- Investment Specialist
United States, Institutional
Change
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What is driving Japan’s rally?
Japan’s equity market has extended its rally from last year. Symbolically, Japan's Nikkei 225 index hit a record high and surpassed the previous record set 34 years ago when the Japanese economy was at the peak of its real estate bubble.
We believe this rally is driven by global investors becoming more constructive on two structural themes in Japan:
- Corporate governance reform: While this initiative is already 10 years old, it still is a work in progress. As investors, regulators, and other capital market stakeholders ratchet up the pressure on companies to focus more on return on capital, management behavior is changing toward more effective use of its corporate balance sheet.
- The domestic economy's escape from persistent deflation: This is supported by robust wage growth and higher corporate pricing power, which were missing from Japan's macro picture over the past three decades.
Is it too late for investors to consider a dedicated Japan equity allocation?
At this point you may wonder if it's already too late to consider a dedicated Japan equity allocation. Our answer is no: We believe there are still plenty of attractive alpha opportunities in the market.
Small- to mid-cap, less well-known companies typically found in domestically oriented industries provide examples. These businesses largely have not participated in the Japan rally we have seen recently; investors have chased high beta, large and liquid, well-known companies such as major manufacturers for autos and electronics, or AI value chain names such as semiconductor equipment companies. This dynamic has also manifested itself in the massive outperformance of momentum and beta risk factors year to date. We should point out that in Japan, however, the reversal factor has been more effective than the momentum factor in the long term, and the near-term momentum performance is reaching a level similar to the peaks of past cycles.
We expect returns will be generated more broadly across the market as global investors start to engage with less well-known companies over time. In fact, in past cycles, investors first dealt with large-cap and then more broadly with small- to-mid cap, relatively unknown companies. Over the past quarter century, we observed three major waves of overseas capital flowing into Japan’s equity market. Those are 1) the “Koizumi rally” in Fiscal Year (FY)2003 – 2006, backed by hopes for structural reform initiatives, 2) the “Abenomics” era, which includes the initiation of corporate governance reform, along with the Bank of Japan’s (BOJ’s) “Kuroda Bazooka” monetary easing policy in FY2012 – 2014, and 3) the yet unnamed rally since FY2023 backed by Japan’s strong relative fundamentals as discussed above. Every rally is different; however, history suggests that the large-cap/small-cap relative performance tends to be cyclical, and that large-cap rallies in the initial phase of capital influx will subside over time.
In one of our dedicated Japan equity approaches, we own a small-cap information technology (IT) services company that is helping Japanese companies transform their digital infrastructure. It is known that many Japanese companies are lagging in terms of digitization of their business operations, partly because they are often stuck with legacy IT infrastructure. However, faced with the new reality of rising labor costs, more Japanese companies are investing in digital transformation (DX) initiatives to drive productivity, offering structural business opportunities for the IT consulting and services industry. This IT services company has a strong consulting capability, and despite its small size compared to competitors such as Fujitsu or Nomura Research Institute, it generates more than a 20% operating margin,1 which is higher than its rivals do. Yet, the company has been overlooked by the market, and its valuation (price-to-earnings ratio) remains below those of its competitors.
Looking at domestically oriented sectors, we find interesting developments occurring in property and casualties (P&C) insurers. Earlier this year, Japan’s Financial Services Agency (FSA) urged four leading P&C insurers to unwind their cross-shareholdings with business customers, on the basis that this practice led to price distortion in the corporate insurance market. This forced unwinding of cross shareholdings for P&C insurers is a huge tailwind for these stocks, as they can free up capital which could be used for share buybacks (which leads to better capital efficiency). Historically, these P&C insurers had not been able to unwind their cross shareholdings partly because they feared losing business. (For example, they own significant shares of Toyota Motor, with whom they have a business relationship.) The FSA’s guidance freed them from this shackle. This movement may spill over to other financial subsectors such as life insurers and banks, which also have significant cross-shareholdings.
To conclude, we see attractive investment opportunities in Japan’s equity market. Recent underperformance of small- to mid-cap, domestically oriented businesses are offering attractive valuation opportunities. More important, corporate governance reform is still in progress and also spilling over to small- to mid-cap companies (in addition to large-cap, blue-chip companies that have been early adopters of corporate governance reform). We seek to unlock value through long-term-oriented, constructive engagement with company management.
What are the implications from the BOJ’s monetary policy normalization?
In our view, the BOJ’s policy normalization is in line with our view that Japanese equities continue to offer attractive investment opportunities. The end of negative rates and yield curve control policies reflect the Japanese economy’s emerging new equilibrium, with sustained wage growth and higher corporate pricing power. Amid the reflationary environment, many companies are finally departing from the long-standing deflationary mindset and increasing their capital expenditures for future growth. For example, a tighter labor market is forcing companies to invest in productivity initiatives such as digitization of business operations in cases where Japanese companies had been lagging versus global peers. Along with the ongoing corporate governance reform initiatives, the change in the macro environment could further drive management to focus on return on capital, as opposed to passively sitting on a pile of cash.
1Source: FactSet l Data as of fiscal year ending December 2023.
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Andrew Heiskell
Nicolas Wylenzek