By James Salter, founder and CIO at Zennor Asset Management
Japan has been steadily outperforming most western markets over the last 10 years, despite seeing its currency depreciate more than 40%. Last year, Japanese equities had a stellar year, with the market up close to 28%. With Japan trading at 34-year highs, it is tempting to believe that the opportunity in Japan may already have passed. Based on the structural reforms and changing dynamics of a country that continues to fly under the radar of UK investors, we believe the opportunity is only just starting to take hold. The corporate governance revolution and new focus on improved returns on capital is unique to Japan amongst developed markets.
Corporate revolution focusing board attention
Beneath the surface in Japan, the governance revolution is beginning to play out. Following the introduction of new guidelines by the Tokyo Stock Exchange (TSE) last year, Japanese companies have begun to restructure and focus on capital allocation and a return on invested capital. The TSE has stressed that equity capital comes at a price and that companies need to be cognisant of what this means. It is maintaining the pressure and recently wrote to over 2000 companies to assess whether their existing operational and governance structures are still appropriate. We believe this will focus the boards’ attention and lead to further corporate action. The TSE is seeking to encourage more effective compliance with existing rules rather than introducing new measures in 2024.
Focus on real wage growth
If Japan can address labour productivity and real wages, perhaps it can finally begin to put 30 years of stagnation behind it. Wages have barely risen for three decades, whilst economy-wide productivity has been declining at an alarming pace. Changing the dynamics of corporate Japan’s profitability can be the catalyst for change – and there are clear signs that this is the intention of Prime Minister Kishida. He has publicly declared that he wants to ensure that the growth in disposable income exceeds price rises, promising on New Year’s Eve that his government “will mobilise all of its policies to achieve this goal”.
What’s more, the biggest changes have been at the firms that very few investors, especially not global investors, have cared about for many years. These companies are typically very cheap, asset-rich and overlooked – and they are, albeit from a low starting point, striving to improve their governance, return on equity and bolster valuation.
MBOs at record levels
MBOs in Japan last year accelerated at their fastest pace for 10 years (there were 26 MBO announcements in 2023, with a combined value of $2.4bn, according to data from LSEG) – and the pace of such activist events is likely to continue in 2024. Finally, there is now a market for corporate control. Given the abundance of cash and other financial assets held by Japanese companies, it is no wonder that Japan is the preferred destination, after the US, for private equity groups. In November, we witnessed, Benesee, Teraoka Seisakusho, Shidax, and Taisho Pharmaceutical, all seeking to take themselves private.
Private investors poised to invest
Households are sitting on piles of cash, but new tax-free savings reforms could unlock an estimated ¥1.2 quadrillion of household assets held in cash. On 1 January, Japan launched its revamped NISA (modelled on the UK’s ISA), making it more compelling for Japanese households to invest in the stock market by increasing limits and tax-exempt periods indefinitely. The government is aiming to double the number of NISA accounts to 34mn, and the amount invested to ¥56tn, over the next five years.
For those looking at Japan from afar, it is difficult to appreciate how cheaply valued companies are; how asset-rich firms are; how poorly focused they are on core business activities; and how inefficiently they use equity capital compared to those in Europe, let alone the US. As firms address these challenges they will spin off dramatic quantities of free cash flow which we believe will be returned to shareholders.
A stronger yen
Timing, as ever on currencies is fraught with risks. However, what does appear likely is that as many Western central banks have scope to cut interest rates, Japan is likely to abandon yield curve control and eventually raise the overnight call rate from 0 per cent. The currency is very cheap on most measures and yet Japan still has a large current account surplus. The Bank of Japan will likely want to see if wage inflation has become more entrenched during the Spring wage negotiations.
Earnings per share matter most
For us, earnings per share is what matters most. As an example; if one were to look at NTT, earnings per share has far outstripped core operating profits due to a nearly 50 per cent buyback of outstanding shares over 20 years. Buybacks, higher dividend pay-out ratios, MBOs, tender offers – Japan has it all, and now domestic activists are joining foreign investors in demanding change. From a bottom-up perspective rich pickings are there to be found in mid and small-cap shares, as over half of the listed market in Japan has virtually no analyst coverage which means that true specialists in this market will have opportunities to add significant alpha.