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Land of the rising shares: Five reasons why Japan’s stock market is surging

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02/06/2023
It’s a new dawn for Japan as the Topix Index hit a 33-year high while the Nikkei 225 recorded a near 20% return since the start of the year. Meanwhile legendary investor Warren Buffett is also looking to top up his Japanese holdings. But what’s driving the recovery in Japan and is interest justified?

Japan has never been the easiest market for investors. But the aggressive economic policy of reform, coined ‘Abenomics’, followed by the ‘four pillars’ for growth strategy under Prime Minister Fumio Kishida, together with its bounce back from Covid, revival in travel demand and green initiatives have helped pave the way for investors.

In the past few weeks, Japan’s Topix Index hit a 33-year high while renowned US investor Warren Buffett also visited Tokyo in April to stock up on his holdings made in 2020.

The AIC Japan sector returned 4.7% in the year to 31 May 2023, compared to 1.9% for the average investment company.

Meanwhile, the Nikkei 225 Index has surged 19.8% on a total return basis since the start of the year – double that of global equities (MSCI AC World Index at 8.5%), and it has also climbed to a 33-year high.

But’s what’s behind the surge? Here are five reasons why Japan is shining bright:

1) Corporate governance and the Tokyo Stock Exchange shake-up

According to Joe Bauernfreund, manager of AVI Japan Opportunity, there have been some very positive structural changes on the back of the corporate governance and stewardship code that mean companies are now “working far harder to deliver shareholder returns than they ever have been”.

Jason Hollands, managing director of Bestinvest explains that historically, the Japanese market has been very low yielding as companies were notorious for hoarding cash on their balance sheets.

But the recent Tokyo Stock Exchange shake-up is “set to add pressure on Japanese-listed companies to become more shareholder-friendly”, he says.

In March, the Tokyo Stock Exchange announced new rules requiring Japanese-listed companies with price-to-book ratios below 1 to disclose specific initiatives for improvement, including addressing their cost of capital.

Price-to-book value is a measure of a company’s market value (share price) divided by the value of the assets on its balance sheet. It came after it revealed that about half of all listed companies have a price-to-book ratio below 1.

“These measures are designed to deter companies from hoarding cash on their balance sheets that generates little value for shareholders and instead drive increases in both dividend pay-outs and share buybacks. Over time this could be a gamechanger in driving higher returns on capital,” Hollands says.

Masaki Taketsume, manager of Schroder Japan Trust, says: “Many Japanese companies have responded by announcing dividend increases and share buybacks.”

This is echoed by Taeko Setaishi, manager of Atlantis Japan Growth fund, who says the results can be seen in steadily increasing shareholder returns; “the adoption of 8% as a minimum target return on equity, the acceptance of 30% as a baseline pay-out ratio, steadily increasing buybacks, an enhanced corporate governance code and some consolidation in overcrowded industries”.

Meanwhile, Japanese equities – as measured by the Topix Index – are yielding 2.5%. While this is still far behind the 4.2% dividend yielding from UK equities – a market with a longstanding dividend culture – “it is significantly ahead of the US where equities are yielding 1.7%,” Hollands says.

2) Cheap and undervalued stocks

Japan has the cheapest stocks on a cash flow and income basis in the developed world, according to James Rosenwald, CIO of Nippon Active Value fund, while its interest rates are the lowest in the world.

“Equities, through their dividends and share buybacks, provide the largest carry trade in the world. The example is Warren Buffett’s borrowing in yen and investing in equities which offer a return on equity of more than 10%. The positive carry is positively amazing.”

Meanwhile, Nicholas Price, manager of Fidelity Japan Trust, says that for some time now, global equity portfolios generally have been underweight the Japanese stock market.

“This reflects misplaced presumptions that date back to Japan’s ‘lost decades’. But that hasn’t been Japan for some time. The Japanese economy has been riding a recovery since around 2012 that has been as steady as it is low-profile, while a structural improvement in operating profitability remains underappreciated.

“Many Japanese stocks are undervalued due to a lack of sell-side coverage and limited disclosures, especially in the mid/small cap space – all of which creates a wealth of overlooked and differentiated opportunities for the trust,” he says.

3) From deflation to inflation

Japan may have finally defeated three decades of deflation, according to Thomas Patchett, Japan Investment Specialist at the Baillie Gifford Japan Trust.

“We have never witnessed this rate of inflation – in pay or products – in the past 30 years of investing in Japan. If sustained, this could stimulate consumer spending and greater capital expenditure, and drive up the required return on financial assets, buttressing recent initiatives from the Tokyo Stock Exchange and the Financial Services Agency,” he says.

4) Weak yen

A weak yen has helped make Japanese exports more globally competitive, boosted foreign earnings in local currency terms and turbocharged returns, according to Hollands.

He explains that a weak yen helps improve the global price competitiveness of Japanese exports, which is especially significant for Japan as a major exporter of both vehicles and parts (e.g., Toyota, Honda, Bridgestone), electronics (Sony, Nintendo, Canon, and Kyocera), and heavy machinery (Kubota and Toshiba).

“A weak yen also boosts the earnings from Japanese companies’ overseas subsidiaries when these are translated back into the yen,” he says.

Hollands adds that the yen’s weakness has been driven by the Bank of Japan’s continued pursuit of a policy of ultra-low interest rates at a time when many other developed market central banks – including the US Federal Reserve, Bank of England, and European Central Bank – have been aggressively raising interest rates.

“Interest rates are currently negative in Japan and through its Yield Curve Control policy, the BoJ, seeks to cap the yield on 10-year Japanese Government bonds at between zero and 0.5%. After years of relentless interventions in the bond markets, the Bank of Japan now owns over 52% of all Japanese Government debt.”

He says that for domestic investors, the weak yen and low yields on Japanese bonds (10-year Japanese Government bonds yield 0.41%) are “two good reasons to be ploughing savings into domestic equities”.

However, he adds that at this stage, “investors shouldn’t rely on a weaker yen to continue providing such strong support to Japanese equities”.

“The dollar has been softening as markets anticipate an end to the Fed’s rate hike cycle, with the possibility it may have to cut rates in several months if a recession arrives. The recent appointment in April of former academic Kazuo Ueda as the new Governor of the Bank of Japan has also laid the groundwork for a gradual shift policy, with the launch of a review into past decisions that will take one to 1.5 years to conclude. From here, the yen may well strengthen again versus the dollar,” he says.

5) The Warren Buffett effect

Further interest in Japan has also been generated as a result of legendary investor, Warren Buffett visiting Japan in early April, Taketsume says.

Hollands adds: “In 2020, when markets were battered by the arrival of the Covid pandemic, his Berkshire Hathaway company which typically invests in US companies, took the unusual step of buying shares in five Japanese trading houses – Itochu, Marubeni, Mitsubishi, and Mitsui and Sumitumo. He has referred to their valuations at the time as “ridiculous”.

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