The Japanese market has been the surprise success story of the past 12 months. The Topix has hit multi-decade highs, rising 21% since November last year, fuelled by corporate governance reform and economic revival[1].
Yet the spoils have not been equally shared, with small and mid-cap companies trailing the index heavyweights. Could there be more to play for in Japan?
After decades in the wilderness, Japan continues to draw investor attention. Warren Buffet led the way, with a high profile investment in a series of Japanese trading companies. Japan now forms the largest market in his portfolio outside the US. International investors have followed, driving capital into Japan’s larger companies.
Joe Bauernfreund, manager of the AVI Japan Opportunity Trust, says: “Investors have started to get more interested in Japan. Foreign flows have picked up, driving the broader index. In this type of environment, the money tends to be cautious, and it goes into companies that people are familiar with. This year, that has been ‘value’ areas, such as trading conglomerates, banks, plus exporters because the yen has been weak.”
This has been reflected in the performance of trusts. The Baillie Gifford Japan Trust, for example, is down 14% in share price terms over the past 12 months[2], with Fidelity Japan down 2.7%. Both favour smaller companies. The more value-focused Schroder Japan is up 14.8%, with CC Japan Income & Growth up 13.9%.
The question is whether market strength can broaden out, allowing some of the trusts that have lagged to catch up. Certainly, some rebalancing seems in order. Many of the companies that have done well over the past 12 months will now have to contend with a tougher global economy, says Nicholas Weindling, co-manager of the JPMorgan Japanese Investment Trust. In the meantime, the outlook for the domestic economy remains robust.
The country’s GDP expanded by an impressive 4.8% from April to June, even if it has slowed in the most recent quarter[3]. Inflation is picking up, helping to create wage inflation[4] and encourage consumer spending. Unlike China, the post-Covid economic revival continues; tourist numbers, for example, are hitting record numbers. While there are no ‘animal spirits’, it is new environment for a country that has struggled with deflation for so long.
Corporate governance
Equally, implementation of corporate governance reforms is still nascent. It was only at the start of this year that the Tokyo Stock Exchange (TSE) took action to encourage companies to address their low valuations. In October, it announced plans for a radical new ‘name and shame’ regime, publicly naming the listed companies that have and haven’t complied with its requests[5].
Weindling says: “We have already had the stewardship code for eight years and there were a number of good trends emerging. Buybacks in Japan have been increasing each year. There is a lot more to go for. In particular, around 50% of Japanese companies have net cash on their balance sheets.
“Asset managers have become much more aggressive in voting their shares, which is leading to much more dramatic results at AGMs. Blue chip companies are seeing large votes against the management team. Finally, there is a generational shift in the management of major companies. Previously, there could be a CEO or chairman in their eighties, but those people are starting to move on.” He says that the TSE reforms are already having an impact on corporate behaviour, with companies looking to address over-capitalised balance sheets.
Reform in action
Weindling is looking for companies that can combine structural growth with improving governance. He sees this in the robotics and automation sector, for example, with companies such as pneumatic equipment maker SMC. It has structural growth because of increased use of automation in manufacturing and the reshoring trend, but it also has net cash on its balance sheet. He adds: “It’s started to do more in terms of shareholder returns and also has a new CEO”.
He also holds Nintendo: “It has world-leading intellectual property with Pokemon and Super Mario, yet it had showed no inclination to monetise this IP. Now, there is the Nintendo World at Universal Studios, and the Mario movie. Bicycle company Shimano has 25% of its market cap in cash, but is also seeing structural growth. These are successful companies with long-term prospects and investors also get the benefits of corporate governance improvements.”
Valuations
Even after the recent spike in markets, valuations are still reasonable, says Weindling: “There have been some inflows, but people are still sceptical about Japan. When Abe was elected in 2013, there was about $250bn of inflows from foreigners into Japan. Over the next 10 years, all that money left. Over this year, when people have been quite excited about Japan, $35bn has come in. Although the market is at a 30-year high, it only trades on 14x earnings. It’s not an expensive market.”
For Bauernfreund, the big question is where international and domestic investors look next. He says: “International investors have been big buyers of Japan over the past 12 months and there is a lot more interest. But there is also some panic – a sense that they have disregarded Japan for so long. They are dusting off their research.”
However, he believes domestic investors will be more important in determining whether market leadership broadens out. They may be lured back into domestic bond and equity markets by rising yields, and may be more inclined to buy smaller, domestically-focused companies. “That will be the key – if domestic investors start buying their own market.”
He adds: “We haven’t changed our positioning. We’ve kept our focus on small cap names, where there are opportunities for active engagement and strategic operational improvements. They’ve had an underwhelming few months, but from a valuation perspective, these companies are looking good and from an engagement perspective, they’re looking good too.”
A final consideration may be the currency. The yen has been weak, which has meant international investors haven’t seen the full benefit of recent market strength. Ultimately, it may take clearer signs that the Bank of Japan is moving closer to normalising monetary policy. If it happens, investors may rotate away from exporters and look for alternative options within the Japanese market.
Ultimately, the easy gains may have been made in the Japanese stock market, but there are still parts of the market that haven’t participated in the rally. These companies are still transforming, and still have the backdrop of stronger domestic growth and, potentially, a stronger currency. The Japanese market is still worth investigating.
[1] https://www.ft.com/content/af96b1e8-59bc-4e01-bf43-863953a51dd2
[2] https://quoteddata.com/sector/investment-companies/asia/japan/
[3] https://www.reuters.com/markets/asia/japans-gdp-likely-shrank-q3-china-slowdown-hits-exports-2023-11-02/
[4] https://www.bloomberg.com/news/articles/2023-11-06/japan-pay-growth-strengthens-for-first-time-in-four-months
[5] https://www.ft.com/content/94dfe7fb-d244-4c26-809b-3d1ec213815d