Expert: Alex Hart, Investment Director, Japanese Equity Group, Sumitomo Mitsui Facilitator: Sam Shaw
Headlines:
- Japan's equity market is undergoing a transformation, with moderate inflation, rising wages, and enhanced capital efficiency driving profitability and return on equity (ROE)
- Companies are increasingly focusing on shareholder returns through share buybacks, dividend increases, M&A activity, and divestment of non-core assets
- Global institutional investors and expanded domestic NISA accounts are funneling significant capital into Japanese equities
- Over 3,500 listed small-cap companies present fertile ground for active management due to inefficiencies and limited analyst coverage
- Nominal GDP growth is expected to improve, supported by wage growth, import inflation, and a tightening labour market
- Risks include potential volatility from Bank of Japan policy shifts, geopolitical tensions, and the need for sustained corporate governance improvements
Discussion points:
Historical Deterrents to Japanese Equities
For decades, the Japanese equity market suffered from:
- Suppressed nominal GDP and earnings growth, leading to market volatility and export dependence.
- Pre-financial crisis ROE was just 4%-5%, hindered by corporate inefficiencies and cash hoarding by conglomerates.
- Minority shareholders often received inadequate returns, and corporate governance practices lagged behind global standards.
Shifting Market Dynamics
The market is now benefiting from several transformative factors:
- Market-wide ROE has doubled to around 9%, supported by restructuring, supply chain optimization, and reinvestment in core business areas.
- Rising wages (averaging ~5% in recent negotiations) are contributing to a positive wage-price cycle, boosting household savings and investment.
- Share buybacks and dividend payouts are increasing, reflecting improved capital allocation.
Economic Reality and Domestic Investment
Nominal GDP growth is poised to rise due to:
- Structurally weaker yen and moderate inflation
- Cycle of higher prices and wages as labor market conditions become tighter
- "Wealth effect" is expected to arise from greater levels of risk asset ownership to supplement incomes. This should support consumption in the medium to long-term. Japanese individuals have traditionally held mainly cash during the deflationary period. Support on the policy side for a shift from savings to investments from expanded tax-free savings accounts (9.5 trillion yen invested since January, 41% in Japanese stocks) is boosting domestic equity markets, with younger investors favoring higher-yield, volatile assets over time.
- Expanded tax-free savings accounts (9.5 trillion yen invested since January, 41% in Japanese stocks) are boosting domestic equity markets, with younger investors favoring higher-yield, volatile assets over time.
Institutional Interest
Global institutional investors are increasingly interested in Japanese equities due to:
- Japanese corporate earnings have matched S&P 500 growth over the past decade.
- Better capital allocation practices make Japan a compelling destination for foreign capital.
Small-Cap Investment Opportunities
The markets over 3,500 listed small-cap companies are ripe for active management due to limited analyst coverage, presenting potential inefficiencies and mispricing.
Risks and Challenges
- Aggressive policy shifts by the Bank of Japan could destabilize economic growth.
- The Taiwan Strait and commodity price spikes pose risks to market stability.
- Continued improvement in board diversity, composition, and shareholder engagement is essential.
Key takeaways:
- Rising ROE, corporate governance reforms, and moderate inflation are creating a more investor-friendly environment
- Make sure your Japenese equity expsure is through a fund/fund group that is well resourced with on-the-ground expertise and local knowledge
- Consider a fund that can take full advantage of the pricing inefficiencies and performance dispersion, especially at the smaller end of the market cap spectrum
- Keep abreast of policy expectations to challenge fund managers on their positioning
- Encourage the fund managers you invest with to hold company management to account on corporate governance
