Japan’s corporate transformation fuels renewed optimism

5 min read 23 May 24

After a 34-year wait Japan’s stock market has reached a new record high, driven by optimism about corporate governance changes and attractive valuations. Following a stellar rally over the past year, Carl Vine, Co-Head of Asia Pacific Equities, believes there are further chapters to come in the Japanese equity story and the ongoing transformation of corporate culture offers potential opportunities for patient, engaged investors.

Over the past year Japan’s equity market has experienced a notable resurgence as optimism about the end of deflation, attractive valuations and, most importantly, the transformation of corporate culture have drawn investors to the asset class.

This trend is continuing in 2024. We have seen substantial foreign inflows into the Japanese stock market this year, following on from 2023 when overseas investors purchased the biggest amount of Japanese equities, on a net basis, since 2014[1]. With the Bank of Japan (BOJ) officially announcing the end of deflation by exiting its negative interest rate policy, Japan has signalled to the world that this time is, indeed, different.

The stock market has made a strong start to the year, recording one of its best quarters in a decade, in local currency terms, with the Nikkei 225 Index surpassing its previous peak from 1989. This follows stellar gains in 2023 when the Nikkei returned more than 28% (in yen terms, before dividends).

In our view, Japanese equities have been cheap versus their “potential” for decades. Today, we believe this potential is increasingly being realised. The long-standing “if only” bull-story has finally turned into a reality. Luckily, several chapters remain. 

Optimism stems from change in corporate behaviour

Whilst media attention understandably gravitates to what the BOJ is thinking in terms of monetary policy and the economic outlook, we suggest the main reason for the renewed optimism for Japanese equities stems from something a little less headline grabbing: arduous acts of behavioural change and self-help that have been delivered over the course of several years at the individual company level.

“It is our long-held view that Japanese equities represent a compelling long-term opportunity in a global context.”

Until last year, the change of mentality at Japanese corporates around pursuing profitability went largely unnoticed by investors – but the opportunity was hiding in plain sight. The present excitement about Japan suggests that investors are now understanding what is happening – partly because of the sheer amount of evidence that companies are actually changing their behaviour.

Japan’s long-term strategic appeal

Now, investors might be tempted to ask whether Japan’s stock market rally can continue. Although the market has risen meaningfully, we don’t believe that this is end of the story. Of course, we need to acknowledge that there has been valuation expansion in Japan over the past year so the starting point for investment now is not the same. Nevertheless, we don’t see any euphoria about pricing – with the possible exception of artificial intelligence (AI)-related stocks such as semiconductors, which are arguably priced for some very good outcomes, a phenomenon not specific to Japan alone. However, these stocks are a very small percentage of the Japanese corporate sector. 

The rise of Japan’s stock market has been healthy and diversified, in our view. Importantly, it is mainly supported by earnings rather than a single thematic dynamic. As a result, we think the Japanese equity asset class remains appealing in both absolute and relative terms, particularly compared to the US. For example, in the US only 13% of the index has a price-to-earnings ratio of less than 15, whereas the figure for Japan is nearly 50%.

In the absence of any euphoric price behaviour, we believe investors should avoid the temptation to be overly tactical and simply stick to the long-term strategic appeal of the market. It is our long-held view that Japanese equities represent a compelling long-term opportunity in a global context.

We continue to believe that structural earnings growth, principally derived from corporate self-help, will be a strong driver of an asset class that could deliver a multi-year mid-teen return with modest risk of ownership. The current valuation does not invalidate this thesis, in our opinion. 

Investor focus likely to broaden

Whereas the market’s recent gains in the US have been focused on a handful of (mega-cap tech) stocks, in Japan, they have been mainly centred around two factors: company size and the price-to-book metric.

In 2023 and so far this year, large-cap stocks have meaningfully outperformed smaller companies. The other factor that has played a part is price-to-book ratio (PBR). This can be traced to the strong directions given by the Tokyo Stock Exchange last year to companies with a PBR below 1 to increase corporate value.

The table below showcases the difference in average return between different cohorts of the MSCI Japan Index, notably the considerable outperformance of companies in the top third of the index by market cap and those with PBRs less than 1.

As a result, we see an unusually narrow market. With performance concentrated on these factors, it is not surprising that the active management community has suffered during this period; actively managed funds have on average underperformed the broader market.

The narrow focus is not particularly healthy, in our view. But we expect these trends will start to spread out and we're already seeing evidence of that as 2024 has progressed.

In a bull market, investors’ ‘animal spirits’ normally come alive and they typically look for opportunities lower down the market-cap spectrum. This has not happened yet in Japan but we expect it will, and it is likely investor focus will broaden out from here. 

Opportunities for stock pickers

After a period where the return from stock picking skill has been low, we believe the stock market is currently presenting us with an abundance of opportunities that have been left behind by the somewhat indiscriminate rally.

We remain cautious around the changing macroeconomic environment in Japan, and the micro-currents within the market. Nevertheless, as we expect the structural corporate reform programme to continue, we are optimistic about the wider opportunity set of Japanese equities and the stock picking opportunities within the market. 

1 Foreign flows into Japan stocks topped 6 trln yen in 2023’, Reuters.com, January 12 2024.

By Carl Vine

The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.

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