Regime changes restore appeal
Japanese equities have been a neglected and under-owned asset class for the past 30 years. Japan’s weight in the MSCI World Index has declined to around 6% from 40% back in 1987. According to our research, global investors remain underweighted Japan relative to the MSCI World Index and foreign investor holdings in Japanese equities remain at half of what they were in 2015.1
The lack of global investor interest in Japanese equities is understandable given the country’s structural issues. Japan has been the poster child of an economy with chronic deflation since the 1990s, fostering market expectations of lackluster earnings growth for corporate Japan relative to its developed market peers. Japanese companies also have a reputation for having a poor focus on shareholder interests, as evidenced by their notoriously low return on equity (ROE). The ROE for the MSCI Japan Index stood at 9.9% at the end of 2022, compared to 14.7% for the MSCI World Index.2
These structural issues for Japanese equities are well understood and the market is priced accordingly at 15x forward earnings. In our view, that is a significant discount to developed market equities, as the MSCI World Index trades at 18x forward earnings.3
However, multiple regime changes in Japan are underway, and in our view, global investors don’t fully appreciate these changes. First, inflation has returned to Japan, and this should boost Japan’s earnings growth outlook. Second, corporate reforms in Japan have reached a tipping point, and we believe the potential value to be unlocked is game-changing. With these paradigm shifts at play, Japanese equities are fundamentally a bargain, in our view.
From a global asset allocation perspective, Japanese equities can provide diversification benefits in an era of geopolitical rivalry between the United States and China. Afterall, Japan remains a force in the global economy and is the third-largest stock market in the world after the United States and China.
Inflationary tailwind for earnings growth
For the first time in three decades, Japan is seeing a sustainable inflation cycle in motion. While there have been false dawns in the past, what is different this time is that companies have regained the confidence to raise prices, and households are accepting them. A notable shift in inflation expectations and price-setting behavior has taken root in Japan. Inflation has been above the Bank of Japan’s (BOJ) 2% target since April 2022, the most enduring bout of inflation since the 1990s. The price of a bowl of ramen, one of Japan’s favorite affordable meals, has gained over 5% over the past 12 months after years of subdued price changes. Most importantly, wages are rising at the fastest pace in three decades. Rising wages are the key to sustainable inflation in Japan.
We believe wage increases in Japan are likely to be sustained. Japan has an aging and shrinking population. The unemployment rate is very low at 2.5% (as of June 2023) and the country has exhausted its slack labor. The female labor participation rate is around 75%.4 Competition for labor is rising in Japan for the first time since the bursting of its economic bubble in the early 1990s, and this is constructive for Japan’s wage outlook.
The return of inflation is helpful for the corporate earnings outlook in Japan. When prices increase in an inflationary environment, what tends to happen is that revenue growth accelerates and profit margins improve. That is because most businesses have a reasonable degree of fixed costs even amid inflation, so higher prices will boost revenue and profits at a faster pace than the increase of business costs.
As Japan had been in deflation since the 1990s, the lack of price increases handicapped Japanese companies. We see the effects of this in corporate Japan’s revenue growth. Over the past 20 years, revenue growth recorded by corporate Japan—as represented by the MSCI Japan Index—came in at just 1.3% per annum (p.a.), lagging its developed market peers of the MSCI World Index, which delivered revenue growth of 3.4% p.a.5 The anemic revenue growth for Japanese companies translates to inferior margins relative to their developed market peers, which enjoy greater operating leverage benefits. The operating profit margin for the MSCI Japan Index stands at 7.6%, while that for the MSCI World Index is at 13.6%.6
Consequently, the tailwinds from a sustainable 2% inflation in Japan for corporate earnings growth cannot be understated. The long-term earnings growth outlook for Japan has brightened and the country is arguably on a structural path of closing the earnings growth gap relative to its developed market peers.
Corporate reforms at tipping point, significant value to be unlocked
The lack of focus on shareholder interest in corporate Japan is another key reason for its significant valuation discount to developed market peers. We believe the value that could be unlocked is potentially game-changing for Japanese equities. Half of the listed companies in Japan trade at below book value. Most of these companies are in a net cash position.
Japan’s corporate reform journey began about 10 years ago with the introduction of the Corporate Governance Code. Since then, dividends and share buybacks have been steadily improving. Today, Japan is second only to the United States in terms of the number of activist shareholder campaigns.
The institutional pressure to focus on shareholder interests stepped up further in the spring of 2023, when the Tokyo Stock Exchange requested listed companies trading below book value to provide an action plan aimed at improving their market valuation and ROE. The action plan involves identifying the company’s cost of equity and explaining how ROE can be improved to at least match the cost of equity. Further, the action plans should state the steps that will be taken for the market to award a price-to-book (P/B) valuation of at least 1x for the company’s shares. Essentially, the Tokyo Stock Exchange is providing a platform for active dialogue between the listed companies that trade below book value and investors for mutual benefit. This institutional initiative to unlock shareholder value in the stock market is unique to Japan.
As half of the listed Japanese companies trade at below book value, the corporate reform movement has gone mainstream. In our view, global investors should seize the opportunity afforded by the Corporate Governance Code and the Tokyo Stock Exchange to engage with Japanese listed companies on the best way forward to unlock shareholder value.
We believe the scale of potential value to be unlocked is significant. For a start, Japan’s corporate balance sheets have lower financial leverage than developed market peers. If the financial leverage for the MSCI Japan Index is adjusted to levels comparable to those for the MSCI World Index, the ROE for Japanese corporates would improve to 12% from 10% currently.7 This narrowing of the ROE gap should support market multiple re-rating for Japanese equities.
In addition, the long-held practice of cross-shareholdings in Japan—where a company takes a small stake in their suppliers and customers as a gesture of goodwill in their business relationship—implies further trapped value in the Japanese equity market. 20% of the Japanese stock market capitalization is held by listed Japanese companies, and much of this is due to cross-shareholdings.8 We expect these cross-holdings to be unwound as companies ramp up their compliance with the Corporate Governance Code, and this may become another source of shareholder value creation for Japanese equities.
Active management offers better access to Japan’s unique opportunities
From inflationary tailwinds for earnings growth to corporate reforms that unlock shareholder value, stock indexes are likely to under-represent the unique opportunities in the Japanese equity market; we believe they are best captured through active management.
For example, domestic-facing companies are likely more geared to the earnings growth outlook improvements as a result of Japan’s return to a world of sustainable inflation. However, domestic-facing companies only make up 40% of the MSCI Japan index.9 In addition, we believe the corporate reform opportunities are best captured through stock selection. The scope of value to be unlocked varies by company, and each company is at a different stage of its corporate reform journey. We think global investors who are seeking to benefit from the regime changes that are taking root in Japan should consider an active manager with a focus on stock-picking across all market caps and types of value situations.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Equity securities are subject to price fluctuation and possible loss of principal.
International investments are subject to special risks, including currency fluctuations and social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.
Active management does not ensure gains or protect against market declines.
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1. Source: Morgan Stanley, June 16, 2023.
2. Source: Jefferies, FactSet, data as of end-2022. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
3. Source: Bloomberg, data as of July 31, 2023.
4. Source: Citi Research, data is forecast for 2024.
5. Source: Bloomberg, data as of end-2022. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
6. Source: Ibid.
7. Source: Jefferies, FactSet, data is for the financial year ended March 2023.
8. Source: Jefferies, FactSet, September 2023.
9. Source: Bernstein Research, August 2023.