Japan: Land of the rising equities?


11 Jun 2024

With Tokyo’s stock exchange breaking performance records, Andrew Holt asks if investors are riding a wave or have missed the boat.


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With Tokyo’s stock exchange breaking performance records, Andrew Holt asks if investors are riding a wave or have missed the boat.

Japan appears to be at something of an interesting crossroads for investors. Some commentators have suggested that Tokyo’s stock market is set for a transformational year. Such a scenario appears to be bearing fruit.

The Nikkei 225 has already hit record highs and the TOPIX, an index of the exchange’s largest companies ranked by market cap, is projected to rise about 13% by the end of this year – a considerable fillip by any investor standards, but mammoth in this environment.

This is good news. But is it too good?

Has Japan’s market reached a peak? If so, how should institutional investors position their portfolios? Should they go big in Japan?

Or does the potential for record highs indicate that this is an ideal time to retreat?

There is a case for both scenarios. Which though is the stronger? The reality for investors is more nuanced than one scenario suggests.

Given the shape of the markets there is a strong element of investors having a fear of missing out, which is contributing to how they view Japan, because, “a lot of people don’t have Japan in their portfolios or don’t have enough of it,” says Yue Bamba, head of active investments at Blackrock in Japan.

But the themes driving Japan’s equity markets “are fundamental and long-term in nature”, Bamba adds. Meaning the fear of missing out may well be justified.

Growth momentum

One such strong element is the growth momentum in the Japanese economy, which plays into the ‘don’t miss out’ narrative, especially when compared with the risks of further slowdowns in the US and Europe. Corporate balance sheets in Japan are in much better shape than in previous years, and, for the market overall, the return on earnings for listed equities has more than doubled in the past 10 years.

This is good news for investors and one that is predicted to continue. “We expect corporate Japan to keep unlocking value as management teams pay more attention to the costs of capital, corporate governance, and institutional investor steward- ship,” says Tamara Stats, index and ETF specialist at Blackrock.

And here, there is no doubt that Japan boasts an array of world-class companies: from those involved in semi-conductor equipment, healthcare, medtech and robotics, as well as more traditional heavy industries and not forgetting speciality chemical producers.

That said, valuations are low. The price-to-earnings ratio of the MSCI Japan stands at 14.2, which remains below its 15-year average and represents a sharp discount with the US.

But with half of all Japanese companies trading on a price-to-book ratio of below one, there is plenty of room for improvement. So as corporate returns continue to improve, the strong expectation is share prices will inevitably follow.

Powerful tailwinds

John Lothian, portfolio manager at Border to Coast Pensions Partnership, sees several powerful tailwinds supporting earnings growth and share price valuations for Japanese stocks on three levels. “One, reflation is enabling corporate Japan to close the once-considerable gap in profitability with global peers,” he says.

“Two, corporate governance reforms have finally reached the tipping point such that large-scale improvements that used to take years or decades can now be achieved in months. And three, global investors are still underweight Japan, which should support further inflows.

“Japan is by no means a crowded trade,” Lothian says. “A temporary correction would not be unusual, however, given the run-up Japanese shares have enjoyed.”

Junichi Takayama, Japan equity investment director at Nikko Asset Management, goes further, offering five reasons why the country’s economic resurgence still has ample runway, and why investors should consider increasing their allocation to Japan.

The first is that domestic spending is set to be unleashed. “Never before has Japan looked so exciting for cash-rich domestic consumers. The combination of extended pent-up demand and the highest wage hikes in decades, following the recent ‘Shunto’ spring wage negotiations, is likely to lead to higher consumer spending in Japan as evidenced by the recent stronger consumer confidence in 2024 and beyond,” he says.

The so-called ‘forced savings’ of Japanese consumers, estimated at Y50trn (£259.7bn), could serve as a catalyst for sustained economic growth, as these savings are deployed across a number of different sectors, Takayama says.

The second is the recovery in inbound tourism, which is set to gain further momentum. “The lifting of all Covid-19-related border control measures has led to a rapid increase in inbound tourists, revitalising Japan’s tourism industry and associated businesses, including hospitality, retail and transportation,” he says.

As China’s economy rebounds in 2024, “its burgeoning middle class, armed with savings and a pent-up desire for travel, and an affinity for Japanese goods, will likely look towards Japan as its primary destination”, Takayama says.

Weak yen

The weakness of the yen further enhances Japan’s appeal as an attractive destination for international tourists, reducing the cost of travel, accommodation and shopping in the country. “This revival is not merely about restoring pre-pandemic levels of tourism but expanding them, driven by volume of tourists and intensity of spending in the years to come,” Takayama says.

James Lydotes, Newton Investment Management’s deputy chief investment officer for equities, also believes that it is worth pausing and focusing on the yen.

“We are just past two years into the collapse of the yen,” he says. “This has been great for the exporters and has lifted the local markets to new heights. But global investors can’t eat local returns, and the benefit of strong local stock market performance has been offset somewhat by the weaker currency.”

However, he adds it is becoming more expensive to live in Japan as imported goods cost a lot more money to buy, and that is what the government is grappling with. “There is a lag effect with the policy changes that an export economy needs to deal with. Some form of currency intervention to slow the decline in the yen is likely.”

Tokyo teeth

The third important element of Takayama’s outlook is the Tokyo Stock Exchange (TSE) showing its teeth in improving corporate governance.

This is an interesting development dating back to January 2023, when, hidden in the footnotes of that month’s TSE update on market restructuring, lay an intriguing statement, which was essentially an appeal for companies with a price-to-book ratio consistently below one to disclose how they intended to make improvements.

It was a direct call to action, and two months later was expanded to all listed companies across the prime and standard markets. It encouraged “all listed companies to raise awareness and literacy regarding cost of capital and stock price/market capitalisation and promote efforts to improve them. They required that management and the board of directors properly identify the company’s cost of capital and capital efficiency”.

The TSE policy has been one of the key drivers for Japan’s stock market rally during the past year. Since the announcement, investor attention has focused heavily on stocks with significant potential for improvement, and any positive announcements have generally seen strong, favourable reactions.

“The TSE’s more proactive stance on corporate governance could have far-reaching advantages for the Japanese equity market,” Takayama says. “Since January 2024, the TSE has adopted a ‘naming and shaming’ strategy of publicly disclosing lists of companies that are either in compliance with or in defiance of new governance initiatives,” he adds.

These initiatives, which should see compliant companies attracting greater foreign investment, do present Japan as a maturing market that is increasingly attractive from a governance perspective.

That said, it is not the only reason for the Nikkei’s record. Investors are also taking note of structural improvements such as Japan’s economy emerging from three decades of deflation and prime minister Fumio Kishida’s focus on the creation of a virtuous cycle of rising wages and prices.

Greater engagement

The fourth important element for Takayama is that Japan’s companies are finally ready for shareholder engagement, a vital segment for investors. “Since 2019, the number of activists and shareholder proposals in Japan has more than doubled and quadrupled, respectively, with shareholders becoming more vocal and assertive in their demands,” he says.

This increase in activism is not just about challenging management, “but about fostering a culture of constructive engagement, aiming to unlock value and drive long-term growth”, Takayama adds.

Dividend yields offered by Japanese companies are significantly higher than long-term interest rates, signalling confidence in earnings and an improvement in governance practices.
 The fifth and final point is that Japan’s value stocks still trade at a significant discount to book value.

“Despite the overall strong performance for Japanese equities in 2023, value stocks – particularly small and mid-cap companies – did not fully participate in the rally. As a result, many of Japan’s small and mid-cap value stocks are still trading significantly below book value, and therefore still have room to move much higher,” he says.

This underperformance has been attributed to several factors, including investor preference for large caps and growth stocks amid the technology stocks rally, heightened macro-economic uncertainties, and a domestic market still overlooked by international investors.

“As the market begins to shift its focus down the market cap spectrum due to changing economic conditions or a re-evaluation of risk, these stocks stand to benefit significantly,” he says.

Top value

Indeed, the performance of the stock exchange being largely driven by a number of top cap value stocks as well as a select few technology-related stocks – even though these two areas of the market are expected to benefit less from the corporate reform push is an important development, and one for investors to keep an eye on.

According to Man Group portfolio manager Emily Badger, the reason is the influx of foreign investors who have focused on a small collection of well-known top cap value stocks. With restricted liquidity, only 220 stocks have an average daily traded value of more than $20m (£16m) in Japan versus nearly 1,500 stocks in the US, Badger says. As a result, the stretch between top cap value and the rest of the value style has widened.

Therefore, Tim Rankin, portfolio manager at Franklin Templeton, identifies certain companies that offer attractiveness for investors in the evolving Japanese market.

“We believe companies that have a clear plan to improve their returns and reduce their cost of capital and are willing to buy back stock trading below book value following the unwinding of cross-shareholdings, are more appealing than those that are simply posturing,” he says.

Additionally, “companies that are managing toward a medium-term growth plan and capital allocation strategy can be better judged on their success”.

These companies could then prove beneficial to investors. “In our view, the companies that are successful could see a significant runway for growth and potential stock price appreciation as book values improve over the medium term.

“This burgeoning Japanese spring could turn into a long summer,” Rankin says.
 So the outlook for Japanese equities is one that could see investors riding another wave – but only if they select well and appropriately.


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