Here's why Japan's stock market deserves a closer look

Unbeknownst at the time, Japan’s bubble economy was on the brink of bursting and the Nikkei would never reach such heights again. By the following year, it had plummeted almost 40% and continued to decline as land prices nosedived.

Japan plunged into an economic crisis and entered what became known as its “lost decade”, a recession period plagued by stagnation and deflation. Entering the new millennium, the country’s sluggish economic growth persisted, and soon the lost decade turned into multiple decades instead.

So when the Nikkei reached over 30,000 in February 2021, the first time it has done so in over 30 years, market observers were intrigued. It signified the break of a psychological barrier that could potentially indicate a new chapter for Japan’s recovery.

While the rally in Japan’s stock market over the last year, much like other economies, has been aided by supportive fiscal and monetary policies following Covid-19, as well as improving sentiment as vaccinations get rolled out globally, a growing number of analysts are reassessing Japan and seeing its equities in a new light.

“Investors willing to look beyond the headlines on Japan will discover a market that remains attractively valued compared to global equities and one that offers opportunities on a bottom-up basis,” says Dean Cashman, a portfolio manager at Eastspring Investments, Prudential’s Asia-focused asset management arm.

Shigeru Aoyagi, chief portfolio manager of Nikko Asset Management, is even more optimistic. “We believe that the long-awaited turnaround in Japanese equities has just started and any corrections will provide an entry point into the market; as such, the 30,000 mark is likely to become one of several milestones marking the Nikkei’s advance,” he wrote on March 24.

Renewed interest

While Japan’s handling of the pandemic last year was largely lauded amongst developed countries, sentiment has backslid in the last few months. Japan’s vaccination rollout has been slow, and a resurgence in cases saw a third state of emergency being declared in Tokyo and other areas from late April.

The impact on the economy is apparent — Japan’s GDP shrunk by a larger-than-expected 5.1% for the 1Q2021. From the 30,000-point mark in February, the Nikkei has corrected to 28,814.34 points as of June 1.

Nevertheless, a number of analysts and asset managers remain upbeat on prospects for Japanese equities as the global economy recovers.

One reason for this is the broader shift in investor interest towards cyclical stocks, a factor that benefits Japan given its higher concentration of equities within economically sensitive sectors such as automobiles, electronics, materials and banks.

The shift has ignited a renewed interest in the country. “Foreign investors, who have been net sellers since 2015, are returning to this market,” says Cushman. He views that supporting this is the fact that Japanese stocks, despite the recent rally, remain at attractive valuations compared to global equities, noting that the MSCI Japan Index’s price-to-cash-earnings ratio relative to the MSCI World Index is trading below average.

In addition, analysts have noted a rotation from growth to value stocks in Japan following the pandemic — a narrative that was amplified when the icon of value investing himself, Warren Buffet, announced in September 2020 that he had invested over US$6 billion ($7.9 billion) in five Japanese companies, namely Itochu Corp, Marubeni Corp, Mitsubishi Corp, Mitsui & Co, and Sumitomo Corp.

Structural reforms

While the pandemic has triggered fresh interest in Japan, a bigger factor underpinning the shift in investor attitude is the growing volume of corporate governance and structural reforms that have quietly been taking place in the last couple of decades.

Japan has a longstanding reputation for weak corporate governance, characterised by cross-shareholdings by companies, poor capital allocation, and a lack of transparency.

This has slowly started changing over the years. “There has been a real economic imperative for this as the need to remain globally competitive and demands from asset owners, such as Japanese pension funds, for better returns have put pressure on Japanese corporate management to change their behaviour,” says Cushman.

Indicators of change include a higher focus on shareholder returns, with a rising trend in dividend payouts and share buybacks. Pre-pandemic, 2019 was a record year for stock buybacks, with buyback exercises done by companies on Japan’s Tokyo Stock Price Index (TOPIX) rising 109% y-o-y.

It is worth noting that Japanese companies, many of which are cash-rich and debt-free, have healthy balance sheet positions, enabling them to sustain shareholder returns. Cushman notes that while activity was impacted in 2020, buybacks still exceeded 2018 levels.

Covid-19 has also brought about its own wave of restructurings. According to Morgan Stanley MUFG Securities Co, many Japanese firms used the pandemic as an opportunity to restructure their accounts, operations and portfolios. To that end, Japanese companies were able to beat estimates to deliver earnings surprises throughout the 2H2020.

The openness to restructure has been accompanied by a willingness to invest. The Bank of Japan’s 1Q2021 economic survey indicated that corporate capital spending plans, which historically tend to be more conservative in 1Q compared to the latter quarters, are at their highest compared to 1Q readings from previous years.

This comes as the Japanese government — led by Yoshihide Suga, who succeeded long-time prime minister Shinzo Abe last September — plans to accelerate the economy’s digital transformation.

To that end, Morgan Stanley MUFG believes Japanese equities are at an inflection point. “Looking ahead, we think one of the Japan-specific features of the Covid experience will prove to be the catalyst for more active corporate restructuring as well as the efficiency potential afforded by the digital transformation of the economy,” the brokerage writes in a March 29 report.

Further catalytic reforms are on the horizon, including a revamp of the Tokyo Stock Exchange that will see its listing requirements tightened and its four trading markets realigned to three. “The realignment should therefore provide an incentive for companies to improve their corporate governance practices, which in turn will enhance shareholder value,” says Aoyagi.

To be sure, a slow but steady revolution of improvements in Japan’s corporate landscape has been taking place and looks set to drive its equities in the long term.

Stock opportunities

Cushman believes there are pockets of opportunity within the Japanese market for patient, fundamentally driven stock pickers. “We believe the ‘catalyst’ for outsized returns is not based on a forecast or macro theme. Instead, we systematically look for mispriced assets, focusing on extremes and identify maximum impact opportunities,” he says.

The sentiment is echoed by Morgan Stanley MUFG, who highlights numerous equity opportunities across sectors driven by the market mispricing, impending cyclical factors, recovery opportunities, or value driven by corporate restructuring activities.

Among these is components manufacturer Ibiden Co, which benefitted from sales of its mainstay flipchip (FC) package substrates during the pandemic due to higher demand for computers. Further growth is expected from increased sales of FC packages for server/data centre applications, with Ibiden said to be a major supplier for “the leading US chipmaker” for central processors.

While restaurants in Japan were hard hit by the pandemic, chain restaurant operator Food & Life Companies (formerly Sushiro Global Holdings) has been a bright spot, with further upside expected as the chain expands under its brand name Sushiro. Its conveyor-belt sushi has been a success in Japan, thanks in part to lockers at its outlets that allow customers to pick up takeout without contact with restaurant staff, a facility it had implemented even prior to Covid-19. “There has also been a marked shift in customer traffic away from traditional sushi restaurants, and given that other chains are hard-pressed to match Sushiro’s product power and digital marketing capability, we are confident that footfall will hold up after Covid,” says the brokerage.

The Suga administration’s push for digital transformation is expected to benefit a broad range of sectors, including IT and e-commerce. Morgan Stanley MUFG expects beneficiaries to include e-commerce company ZOZO, while Fujitsu is also anticipated to see upside as the leader in IT services for the public sector.

Morgan Stanley MUFG also sees potential in the auto industry across the long term, supported by a string of structural reforms happening at a number of manufacturers and the rollout of new business models as electric vehicle penetration accelerates. Its picks include Honda Motor Co and Mitsubishi Motors.

Time will tell whether Japan has finally exited its lost decades. But there are certainly enough factors in place to warrant a closer look at the equity opportunities present.