Japanese equities have been traditionally unpopular among international investors, given the long-held reputation of suffering from the “lost decades” marked by lacklustre GDP growth after the bubble burst in the 1980s. Yet, amid a series of reforms and positive moves that are finally appearing in a bigger way, the benchmark Nikkei 225 has steadily gained and has even recently reached a 33-year high.
From the perspective of analysts at Fidelity International, there are many undervalued Japanese stocks that investors are missing out on, especially on the back of major structural shifts and economic recovery, aside from several emerging tailwinds.
According to Fidelity International’s head of investments for Japan, Miyuki Kashima, Japan’s turning point came in 2012, with the launch of then-Prime Minister Shinzo Abe’s package of economic and financial market reforms prominently known as “Abenomics”. Since then, Japan has shown steady and stable growth, with drivers including regulatory reforms, corporate innovation, a stronger economy, and a larger focus on capital efficiency.
Despite this, there is a major misconception among investors that Japan has experienced a period of “lost 30 years”. This implies that nothing major happened in the market due to the slow GDP growth when Japan experienced 20 years of spectacular economic decline followed by a big recovery, says Kashima.
Fidelity International’s head of investments for Japan, Miyuki Kashima. Credit: Fidelity International
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From 1997 to 2012, Japan’s domestic nominal GDP shrunk by about JPY50 trillion, more than the nominal GDP of Austria and Denmark in 2020. Total wages and capital investments declined by 15% and 24%, respectively. At the time, the only bright spot was the export growth, which increased by 94%.
From 2012 onwards, Japan was on a clear growth path, with nominal GDP recovering to the period before its recession thanks to introducing new monetary and fiscal policies. With this, the International Monetary Fund forecasts Japan’s nominal GDP to reach JPY600 trillion ($5.9 trillion) in the next several years — in line with the target set by the Japanese government during the early years of Abenomics, says Kashima.
The Japanese financial markets have gained considerable ground since the reforms began. For example, the 10-year cumulative change rate from 2013 to 2022 for Tokyo Stock Price Index (Topix), including dividends, stood at 174.2%, with good returns almost yearly except for 2018. Meanwhile, the cumulative change rate for the exchange rate between the yen and the US dollar for the same period was 52.6%.
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Moving forward, Kashima says the long-term uptrend for the performance of Japanese stocks is still intact — illustrated by the uptrend performance pattern of the Nikkei Stock Average for the same period. Additionally, since the introduction of Abenomics, Japan and the US have outperformed other developed economies, with Topix outperforming FTSE 100, CAC 40, DAX 40, and the Hang Seng Index. This follows the expansion of profits, with Topix’s earnings increasing more than the S&P 500, MSCI AC World Index, DJ Stoxx 600 and MSCI Asia Pacific ex-Japan.
Stock price performance in major developed countries and regions. Credit: Refinitiv Datastream, Fidelity International
Myth-busting
As Japan’s financial market undergoes its second growth phase following the reorganisation of the Tokyo Stock Exchange in April 2022, Kashima points out that Japanese stocks are still under-owned. Global active funds remain underweight on Japanese equities, while Japanese households remain relatively underweight on equities when it comes to their mix of financial assets as compared with their counterparts in the US or Europe, as they maintain their conservative stance of keeping a bigger proportion of their assets in the form of savings.
Kashima says several myths surrounding the Japanese market may have caused investors to avoid the asset class. First is the narrative of stagnant wages — in contrast, Japan’s employment conditions continue to improve, especially due to significant labour law changes.
For one, full-time workers’ total hours worked per year have dropped after enforcing the Work Style Reform Act in 2019. Although full-time workers since then have seen stagnant wages due to a limit on overtime work, hourly wages of part-time workers are on an upward trend amid continuing overall wage growth. Additionally, there is a significant increase in the number of people employed now compared to 10 years ago, says Kashima.
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Japanese companies have also undergone significant progress in enacting governance reforms and strengthening dialogue with shareholders — a traditional bugbear of activist investors from overseas. Over 88% of companies now have a third or more of external independent directors on their board, compared to just 6.4% in 2014. Meanwhile, more Japanese companies have participated in the Task Force on Climate-related Financial Disclosures compared to other countries, with non-financial companies making up the lion’s share.
Next is the population drop discourse. Kashima says it is common to hear that investors are avoiding Japan as the population has peaked and there is little future for the country. Although the population did peak about 10 years ago, the Nikkei Stock Average has been on an upward trend almost right after. This suggests that policy changes are more important to a country’s economic recovery, not population growth, she adds.
The final myth that Kashima wishes to debunk is the narrative that Japan is just a play on the global economy; to trade when the economy is good and sell when it is not. However, Japan’s exports are only about 18% of GDP in 2021, compared to Germany’s 47% and France’s 29.4%. While she acknowledges that Japan’s exports as a percentage of GDP are not particularly low, the comparison with other developed markets indicates that the generalisation is not true, Kashima concludes.
Opportunity to unlock value
Following the turning point in 2012, Japan has seen increased dividend payouts and higher share buybacks. According to Fidelity International portfolio manager Dale Nicholls, this has led to the market offering attractive total returns compared to its developed market peers.
He adds that the firm still sees the significant capacity for Japanese companies to return more cash to shareholders, with excess cash on their balance sheet and structural improvements in return on invested capital, primarily driven by company margin expansions.
MSCI Japan total payout trend. Credit: Jefferies, FactSet, Fidelity International
This is because valuations remain stressed compared to other major developed markets, with over half of Topix stocks currently trading below book. In comparison, FTSE All Share, SBF 250 and CDAX only have about 30% of stocks trading below book.
Amid attractive valuations, it is not surprising that activists have increased their focus on Japan to try and unlock value and accelerate change, says Nicholls. Due to the corporate governance reforms, the share of “poison pills” companies have decreased dramatically to below 10% in 2021 compared to above 80% in 2012, while the number of companies held by activists is simultaneously on a steady rise.
Against this backdrop, Nicholls says there is a lot of opportunity for investors to unlock potential value within Japan’s accelerating digital transformation trend from a low base. Although Japan is known for some of the most technologically advanced companies across various industries, the country lags significantly in digitalisation efforts. At number 29 in the 2022 IMD World Digital Competitiveness Ranking, Japan ranks lower than Estonia at 20, Ireland at 24 and Spain at 28.
The pandemic may have catalysed real signs of change, says Nicholls. Japan’s public cloud service market is expected to grow at a CAGR of 16.8% from 2022 to 2027 to revenue of JPY4.93 billion. Additionally, there is a significant adoption of e-contracts, which replaces the need for “hanko” or personal wood-carved stamps used for official documents and registrations in the country.
“I think this is one of the most interesting times to invest in Japan, as someone who has been doing so for the past 27 years. Being a bottom-up stock picker, I sense a real mindset shift in company management, particularly in the understanding of capital allocation and management of balance sheets. Ultimately, I feel that all the stakeholders in the business have become greater priorities for many of these management teams,” says Nicholls.
