I must start by declaring an interest: I have a consultancy agreement with a Japanese fund manager, Arcus Investments Limited. However, the case for allocating to Japan today is a strong one and deserves a wider audience. I find that many institutional investors are still suffering from a hangover from twenty-five years of disappointment and are underweight. This article looks at why that might be an unduly cautious stance.
No leverage and a doubling in profit margins
Japanese companies have over the last thirty years gone in the opposite direction to the United States. In a generally deflationary environment, it has made sense for them to deleverage balance sheets, and they have accordingly applied surplus cashflow to paying off debt rather than investing or paying shareholders. In aggregate, aggregate net debt fell from 300 trillion yen in 1999 to net cash of 23 trillion yen in 2023. In contrast, leverage in the U.S. is at an all-time high after a splurge during the period of ultra-low interest rates. This may not be ideal in a higher rate environment.
There has also been a big shift in corporate governance. The impetus was the implementation of a new Corporate Governance code in 2015 with the objective of improving medium to long term shareholder value. Since then there has been a considerable unwinding of the complex inter-company shareholdings, with subsidiaries being relinquished or merged into the parent.
The consequence of these two trends has been a substantial improvement in profit margins since 2018. For the previous sixty years they had averaged around 3%. In 2023 they reached 7%. Companies have used the extra cashflow to pay back shareholders, and more recently to invest. The proof of that is that aggregate dividend pay-outs have risen six-fold since 2000 and share buy-backs have grown from zero to add a further 50% or so to the total returned to shareholders.
Hostile take-overs are succeeding
As part of the changes in corporate governance, the number of take-overs has been rising for a number of years. But the Tokyo Stock Exchange added fuel to the fire in January 2023 by publishing a paper, crucially with the support of METI (the Ministry of Economy, Trade, and Industry), which requires companies with a Price to Book of less than one to prepare a plan to improve their share price. The sanction for those who fail to comply is delisting.
METI then introduced new guidelines for corporate takeovers in August 2023 which force the target company to demonstrate in financial terms why their proposals would be better for shareholders than the acquirers. Arcus point out that when NIDEC made a hostile take-over bid for Takisawa Machine Tool last summer, the latter’s board rapidly recommended it, as they could not compete. A successful hostile bid of this kind would not have happened ten years earlier.
Almost 1000 stocks in the broader TSE index trade at a Price to Book of less than one today and it is hardly surprising that global private equity firms are increasingly concentrating on the value to be found in listed Japan. The cost of finance below 1%, conservative Japanese accounting, and balance sheets without leverage are added bonuses to the private equity model. In time they will be part of the mechanism how (some) Japanese companies escape the value-trap.
Retail investors are being wooed too
Japanese households (Mrs Watanabe in the vernacular) famously held their savings under the bed during the deflationary years. Only 11% of household assets is invested in equities today, compared to nearly 40% in the United States. The tax free-allowances (Nippon ISAs) available to Japanese individuals will triple from 1st April 2024 to try and encourage some of this into the stock market. The cynic might say that the Bank of Japan is trying to boost retail demand before selling the equities they purchased as part of QE back into the market. However, the BoJ is sitting on a big profit and shows no signs of wanting or needing to sell its holdings.
In summary, valuations are cheap, at least outside the largest 30 companies, and there are lots of reasons why profits should rise and the demand for Japanese stocks should increase over the next few years. For foreign investors there are two other reasons to consider going overweight in Japan.
Even cheaper for foreign investors
One is the cheapness of the yen, which is currently around 50% cheap on purchasing power parity calculations. One can debate the reasons why it has fallen below 150 yen to the USD: the lure of the 5% interest rate differential, and the Bank of Japan’s desire for the currency to trade roughly in line with the renminbi would be my top two reasons. But it is undoubtedly abnormally cheap.
In the short term the weakness may continue, as Japanese interest rates are unlikely to rise by much, despite the recent move to positive territory, nor do I expect U.S. rates to fall as much as the consensus. It makes Japan an attractive place for inward investors to access a skilled workforce (think Taiwan Semiconductor’s decision to site its new factories in Kyushu). In the longer term, especially given its safe haven status, the yen can be expected to revert somewhere near the norm, providing a useful extra return for unhedged foreign investors.
Japan well-placed geo-politically
Then there is Japan’s geo-political position. While it has a leg in both the Chinese and the American camp, there is no doubt which way it will fall if pushed. The financial changes described above are further proof that Japan is aligning itself with the United States. Whatever happens between the United States and China, as a firm ally Japan is well-placed to benefit.
Could demographics derail this?
What are the counter-arguments? The main ones are based on demography and a view that there is a lack of commitment to reform, perhaps evidenced by the occasional corporate scandal when it hits the newspaper headlines.
Japan is certainly an ageing society, and it perhaps finds itself in the forefront of the demographic challenge. But its profile is not dissimilar to countries such as South Korea, much of Europe, and even China. Japanese resistance to immigration is usually seen as a part of the specific problem, but even here Japan is changing, with significant immigration now coming from the Philippines and Vietnam in particular. And Japan’s relatively cohesive social structures have been effective in raising labour participation rates for older age groups.
There are still some governance challenges to overcome, most notably around diversity and inclusion. But the margin and earnings growth is evidence that Japan has changed. It’s an interesting statistic that over the past thirteen years TOPIX eps growth has kept pace with the S&P500.
I rest my case, m'lud.