2012g

free-float. companies, securitiesdepositories, nominees for depositoryTerm Date Date

January –March

Fifth business day of October

Last business day of October

April – June Fifth business day of J

Last business day of J

depositoryReceipts

Shares likely to be seemed as free-float.Cases where any of the following conditions are met and the TSE deems it appropriate to

Trust banks, master trusts, global

January January

July –September

Fifth business day of April

Last business day of April

October - Fifth business day of Last business day of

consider such shares as free-float.- There are descriptions in the Securities Report on the type of trust, the purpose of purchase of shares, etc.- It is clear that shares are held by several

gcustodians,insurance companies, securitiescompanies etc

31

Decembery

Julyy

July beneficiaries and managed centrally- It is clear that shares are held for margin Transaction

companies, etc.

Source: Nomura based on Tokyo Stock Exchange Index Guidebook published 9 February 2012 Source: Nomura based on Tokyo Stock Exchange Index Guidebook published 9 February 2012

※The TSE may review FFW in the cases (allocation of new shares to a third party, etc) where it seems that the existing FFW is expected to be significantly affected.

Appendix A-1

Any Authors named on this report are Research Analysts unless otherwise indicated

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