For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
Born in the 80’s?
Where else could we start when writing about investing in Japan but the mighty 1980’s. A decade that saw Japan’s economy and stock market soar, leading to a speculative bubble in housing and share prices. This was further inflated by a booming economy financial deregulation, strong exports and a highly competitive manufacturing sector. This was classic and unprecedented bubble territory. Real estate skyrocketed to astronomical levels. Land in Tokyo, for example, became incredibly expensive. A popular myth at the time was that the value of the land under the Imperial Palace in Tokyo exceeded the value of all the real estate in California! In equity markets, the market cap of the Tokyo Stock Exchange briefly surpassed that of the US, heady heights indeed – but like a soaring Icarus, a plunging descent was shortly to follow.
The Bank of Japan hits the brakes
The Bank of Japan (BoJ) put the brakes on the money supply in the late 1980s, which may have contributed to the bursting of the equity bubble. As equity values fell, the BoJ continued to raise interest rates because it remained concerned with still-appreciating real estate values.
When the bubble burst, real estate values plummeted leaving many investors and financial institutions with significant losses. The banking system was burdened with non-performing loans and struggled to recover. The weakened financial sector constrained lending and limited the availability of credit, hampering economic growth. The economy fell into a prolonged period of stagnation known as the “Lost Decade” as Japan grappled with deflation and sluggish growth.
A culture of risk aversion dominates
To counter the economic downturn, the Japanese government embarked on a series of expansionary fiscal policies and public works projects. However, these measures largely failed to end deflation and the consequence was a significant increase in government debt which reached one of the highest levels in the developed world.
Many Japanese companies faced difficulties in adapting to the changing economic landscape. The keiretsu system, characterized by interlocking relationships between companies and banks, made it challenging to implement necessary restructuring measures. Companies often resorted to cost-cutting measures, such as reducing capital investment which further impacted economic growth.
The experience of the bubble led to a culture of risk-aversion, quite contrary to the freewheeling approach in the 1980’s. With the banking system broken and the availability of debt finance limited, companies resorted to holding large cash balances to provide security in case of difficult economic times. Japanese corporate governance emphasised stability, long-term relationships and keeping harmony among stakeholders and having substantial cash reserves was seen to fulfil obligations and mitigate risks, ensuring stability for employees, suppliers and customers.
This led to poor returns on capital and disappointing shareholder returns which resulted in Japan being one of the worst performing markets during the 1990s and 2000s.
Abe’s three arrows
Japan began implementing economic reform in the mid-2000’s to revitalize its economy but this really gathered pace with the launch in late 2012 of “Abenomics”, named after the Prime Minister at the time, Shinzo Abe. Abe’s “three arrows” approach consisted of monetary easing, fiscal stimulus and structural reforms. Its goal was to combat deflation, stimulate growth and increase Japan’s competitiveness in the global market.
Additionally, Japan has introduced various other reforms targeting areas such as labour market flexibility, corporate governance and increased participation of women in the workforce.
Japan has also pursued deregulation and competition promotion measures to stimulate innovation, attract investment and foster economic growth. Efforts have included simplifying regulations for startups, promoting entrepreneurship and easing market access for foreign companies. The government has also established special economic zones to experiment with deregulation and attract businesses.
Throwing the book at it
The most recent reform has been measures implemented by the Tokyo Stock Exchange to improve the corporate value of listed companies, especially those that trade below book value which represent about half of the companies on the Japanese stock market.
The Tokyo Stock Exchange now requires companies to disclose their cost of capital, explain their share price and capital efficiency and provide initiatives for improvement. This has resulted in some companies initiating measures such as a return on equity target and returning excess cash to shareholders. If companies fail to act, the Tokyo Stock Exchange raise the possibility of delisting.
What are the key reasons why we like the look of today’s Japanese equity market as smaller companies’ investors?
The Tokyo Stock Exchange measures also require companies to expand their English language disclosures and improve the effectiveness of dialogue with investors. They recognise that the ratio of overseas investors is low, especially for smaller companies and a key reason is insufficient disclosure in English. The Tokyo Stock Exchange is encouraging Japanese companies to have more constructive dialogue with investors and to reach out to foreign investors.
We are noticing the impact of these measures already with both Japanese companies and investor relations firms reaching out to us to arrange meetings. More disclosure and more dialogue can only be a good thing for investors.
Smaller company opportunities are on the rise
Much like in other regions of the world, smaller companies in Japan have struggled in recent years from the headwinds caused by the pandemic and a slowing global economy. However, they have been making steady gains since the end of last year helped by accelerating economic growth and rising inflation. Combined with corporate reform efforts, smaller companies are an obvious beneficiary from the improving environment.
The fiscal stimulus package announced in last year will boost economic growth. Further support for small to mid-sized businesses will help aggregate consumption and business investment.
What areas of the market do we like?
We like the consumer sector in Japan given the end of Covid lockdowns, the pickup in the economy and an increase in wages. Consumers are out shopping again and, in many cases, making up for lost time!
While many developed market countries and their squeezed consumers are struggling with excessively high core inflation (particularly the US and UK), Japan has some way to go before core inflation will require central bank tightening. In fact, reversing the ‘deflation mindset’ would likely be a positive.
Within this framework, one company we like is Rohto Pharmaceutical, a consumer healthcare products company that specialises in skincare, eyecare and gastrointestinal medicine. A focus on R&D and product innovation is driving strong growth, particularly in its skincare range such as its vitamin C-based products.
We also like Shoei, a manufacturer of high-end motorbike helmets. Increased mobility combined with product innovation such as improved safety features, better designs and noise reduction are spurring demand.
The final word – a new dawn for investing in Japan?
Investor enthusiasm for Japanese equities has long been dampened by the downward trend in the market during the 1990s and 2000s, as well as by structural challenges ranging from deflation to weak corporate governance. But we think this is an opportune time to consider a Japanese equity allocation with a Global Smaller Companies Fund.
There have been many false dawns in Japan and many experienced investors have been caught out in the past. However, perhaps the most experienced investor of them all, Warren Buffett, is a believer that the sun is finally rising over Japan. It is reported that after a recent visit to Japan, he has been increasing his investments in the country, making it his second largest regional weighting after the US. We agree with Warren and expect Japan to be a significant part of the portfolio in coming years.