Morgan Stanley, one of the louder bulls on Japan, has found further reasons to bet on this market — potential gain in valuations to be squeezed out from companies showing improvements in their corporate governance.
In its Sept 13 report, a team of Morgan Stanley analysts stated that Japan remains their preferred equity market globally. “Our thesis is clear — We continue to like Japanese equities as nominal GDP accelerates, policy and JPY remain supportive, and corporate reform advances,” says Morgan Stanley.
“However, Japan’s valuation and ROE levels are still lagging the US and Europe,” the US bank adds, pointing out that the median P/BV ratio of MSCI Japan constituents stands at 1.5x, 25% lower than that of Europe and 53% lower than that of the US.
In other words, more than 40% of MSCI Japan constituents recorded an ROE of less than 8%, versus around 30% of counterparts in the US and Europe.
“In our conversations with investors, governance is cited as one of the key reasons for investors’ underweight stance,” says Morgan Stanley.
However, in recent years, there has been a “transformative shift” in governance regulations and policies and the market is seen “making strides” on this front.
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Over the last few years, key changes to governance frameworks introduced by the Tokyo Stock Exchange include one in 2021 that says companies should present targets for profitability when establishing business plans.
Earlier this year, the exchange proposed that companies trading at below book value should be required to disclose specific actionable plans to improve capital efficiency and growth expectations by investors.
The Ministry of Economy, Trade and Industry, on its part, had in 2022 included a new set of guidelines for corporate governance systems, including one stating that a criteria for the dismissal or non-reappointment of a company’s president and CEO is if the share price is below the book value.
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In its comparison, Morgan Stanley notes that European companies with better governance metrics have been rewarded with better valuations, but Japanese companies have not.
“We believe this trend for Japan will change under various governance drivers” and there’s ‘significant alpha potential’ from owning companies with leading governance metrics and those that may improve their governance practices over time,” says Morgan Stanley.
Using a set of correlation analysis covering the relationship of governance metrics and historical excess return, insights from its sector analysts about business models, near-term corporate developments, as well as its forward-looking view on how governance may evolve, Morgan Stanley has come up with a list of stocks with the potential to do better in this regard.
They include Astellas Pharma, whose products are focused on infectious diseases, diabetes, gastrointestinal diseases, oncology, and diseases of the central nervous system; Mitsui Chemicals, which makes a range of chemicals and chemical-based products including refractive lenses; as well as electronics giant Sony Group. According to Morgan Stanley’s view, these three stocks have an upside of 74%, 29% and 28% respectively to their price targets.
