By Rob Morgan, Chief Investment Analyst, Charles Stanley
The Japanese stock market is suddenly in the spotlight after finally surpassing the highs of the bubble era in the late 1980s earlier this year.
Drawing a comparison over this timescale doesn’t make much sense, though. At the 1989 peak the market was a in a crazy bubble buoyed by astronomical real estate prices. Today’s valuations make far more sense and are rooted in strong earnings and sensible asset values. Furthermore, just looking at the level of the Japan stock market index ignores dividends which are a key component of overall returns.
Multiple factors have been driving this performance including corporate governance shake-ups, cheap valuations, a move from deflation to inflation, a weak yen and increased M&A activity. However, the currency weakness has also diluted returns for UK investors. Although the flagship TOPIX index is up 33% over the past year to the end of April, that translates to just 16% in sterling terms.
What’s driving returns from Japanese shares?
There have been several elements that have led to the most recent rally. The falling yen has increased the competitiveness of Japanese goods to overseas buyers, benefitting many of the big exporters that dominate the larger company indices
Meanwhile, the weaker currency has contributed to higher inflation which has a mixture of effects for companies and for Japanese consumers. Japan imports a lot of resources, like oil and gas, and a weak yen makes them more expensive. Some Japanese companies are suffering from these higher input costs without sufficient ability to pass them onto customers. Nonetheless inflation is now firmly back, and after decades of deflation the land of the rising sun is now the land of the rising prices. Inflation currently stands at 3%, above the Bank of Japan’s (BoJ) 2% target and employers are now offering significant wage rises.
Although this is painful for some areas of the economy, a return to a more inflationary environment is welcome. It is highly likely to drive changes in consumer behaviour and over time create a virtuous cycle of wage and price rises, which could be positive for the economy and stock market in the long run. The upside-down world of negative Japanese interest rates looks to be over, though the yen is likely to remain weak as rates remain close to zero, completely at odds with the global norm.
An important ongoing trend is corporate governance reforms. In 2012, Shinzo Abe’s economic legacy, known as Abenomics, marked the start of corporate reform. The first of his two ‘arrows’, monetary policy and increased government spending, were quick to implement while early signs of the third, economic structural reforms, have been slower to take root. Yet the Tokyo Stock Exchange (TSE) has since built on the groundwork of the late prime minister through its Stewardship and Corporate Governance codes.
Governance is ‘big in Japan’
One of the bolder measures from the TSE requires companies to disclose capital efficiency improvement plans, particularly by those trading below 1x book value – a financial metric that determines how close a company’s shares trade to its net assets. A company that trades below book value implies it is priced below its break-up worth and seen by investors as a ‘value destroyer’.
Other measures are targeted at unwinding ‘cross holdings’ where Japanese businesses take stakes in one another. This strategy has long been used by Japanese companies to support business relations, shield themselves from hostile takeovers and protect against uncertain, volatile markets. However, such activities have been criticised as locking up shareholder equity and for being too aligned with management.
In December 2023, the TSE announced it will add further pressure by calling on over 1,000 companies that have parent-subsidiary or affiliate relationships, to increase disclosure around their rationale for this and their efforts to ensure their independence.
Then, in January 2024, the TSE released the names of over a thousand companies that had disclosed information regarding their actions to implement policies conscious of cost of capital and share price, shaming the roughly 2,000 that did not.
Satisfying short-term financial metrics has typically not been at the forefront of Japanese management’s priorities in the past, and a mindset shift will always take time. However, increased pressure on companies to change practices to place an increased focus on shareholder returns through balance sheet reform, higher dividend payouts and share buybacks could continue to benefit investors over time, drawing on the deep cash reserves many Japanese companies have built up.
Overall, the effect is reshaping the business landscape with shareholder friendly policies such as better capital allocation becoming more widespread. Meanwhile, a more financially motivated shareholder base is pushing to effect change from the outside. While not all companies will wholeheartedly embrace this, the progress so far has deservedly caught the attention of global investors.
Partying like it’s 1989?
While it’s been a good year for the Japanese stock market, there has been significant divergence in how different areas of the market have performed. The weaker yen has supported exporters and international-facing businesses but has made more domestically focused companies less attractive to overseas investors.
In addition, the extra investor attention from corporate governance reforms has been directed more at the larger companies thus far, leaving funds more invested in smaller companies trailing behind. This has led to a wide dispersion of returns from Japanese equity funds over the past year.