23 MAY, 2023
By Harrington Cooper
a) Japanese equities valuations are cheap relative to developed markets; “as of March 2023, Japanese equities (as represented by the TOPIX), were trading at 1.2x book value, roughly a third lower than the average among the top developed equity markets, and more than two-thirds lower than the U.S” – Compelling Valuations in Japan
b) Unlike Emerging Markets, where equities are also at historically cheap levels but investors are being put off by the geopolitical situation, Japan has high political stability.
c) Valuations should provide a margin of safety and a defensive cushion (alongside an attractive re-rating option). However, positive performance is not dependent on a re-rating given the various other potential positive drivers (explained in more detail below).
a) Why have Japanese companies’ valuations been historically cheap? According to Nissay Asset Management, valuations in Japan have historically been low because, in the past, Japanese company management teams have destroyed corporate value through poor governance and capital allocation decisions.
b) Why will Japanese companies’ share prices perform better going forward? Top-down Tokyo Stock Exchange (TSE) reforms have specifically targeted Japanese companies’ return on equity (ROE), capital efficiency, and improvements in corporate value:
i. For example, on 4 April 2022, a new categorization of listed companies was introduced: Prime, Standard, and Growth. “Prime” companies must meet criteria across three key areas: Governance, Liquidity, and Business Performance/Financial Status, all of which are aimed at keeping a higher quality of corporate governance and improving medium- to long-term corporate value – Listing Criteria for the Prime Market
ii. TSE reforms are also targeting companies with very low price-to-book (PBR) ratios and encouraging them to focus on ROE, cost of equity, and capital efficiency. Companies that trade at a PBR less than 1x will be required to disclose their policies and specific initiatives for improvement – TSE requires adequate actions in cases where PBR is below 1x.
iii. Unlike in the past, there are several good examples of Japanese companies that have implemented shareholder-focused reforms and whose share prices have been rewarded as a result, e.g., SONY, Hitachi & Fast Retailing (Uniqlo). Their competitors have been watching these ‘reform leaders’ closely and there is evidence some have started to replicate their behaviors.*
a) Domestic Japanese companies are increasingly divesting their historical cross-shareholdings with the slack being picked up by foreign investors, encouraged by shareholder-friendly reforms – Divesting of cross-shareholdings.
b) Recently Warren Buffett visited Tokyo which has been described as a “stamp of approval” for investing in Japan, this has led to an increase in interest from European investors – Warren Buffett’s trip is a ‘stamp of approval’ for investing in Japan.
a) Increased tax benefits – the Japanese government announced a significant expansion of the new NISA (Nippon Individual Savings Account) program starting in 2024, which has further increased domestic interest in investment. The tax exemption period will be extended from the current 5 years to permanent, and the lifetime tax exemption limit will increase from JPY 6 million to JPY 18 million – What is NISA (Nippon (Japan) Individual Savings Account)
b) Increased domestic investment by younger generations in Japan – according to the 2022 trading data released by the Tokyo Stock Exchange, individual investors in Japan bought 1.18 trillion JPY net in 2022 (4.2 times the net purchase of 2021). The number of young investors in their 20s and 30s has increased by 1.5 times compared to 2015 because there is growing anxiety about future financial security.*
a) In the wake of increased geopolitical tensions, there is an increasing trend by the US and others to secure supply chains with key allies. This can be seen by the recent confrontation and intensifying competition between the US and China, where large investments are now being made on a medium- to long-term basis under government initiatives.*
b) Japanese companies are benefitting from this trend as they are leaders in certain key industries, such as the semiconductor industry, due to their competitive advantage in the high-tech manufacturing of critical components. Semiconductors are massively important to a country’s economic development and are particularly sought after by major powers such as the US and China. In addition to PCs and mobile phones, a huge amount of semiconductors will be needed in future fields such as data centers, and AI, as well as the advancements in automobiles and home appliances – Japanese semiconductor-related companies are leading the industry.
a) Consumers: Due to inflation in Japan, which is relatively muted compared to Europe and the US, and with wage inflation (3-5%) starting to come through (especially from larger cap companies such as Toyota, Hitachi and Toshiba), consumers are not as squeezed as in other countries, allowing for sustainable domestic demand.*
b) Corporates: The gap between PPI and CPI is down to 4% from a high of 7.5%, allowing Japanese companies to pass costs onto consumers more easily and therefore improve margins.*
a) Japanese banks are very well capitalized and conservatively run with low levels of debt and high cash reserves. By even modestly increasing their interest rate on consumer and corporate loans, they should benefit from expanding operating margins.
a) Roughly three-quarters of the TSE is in the inefficient small or mid-cap categories with low levels of sell-side research making it a very attractive space for well-resourced fundamental stock pickers to find alpha-generative value opportunities.*
a) Due to the re-opening of China and the removal of Covid restrictions, there is a significant amount of pent-up demand from Chinese tourists wanting to visit Japan. Air travel from China to Japan is currently operating at 30-40% of total capacity (and Europe is at 60-70% of total capacity). As supply builds up to full capacity, this could considerably boost domestic consumption levels from tourists.*
a) Although top-line growth over the next 5-10 years may be hindered by an aging domestic population, Japanese companies can still independently grow profits and earnings through overseas expansions and improving their capital allocation activity.
b) Dividend yields for the TOPIX are currently at 3% and likely to grow faster than earnings because the payout ratio is still low, which would add an extra 1-1.5% to the compound return; in addition, the stock market is buying back about 3% of itself each year.*
c) Japanese earnings have compounded at around 8% historically and, if history repeats itself, 15% compound returns are possible without any change in valuations – The Japan opportunity – long-term strategic case
*Sources: Harrington Cooper Research, FactSet, Bloomberg, Morningstar, Daiwa Securities, Nissay Asset Management, Nippon Life, Tokyo Stock Exchange, Inc., SPARX Asset Management Co., Ltd, Man Institute, JNTO, M&G Investments, CNBC, Reuters, TTG Asia, Japan Exchange Group, Nikkei Inc.