There has been no better advertisement for global diversification in modern times than Japanese equities. 35 years ago, Japan was bidding to overtake the US as the world’s largest economy. Its “economic miracle” looked set to continue as the Nikkei 225 index hit an all-time high of nearly 39,000 points in December 1989. But then the market crashed spectacularly, and it didn’t reach that level again until February this year.
Over three-and-a-half “lost decades” of economic stagnation, falling prices and zero wage growth, returns on Japanese equities struggled to keep up with interest on instant savings accounts.
Now, finally, there are signs that Japan may have turned a corner. Stock prices have risen sharply over the past two years, and, despite a wobble in late July and early August, the Nikkei continues to hover around 40,000.
With foreign investment growing, the combined market capitalisation of Tokyo-listed stocks recently hit quadrillion territory — ¥1,000 trillion — for the first time. As one fund manager told the FT: “For 30 years, the investment has been all about Asia ex-Japan. Now the biggest game in town is Japan ex-Asia.”
We’ve been here before
So, is it safe to say that Japan is out of the doldrums at last? After all, we’ve heard this story many times before. When I started investing in the mid-1990s, I recall my financial adviser confidently predicting a rebound for Japanese stocks. One well-known columnist told FT readers at the start of every year that now was the perfect time to invest, but it never was. Why could this time be different?
As an evidence-based investor, I don’t look for market signals, and I certainly wouldn’t change my strategy on the strength of economic forecasts. But there’s a significant ongoing development in Japan which investors should be aware of, and that’s the growth of corporate activism.
Shaking off the “value trap” tag
Increasingly frustrated by anaemic equity returns, Japanese ministers and regulators have been trying to shake off the country’s reputation as a “value trap” with a series of reforms. In March 2023, for example, the Tokyo Stock Exchange announced that it was asking all companies with price-to-book ratios below 1 to issue a plan to get to 1 times book. New research by the asset management firm Verdad into more than 3,000 companies shows that the initiative appears to be paying off.
At the time of TSE’s announcement, the number of companies with price-to-book ratios below 1 highlighted what Verdad called “a shocking degree of pessimism and inattention by investors”. But, as of the end of June this year, 50.9% of firms had disclosed plans to the TSE and 9.8% were considering doing so.
Researchers found that 58 percent of the companies which had submitted plans were increasing dividends, 23 percent were repurchasing shares, and 13 percent were selling cross-share and strategic holdings to increase competitiveness.
Figure 1_Japanese equities
Verdad then looked at the returns of all the companies they analysed in the 15-month period to the end of June. Firms which had not submitted a plan to the TSE produced the lowest returns, followed by those which were considering doing so. Firms that had disclosed a plan produced the best returns — none more so than those which had sold cross-share holdings.
“Dramatic change is afoot”
In a research note, Verdad said: “Firms that have made an effort to lay out a specific and tangible action plan to reach 1x book have experienced a significant rise in their stock prices since the TSE announcement, more than double compared to companies that haven’t submitted or are still considering doing so.
“We believe… that dramatic change is afoot, with widespread dividend and buyback increases. This is activism at scale — a compelling catalyst for a continued rally in Japanese stocks.”
The Japanese love cash
There are other reasons to believe that the outlook for Japanese equities is brighter than it was. For example, Japanese investors have been especially cautious in recent decades. Cash and deposits represents more than half of households’ total financial assets, compared with a worldwide average of 28.6 per cent.
Total household wealth in Japan is vast. At the end of June 2023 it stood at ¥2.1 trillion, or £11.34 trillion, and there’s potential for much larger proportion of that wealth to flow into equities. The government is certainly trying to encourage it. In January it launched an expanded tax-protected investment scheme, rather like a UK ISA, to incentivise people to move money from cash into stocks.
Much cheaper valuations than US stocks
Current valuations are another source of encouragement. Investment analyst and author Larry Swedroe recently wrote: “Japanese stocks are trading at much cheaper valuations than US stocks. For example, using Morningstar data as of July 31, 2024, iShares MSCI Japan ETF EWJ had a price/earnings ratio of 15.9 as compared with the 21.9 P/E of iShares Russell 3000 ETF IWV. Similarly, the price/book and price/cash flow ratios are 1.4 and 8.1 for EWJ and 3.9 and 14.3 for IWV, respectively.
“What should be of interest to investors is that despite the dramatic gap in valuations, Morningstar’s long-term earnings projections (an average of analysts’ projections for a company’s earnings growth over the next three to five years) for EWJ’s portfolio is slightly higher than for IWV’s: 12.6% versus 12%.”
Conclusion
So where does all this leave investors? As regular readers of this blog will know, jumping in and out of different markets is a bad idea. The best approach is to stay invested in a globally diversified portfolio. Japanese stocks, which account for about 20% of the global ex-US market, certainly deserve a place.
Will we see a return to the heady days of the 1980s, when the Nikkei rose more than fivefold in less than a decade? Almost certainly not. But there are strong reasons to believe that the days when Japan was the perennial laggard of the global equity markets may be over.
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