Tim Richardson CFA, Investment Specialist
The sun may finally be rising on Japan’s share market. Higher inflation and a changing business culture in Japan are pushing companies towards a greater focus on shareholder returns. Exciting opportunities are emerging for global equity investors who can identify quality businesses adapting to this new environment.
“You don’t implement change easily in Japan unless you explain very carefully why you need to do this change, how you’re going to do this change and what’s going to be the outcome of this change. If you offset or you forget to explain one of these three steps, you’re not going to do it.”
– Carlos Ghosn, former Chairman and CEO of Nissan
Inflation reaches Japan, finally
Japan’s ageing population, cultural adversity to consumption and reluctance to switch employers all contributed to decades of deflation, stagnant wages and weak investment returns. But inflation is now finally rising in Japan. The core-core consumer price index (CPI) – which excludes volatile food and energy items but includes alcohol – rose 3.5% in February, the fastest since 1982.
Price rises were initially imported, as global food and energy costs soared in 2022. Inflation edged up as Japan’s interest rates stayed low, forcing down the yen and raising imported material costs. Locally generated price pressures followed as major companies agreed to a 3.8% annual increase at the annual shunto pay talks. This was above expectations and has started to push up consumer prices, especially services.
The Bank of Japan is expected to ease its yield curve control policy and eventually raise interest rates – which have remained at -0.10% since 2016 – which will increase Japan’s cost of capital.
Japanese business is changing
Japan’s Nikkei index currently trades at 15.8 times trailing earnings, compared to the US S&P500’s 19.6 times, and remains 28% below its 1989 peak. The market value of around half of Japanese companies is below book value.
An ageing population, sluggish GDP growth and deflation led former Prime Minister Shinzo Abe to introduce measures to boost the economy. These comprised ultra-loose monetary policy, fiscal expansion and structural reforms.
Reforms took time to implement but the benefits are now being realised. They included a corporate governance code, the requirement that a third of large company directors be independent, annual board elections, greater board diversity, stronger minority shareholder rights, reduced cross-shareholdings, sustainability disclosures, a stewardship code and improved M&A guidelines.
Investors are now more engaged and willing to vote against management, leading to companies prioritising shareholder returns over revenue growth. Independent boards and incentivised managers (through share ownership schemes) are boosting returns on equity, dividends, share buybacks and M&A activity.
All change in Japan’s share markets
These measures are now beginning to make an impact as Japan changes.
Sony has transitioned from a consumer electronics to a global entertainment business, enjoying more subscription-based revenue that delivers faster growing but more stable earnings. This pivot helped the company double in value over the last four years. It also separates the roles of CEO and Board Chairman, who is an independent director.
Japan’s labour shortage and changing business culture have shifted attitudes towards work. Crowdworks connects freelancers to tech companies and has benefitted from the switch to home working, which women, especially value. The share price has almost doubled since the start of last year.
A practical example of the stronger corporate governance environment was Mitsui’s bid to acquire 63.4% of its affiliate Relia which it did not already own at a 50% premium. Relia was an early beneficiary of the growing demand for contract workers, technological developments such as AI and the normalisation of remote collaboration boosting demand for outsourcing. Following recent changes to Japan’s tax laws, parent companies are taking full ownership of affiliated businesses on terms more advantageous to outside shareholders than was previously the case. This provides greater levels of protection to investors in Japan, creating opportunities for investors in many smaller businesses.
So what should investors do now?
Rising inflation has brought a more competitive labour market, greater emphasis on cost management and a higher cost of capital. This is forcing companies to put their cash piles to work or return it to shareholders. Both are positive for investor returns.
Structural improvements in Japan have brought more professional and less conflicted boards which focus on delivering value to all shareholders. Foreign share ownership has risen to over 30% from just 5% over the last 30 years.
Reforms and monetary policy normalisation are providing exciting opportunities for global investors, as the weak yen currently provides an attractive entry point. Global equity investors now have the opportunity to boost long-term returns through selective exposure to high quality Japanese companies that are well aligned with the country’s structural reforms.