Stockmarket reform ‘key’ to further gains as Nikkei hits all-time high

Zennor, T Rowe Price and Quilter react to the Japanese index surpassing its previous highest level set in 1989

Tokyo, Japan - November 27, 2023 : General view of the Tokyo Stock Exchange building in Tokyo, Japan.


The Nikkei 225 rose 2.2% on Thursday to end the day’s trading at an all-time high 39,098 points, eclipsing the previous record set on 29 December 1989.

Investors have been excited about the prospects for Japanese equities in recent times, with managers suggesting structural reforms, changing dynamics, and a corporate governance revolution with a new focus on improved returns on capital are starting to take hold.

James Salter, CIO and manager of the Zennor Japan fund, has managed Japanese securities for over 30 years.

Reflecting on his experience investing in the market, he said: “A real estate bubble as well as a capital expenditure bubble. Debt deflation. A banking sector in crisis by 1997. Sanyo Securities, Yamaichi Securities, Hokkaido Takushoku, and then Long-Term Credit Bank all went bust. Bear market rallies were tough and required the patience of the job. They lasted sometimes 18 months and have important lessons for us all.   

“At Martin Currie, my boss was a pioneer of investing in quality blue chips. We never had any banks in our portfolio. That alone was 300 basis points per annum of outperformance. Zombie companies sucked the lifeblood out of the economy. We were bearish throughout the 1990’s. Japan had its technology bubble in the late 1990s. Hikari Tsushin and Softbank were 5% of the benchmark and traded at 200x forward earnings. Again, we never were tempted. 

“As the Nikkei reaches an all-time high, I am reminded of my mentor, Michael Thomas [Martin Currie] showing me a piece of research on Hitachi from Vickers Da Costa, written in 1974. It had a buy rating, and the forward PER was 4x. The market at that time stood on over 60x earnings. It was very possible however to have a great career handsomely outperforming the Nikkei 225. What you did not own was almost more important. Jewels such as the semi-conductor company Rohm, were possible to buy cheaply, and we made 500%.” 

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Reform key to further gains

Japanese companies have begun to restructure in reaction to guidelines introduced by the Tokyo Stock Exchange last year, to focus on capital allocation and a return on invested capital.

At the start of year, the TSE reported that 41% of Tokyo Prime companies had announced steps to address undervaluation or were contemplating the cost of capital.

The stock exchange also recently wrote to more than 2,000 companies to establish whether their existing operational and governance structures remain fit for purpose.

Looking ahead, Salter added: “In 2024, Japan looks frighteningly ‘normal’ from a stockmarket perspective. Much improved corporate governance and world-beating niche manufacturing businesses, particularly in technology and robotics.

“The death of Zaitech (financial engineering) and poor disclosure at company meetings are all distant memories. However, what has not changed is the possibility of significant alpha generation as 50% of the market now has no analyst coverage. When I started there were seven dedicated small-cap strategists. Today there is not one. 

“Brokers told me as a graduate that if I stripped away cross-shareholdings the hypothetical market PER was in the late 20x region, not 60x. From a bottom-up perspective, rich pickings are there to be found in mid- and small-cap shares; true specialists in this market will have opportunities to add significant alpha. And, as interest rates rise, the yen will strengthen, enhancing returns for UK investors.”

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Daniel Hurley, portfolio specialist at T Rowe Price, also believes reform is the key to the Japanese market making further gains.

“Japan’s strong performance has been driven by three key factors – a robust global economy and growth, supportive FX helping exporters, and corporate governance reforms boosting shareholder returns,” he said.

“The rally of Japanese stocks has been centred on large caps, but not to the extent the US market has been concentrated on the ‘Magnificent Seven’. The Nikkei 225, which is more focused on exporters and tech companies, is at a three-year high relative to the broader TOPIX index. While this is partly supported by foreign inflows buying larger names, it is primarily driven by fundamentals – the weak yen supporting exporters and tech names rallying on AI and hardware technology demand and earnings.

“Large-cap value names have also been leading returns in Japan, partly thanks to the improved profitability from the weak yen. At the TOPIX level, around 48% of underlying earnings come from outside of Japan – with 15% coming from the US. A number of the beneficiaries of this have been larger cap exporters, driving returns and attracting investor attention.”

He also believes the multi-decade weakness of the yen has been important to recent stock market returns.

“The multi-decade weakness of the yen, which has been dramatic in recent years, has boosted overseas earnings. To give this some scale, the correlation between the monthly change of the Nikkei and JPY/USD over the last 30 years was 0.51. Since the beginning of 2020 to January 2024, this has increased to 0.66. The rapid weakening of the Japanese yen has been increasingly important to stock market returns of late.

“In addition, JPY weakness is certainly something that has helped value stocks over the past two years, which will be cyclical and determined by central bank policy and inflation rates within the US and Japan. From here, it is increasingly likely the JPY will strengthen – as we do not believe it will weaken much further as rates peak in the US.

“Finally, the key to unlocking sustainable value in Japan is primarily linked to corporate governance reforms. Continued improvements on this front will be crucial to future returns across the market.”

Lindsay James, investment strategist at Quilter Investors, added: “Valuations in Japanese stocks remain attractive and we believe this is a market that has finally thrown off its shackles and is now ripe for the evidently increasing attention from international investors.

“Corporate governance reforms have driven better use of balance sheets, triggering a raft of share buybacks and reduction of cross holdings which is enhancing shareholder returns. Together with an export-focussed economy that has contributed to forecasts of 10% earnings growth in 2024, very close to the expectations for US equities, this is no longer a market to overlook, and we remain bullish about the prospects for this region.”