Reigniting interest in Japanese equities
Following decades of economic stagnation in Japan, the region's stocks are finally attracting investor attention again. Head of Japanese Equities, Junichi Inoue, discusses the past, present and future of this dynamic market on the rise.
6 minute read
Key takeaways:
- The Nikkei 225 Index recently reached its highest level in almost 35 years, following Japan’s prolonged economic malaise due to decades of deflation and weak demand post the bursting of the asset price bubble in the early 1990s.
- The resurgence of the stock market, coupled with improvements in shareholder returns and corporate governance, should rekindle investor interest in Japanese equities.
- Japanese equities, a well-established, unique asset class offering both breadth and depth, is perfectly set-up for a stock-picking approach.
The past
It was 29 December 1989 when the Nikkei last hit an all-time high. At the time, I was a high school student, on a year’s stint as an exchange student in the US. Thanks to the strong yen, everything I bought seemed a bargain but, back then, Japan’s relationship with the US was nothing like the close ties that exist today.
Japan, then being the second largest economy, was viewed as a competitor and threat to US economic success. In the news, we saw Toshiba ‘boomboxes’ and Honda cars being destroyed by American workers. Indeed, Japan at that time – including its work culture – must have seemed foreign and alien. Japanese ‘salarymen’ were guaranteed lifetime employment, and lifelong dedication to the company was considered a virtue.
My father would leave home for work at 7am and typically returned after midnight, working six days a week. After a long day in the office, he was often expected to attend dinner and drinks with clients and colleagues, usually at corporate expense. The prevailing thought then was that companies belonged to the employees, not the shareholders. As a high school student in the late 1980s, my ability to enjoy the fruits of the burgeoning Japanese economy was limited, but I had the impression that the future was incredibly bright.
The recent strength in the Nikkei 225 Index is occurring under very different and challenging conditions compared to the golden era of the 1980s when Japan was riding high, having achieved the highest gross national product (GNP) per capita in the world, thanks to its technology-driven export-led growth and low unemployment. But this then led to investor exuberance and excessive valuations in the property and stock markets, with the asset ‘bubbles’ bursting in the early 1990s. Japan entered a period of economic stagnation known as ‘the Lost Decade’, caused by a sustained period of deflation (falling prices).
Why it took 35 years for the Nikkei to reach its recent level is worth considering, but the answer is simple – the peak in 1989 was just too high. Adjusting the inflated balance sheets from the bubble economy and bad loans, coupled with prolonged deflation, proved extremely difficult. Today, monetary and fiscal policies would have been deployed as a solution, but such methods were not available at the time.
Non-performing loans continued to be a major issue more than a decade after the bubbles burst, sacrificing funds that could have been better deployed into future investments. Additionally, the 1997/1998 financial crisis in Japan, which resulted in several bank failures, also hampered any progress. A comprehensive resolution requiring significant government capital injection was implemented in 2003, 14 years after the peak of the economic bubble. Later, China’s accession to the World Trade Organization in 2002 forced Japanese industries to lose competitiveness and undergo restructuring. Japan’s so-called ‘Lost Decade’ lasted for 23 years.
The present
35 years have passed since my high school days. It is my son who is now at high school, and he sees that the Nikkei Average is approaching the highest point in its history in a very different environment. He’s been astonished by the high prices in other countries during overseas trips. He notices his father is still working late into the night, but this seems to stem more from his fascination with fund management than anything else. He hears terms like ‘work-life balance’ regularly mentioned in the media as corporate culture is changing.
It is generally said that the country is losing competitiveness but there are still plenty of global companies in Japan. Toyota is the world`s number one automaker. Many semiconductor-related companies, which many industries cannot operate without, are also based in Japan. It is not just in business; Japan also is a centre of cultural attraction. In Shibuya, where my son changes train every day, we can see people from around the globe with smiling faces that are trying to get a shot of the famous Shibuya Crossing. It is worth highlighting that Japan remains one of the world’s largest economies, a pioneer in new technological and business processes, as well as having an influential role in cultural and global affairs.
Abenomics: a turning point
Former Prime Minister Shinzo Abe was tasked to turn around Japan’s sluggish economy and in late 2012 a series of economic policies known as ‘Abenomics’ were introduced. These policies included more liberal use of fiscal and monetary policy, as well as structural reforms to improve Japan’s competitiveness in global markets. This has really worked – The TOPIX’s compound annual growth rate (CAGR) from December 2012 to the end of February 2024 was 14% in yen terms, which represents a strong return over the last 12 years.1
New focus on shareholder returns and corporate governance
Abenomics was focused on solving Japan’s structural issues through accommodative monetary policy and market mechanisms. Companies were not just asked to earn profits, but to maximise them. For this purpose, the return on invested capital for each business was scrutinised, while withdrawal from low-profit businesses was encouraged.
First proposed in 2012, the Stewardship Code required institutional investors to be transparent about their investment processes, engage with investee companies and vote at shareholders’ meetings. The positive results of Abenomics can be evidenced by the following data: CAGR of net profit for the TOPIX during this period was 14% and the total return to shareholders was 12%.2 Share buybacks became common and the total payout ratio has reached about 60%. Corporate governance reforms carried out in parallel have also shown results. Today, the number of companies with more than one-third external directors is almost 90%.
With numbers like that, the 14% CAGR registered by the TOPIX since the beginning of Abenomics in 2012 should be unsurprising.
And the future
Although Japanese companies have been evolving for the better over the last decade, we are only now seeing a revival of investor interest, helped by the decline in Chinese stocks and the lacklustre performance of the S&P 493 (S&P 500 minus the so-called Magnificent 7) in 2023.
In contrast to past decades, the majority of Japanese companies are now owned by shareholders rather than keiretsu banks or employees and management acting as if they own the companies. Profits are growing and corporate governance has been improving, while valuations remain reasonable compared to their historical average or relative to other markets.
Investors may want to reconsider an allocation to Japanese equities, a well-established, unique asset class offering both breadth and depth – the perfect set-up for a stock-picking approach.
Past performance does not predict future returns.
1 Bloomberg, 30/11/2012 to 28/02/2024 in yen terms.
2 Mizuho Securities Equity Research, as at 15 February 2024.
Balance sheet: a financial statement that summarises a company’s assets, liabilities and shareholders’ equity at a particular point in time. Each segment gives investors an idea as to what the company owns and owes, as well as the amount invested by shareholders.
Compound Annual Growth Rate (CAGR): measures an investment’s annual growth rate over time, including the effect of compounding (where any income is reinvested to generate additional returns). CAGR is typically used to measure and compare the past performance of investments or to project their expected future returns.
Dividend payout ratio: the percentage of earnings (after tax) that are distributed to shareholders in the form of dividends in a year.
Fiscal policy: the use of government spending and taxation to influence the economy to promote strong and sustainable growth and reduce poverty.
Keiretsu: an intricate business network with a long-term transactional relationship. The business network is largely composed of banks, manufacturers, supply chain partners, and distributors who work closely together for the success of the whole group.
Monetary policy: policies of a central bank, aimed at influencing the level of inflation and growth in an economy. Monetary policy tools include setting interest rates and controlling the supply of money.
Net profit: gross profit minus operating expenses and taxes.
Nikkei 225 Index (also known as Nikkei Stock Average): a measure of Japanese economic and equity market performance. The index includes 225 of the largest companies listed on the Tokyo Stock Exchange.
S&P 493: S&P 500 minus the dominant technology stocks ‘Magnificent 7’ (Amazon, Apple, Alphabet, Meta, Microsoft, Tesla, and nVIDIA). This alternative benchmark can be considered to provide a better representation of US stock market performance.
Share buybacks: a company that buys back its own shares from the market leads to a reduction in the number of shares in circulation, and as a consequence increases the value of each remaining share. Typically signals the company’s optimism about the future and a possible undervaluation of the company’s equity.
TOPIX: or Tokyo SE First Section Index is a market benchmark covering an extensive proportion of the Japanese stock market and is a free-float adjusted market capitalization-weighted index.
6 minute read
Key takeaways:
- The Nikkei 225 Index recently reached its highest level in almost 35 years, following Japan’s prolonged economic malaise due to decades of deflation and weak demand post the bursting of the asset price bubble in the early 1990s.
- The resurgence of the stock market, coupled with improvements in shareholder returns and corporate governance, should rekindle investor interest in Japanese equities.
- Japanese equities, a well-established, unique asset class offering both breadth and depth, is perfectly set-up for a stock-picking approach.