1. Long runway for the corporate governance reform in Japan

As portfolio managers, our ultimate goal is to work with company management as long-term shareholders to establish strong governance, which helps to facilitate:

1. Better capital allocation - which involves greater shareholder return and balance sheet efficiency; and 
2. Higher profit margins and stronger topline growth.

On the first point, we are encouraged by recent developments, particularly since the Tokyo Stock Exchange (TSE) urged listed companies to take “Action to Implement Management that is Conscious of Cost of Capital and Stock Price” in March 2023. The call has led to a significant increase in share buybacks in 2024.

It is also noteworthy that some companies have officially committed to reducing the amount of cash on their balance sheets and started to return the excess cash to shareholders. However, they are exceptions, and many companies continue to accumulate cash on the balance sheet. Despite the strong EPS growth in the last 10 years, the aggregate return on equity (ROE) has been capped at ~10% due to the increase in the denominator which in turn is a result of retained earnings.

We have also seen 94 de-listings from the TSE in 2024 in a drive for quality, the highest number since 2013 and the first ever decrease in the total number of companies in the market.

On the point of higher revenue and profit margins, we are at the early stage of transformation for many businesses, where some companies have started to focus on a smaller number of business lines by divesting underperforming businesses. Too many companies in Japan are overly diversified into businesses which offer little synergies and inadequate returns. Private equity firms have played an important role in this respect, and we believe this trend will accelerate.

One of the best examples is Hitachi. It had 22 listed subsidiaries in 2008, the same year when it reported a 787 billion yen loss (circa $8 billion at the time). Since then, the company has sold all of these subsidiaries to private equity firms and industrial buyers. This has resulted in a leaner, faster growing business focused on core operations in green energy / rail, and digital systems / services whose stock price has appreciated 18.6% p.a. in EUR terms over the last five years. JSR, a global leader in photoresists used for manufacturing leading-edge semiconductors, is another example. In 2021, the company exited from the synthetic rubber manufacturing which was deeply cyclical and low margin (JSR originally stood for Japan Synthetic Rubber). The firm was acquired by a private equity firm in 2024.

2.  Key drivers for accelerating the corporate reform

Regulators: The Financial Supervision Agency (FSA) along with the Tokyo Stock Exchange is responsible for updates to the Corporate Governance Code. They have been increasingly critical of strategic holdings of shares of other companies, also known as cross shareholdings. We are encouraged to see an acceleration of cross-shareholding unwinding, partly as a result of the FSA’s initiatives. The most noteworthy is the commitment by the three largest insurance companies to sell the cross shareholdings entirely.

Tokyo Stock Exchange: As a follow up to “Action to Implement Management that is Conscious of Cost of Capital and Stock Price”, as announced by the TSE on 31 March 2023, the TSE published a list of companies that have either disclosed capital efficiency measures or have such measures under consideration. The list contained 815 companies, or 49% of the firms listed on the Prime section of TSE (and 19% of those listed on the Standard section) as of 31 December 2023. Following this, the TSE continued efforts by publishing best practice lists showing companies that were conscious of cost of capital and stock price, as well listing examples of bad practices where companies are not aligned with investors’ perspectives.

In addition, the TSE announced higher standards for TOPIX Index constituents which will disqualify around 1000 companies by July 2028. The TOPIX Index is the bellwether in Japan and many companies pride themselves for being part of it.

Shareholders: Companies with poor governance and business performance have seen a meaningful decline in support from shareholders at annual general meetings in recent years. Under this pressure, they are increasing shareholder returns and bringing greater independence and diversity on boards. Shareholder support for top executives who delivered ROE of less than 5% has declined materially in recent years.

Activists and private equity funds: In recent years, the presence of activist investors in Japan has notably increased, driven by a combination of corporate governance reforms and changing market dynamics. Traditionally, Japan’s corporate culture was characterised by stable, long-term relationships between companies, banks, and stakeholders, often resistant to external influence. However, institutional investors are now more willing to support activist campaigns, partly under pressure from asset owners.

Japan has been a fertile hunting ground for private equity firms as well. There are at least three reasons for this:

• There are many attractive targets where the potential to release shareholder value is significant through better capital allocation and restructuring of underperforming businesses.
• An increasing number of companies are looking to divest non-core businesses where they no longer see themselves as “best owners”.
•  Some companies have decided the benefit of going private outweighs the cost of being listed.

These forces which are mutually reinforcing suggest the shift to a more dynamic corporate Japan is likely to accelerate further, not roll-back.

3. Inflation in Japan and its impact on domestic equities

Breaking the deflationary cycle of three decades is prompting households to revisit domestic equities and will return Japan to nominal growth, improving the environment for corporates to grow and invest. In a country where the population is aging and declining, companies are being forced to pay higher wages to attract and retain talent. With this background, the wage growth accelerated in 2024 and the expectations are that they will continue to rise at a similar rate in 2025. At the same time, companies are trying their best to raise prices to absorb rising costs.

The Bank of Japan has responded to this and exited the negative interest policy in March, and further raised the policy rate to 0.25% in July. We believe the Bank of Japan is expected to continue to normalise the policy towards 1.0%, although the pace of the normalisation and where it will end are still uncertain and will be data dependent.

The faster wage growth has encouraged domestic investors to revisit their home asset class, driven by a stronger outlook, reasonable valuations, higher yields and a compelling corporate reform. This can be clearly seen in recent data on the Nippon Individual Savings Account (NISA). The NISA programme offers individuals tax exemptions on capital gains and dividends. Roughly half of the money has been invested in Japanese equities so far in 2024. At the current rate, Japanese individuals will invest approximately over 5 trillion yen ($33 billion) in the Japanese equities market in 2024. Changes made earlier in the year by the government, increasing the amounts invested and confirming the tax exemption status indefinitely are likely to help support demand moving forward.

The surge in household investments under the NISA programme can also be attributed to rising inflation expectations. We think the end of deflation is likely to boost consumer confidence and add to future demand for domestic investing.

The corporate sector is likely to respond to these expectations as well. In a deflationary environment, delaying investments made sense due to anticipated falling costs, but this is no longer the case. Domestic corporate capital expenditure has been rising steadily in recent years, driven by the need for productivity improvements and onshoring/friend-shoring efforts, such as Taiwan’s TSMC building semiconductor fabrication plants. We believe this is also due to rising inflation expectations.

On the other hand, some businesses will face significant pressure on profit margins as costs, particularly wages, rise. For example, labour intensive sectors, such as retail and services, will feel this pressure more than most. However, companies like Fast Retailing (Uniqlo) where there is a strong focus on improving productivity should be winners within the sector. As active managers, we are able to put more focus on those companies that are improving productivity through digitalisation, AI and other measures. Consequently, the gap between winners and losers, in terms of pricing power and the ability to improve labour productivity, will likely widen in the future.

Investing in Japan in 2025: What are the risks?

The Japanese market remains heavily leveraged to the global cycle and any concerns about global growth will ultimately weigh heavily on it. Along with this, the direction of the currency remains one of the most frequently asked questions in our conversations with clients. With approximately 40% of corporate profits made outside Japan, a strong JPY is negative for earnings and for the market. That being said, the sensitivity of earnings to the exchange rate has declined over time. The sensitivity to USDJPY has declined from ~10% (i.e. 10% JPY appreciation reduces the profit by ~1%) to ~5% today. The consensus forecast for FY2024 and 2025 is based on the USDJPY assumption of around 145. Our analysis shows the aggregate profit level will be higher than where it is today even if USDJPY appreciates to 135, with everything else being equal.

Politics and geopolitical issues have been dominating news globally, and Japan has remained a beacon of stability. However, recent events in Japan have tested this after the ruling coalition between Liberal Democratic Party and Komeito lost the majority in the lower house election in October. However, this is unlikely to have a material impact on policy given all three main opposition parties (Constitutional Democratic Party of Japan, Democratic Party for the People and Japan Innovation Party) are not radically different from those of the ruling coalition. All combined, we are likely to see higher fiscal spending in 2025 which will provide additional support for the economy. In addition, there will be another election in July 2025.

Opportunities in the Japanese equity market

While the backdrop has undoubtedly improved for Japan now offers a multi-year opportunity, foreign investors which we believe grapple with the best way to gain exposure to the market. Global and Asia Pacific regional managers are still broadly underweight Japan and predominantly focused on the larger parts of the market. Given the breadth and depth of the Japanese market, there are a wealth of opportunities that fall outside the usual large index names.

The Japanese equity market remains one of the most under covered developed markets. This inefficiency creates a fertile opportunity for active managers and particularly those that have the focus and resource to delve deeper into the Japanese universe of companies.

Style has been a major driver of returns in the last decade, with strong rotations between value and growth leading the market. Growth led for the few years prior to Covid and in 2020, but since then we have seen value significantly outperform. Value, using Russell Nomura Total Value Index as its proxy, is 45% (cumulative) ahead of growth over 10 years to the end of December 2024. Sourced from Bloomberg Data as of 16 January 2025. As a result, the valuation spread between the two groups has narrowed. Our own internal 5-year expected return signal indicates the spread is narrow, which means that going forward stock selection is likely to be a bigger driver of returns, rather than style.

Without any clear signals for any particular style leadership, we believe that style is unlikely to be a big driver of returns in the next part of the cycle, with growth, value and core managers all being able to benefit. Bottom up stock selection will be key in identifying good companies trading on reasonable valuations. The most important factor investors should be focusing on is fundamentals!