It’s an exciting time to be investing in Japan. Despite recent volatility, this has been a landmark year for Japanese markets. In February, the Japanese stock market hit a 34-year high, surpassing its December 1989 record. This has been driven by a range of corporate governance reforms, as well as a move away from a deflationary environment.
What are the drivers behind the Japanese market rally?
After several decades of deflation, Japan is shifting towards an inflationary era, which should benefit corporate earnings growth. Under an inflationary environment, Japanese companies can increase their revenues and earnings not only through volume growth but also through price increases, which were absent during the deflationary period.
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Joe Bauernfreund, Portfolio Manager of the AVI Japan Opportunity Trust, says investors should look first to the dynamic reform policy in the country: “The two key factors have been valuation and corporate governance reform. Japan has looked good value for many years and over the past two decades has periodically drawn in foreign capital. But until last year, the positive flows tended to be short term in nature, as investors became frustrated by a market that was cheap, but nothing ever happened to address that undervaluation. Over the past 12 months, investors have recognised that the governance reforms are working – they are changing corporate behaviour. And that for the first time in decades Japan is no longer a value trap, but it is a cheap market with a catalyst.”
Corporate governance reforms across Japan have contributed significantly towards the recent strong performance of the Japanese stock market. With the encouragement of the government, regulators and shareholders, Japanese companies are now adopting ever higher standards of independence and transparency which have been welcomed by investors.
Measures include the appointment of more independent external directors to company boards, tighter internal controls and more transparent disclosure rules, as well as improved shareholder returns. With many Japanese companies still awash with cash, fund managers expect further significant efforts to return cash to shareholders.
Can this rally be sustained or is it running out of steam?
This is really the big question for foreign investors in Japanese stocks. Paul ffolkes Davis, Chairman of Rising Sun Management, which advises the Nippon Active Value Fund, said: “We believe it is only just beginning, though we will admit the market is currently taking a breather. The attractive fundamentals have not changed, especially in the small and mid-caps.”
Praveen Kumar, Investment Manager of the Japanese Equities Team at Baillie Gifford, which manages Baillie Gifford Japan Trust and Baillie Gifford Shin Nippon, thinks it may be that the stocks that drive the next leg of the rally could be different from those that have driven the current leg.
“The current rally is being driven mostly by large-cap, currency sensitive exporters and other cyclical stocks, plus interest-rate sensitive businesses like banks and insurers,” he said. “Also, large companies with significant cross-shareholdings have been doing extremely well in share price terms as they are rapidly selling down their cross-shareholdings and returning the cash raised to shareholders. The next leg of this rally could be driven by small and mid-cap growth stocks, and other large-cap growth stocks that have been sold off very aggressively and indiscriminately in favour of the type of stocks mentioned above.”
Japanese stocks still look cheap
In terms of valuations, Japanese equities traded on a forward price-to-earnings multiple north of 50x during the bubble period, so the current multiple of around 15x does not look expensive historically nor relative to other markets, especially considering current interest rates. Moreover, a sustained improvement in returns on equity would support a higher price-to-book multiple, and the economic trend towards moderate inflation supports higher earnings-based valuations.
Miyako Urabe, Co-Manager of JPMorgan Japan Small Cap Growth & Income, said: “The Japanese economy is undergoing a period of profound transformation, generating exciting investment opportunities capable of flourishing regardless of the near-term economic environment.”
She thinks Japan is at a very early stage of digitalisation compared to the rest of the world, and this, combined with the trend towards industrial automation, has the potential to help drive significant growth and/or productivity gains over the medium term.
“Demographic changes, developments in medical technology and the transition to renewable energy are also contributing to rapid structural change,” Urabe said. “The country’s innovative and dynamic small cap companies are ideally placed to thrive in this environment, already leading the way in a variety of niche markets.”
But can the Japanese stock market rally be sustained?
The rally can be sustained because there are still so many undervalued companies in Japan. And if we have an environment in which management is focused on shareholder returns and the regulator and the Tokyo Stock Exchange are piling pressure on companies to address their undervaluation, then there is no reason for the capital that has been drawn to Japan to reverse direction whilst there is still value on the table, and whilst there are increasing levels of corporate activity occurring.
According to Bauernfreud at AVI Japan Opportunity Trust, private equity is also a key factor in the increased amount of corporate activity, and the growing presence of both foreign and domestic private equity players in Japan reflects the attractive opportunities they are seeing in the market.
Nicholas Weindling, Co-Manager of JPMorgan Japanese Investment Trust, added: “There are good reasons to believe that we will continue to see improvements in the Japanese market. For example, signs of a positive shift in Japan’s labour market are emerging, with companies starting to raise wages significantly for the first time in 30 years. This year’s spring wage negotiations resulted in a 5.3% wage increase, the highest in 33 years and well above the inflation rate. This rise in real wages should boost consumer sentiment and support domestic demand, especially as rising prices encourage spending now rather than saving.”
Furthermore, through its recent changes to monetary policy the Bank of Japan is making concerted efforts to bolster liquidity and stimulate growth, which should be positive for the market in the near term.
“Despite the strong run in 2023, the market valuations are still well within ranges established in the post-financial crisis period which suggests that there is significant further upside potential on the basis that capital efficiency, corporate governance and shareholder returns are all breaking into new territory and set to go further,” explained Richard Aston, Portfolio Manager of CC Japan Income & Growth Trust. “Combined with an increased confidence in growth potential, I believe this should ensure that the market will continue its strong upward trajectory since it bottomed in 2011.”
