The rewards and challenges of investing in Japan in the current climate

The Japanese equity market has been written off on many occasions since its peak back in 1989. This has led to many investors missing out on it more than doubling, in performance terms, since prime minister Shinzo Abe heralded a shift in the “lost decades” narrative of the post-bubble period back in 2012, launching fiscal stimulus programmes and driving a period of sustained loose monetary policy from the Bank of Japan.

We now see equity valuations – especially among the more domestic companies – as too low and they certainly do not reflect the opportunities of the coming years.

Many foreign investors are hoping that sustained yen weakness provides an argument to ignore the market. Given prospects for higher domestic interest rates and room for yen appreciation as wage inflation becomes more entrenched, this is a risky strategy.

Things have changed

The focus on China and the resulting foreign investment flows at the expense of Japan over the past 15 years have left many investors completely unfamiliar with the extent of changes taking place in the corporate sector. The reality is that the significant share buybacks and cancellation of those shares continues to materially reduce the free float, and this could squeeze share prices materially higher into any sustained reengagement by those foreign investors who sold all the equity and more that was purchased on the arrival of Abenomics.

Secular structural change in the domestic corporate sector is allowing certain industry leaders an opportunity to build greater scale and produce improved cashflow generation. Industry consolidation – already apparent pre-Covid – will continue to accelerate as small companies lack investment funding and face future personnel issues against a backdrop of an ever-tightening labour market. Corporates are shedding non-core businesses to the industry leaders as part of their ongoing restructuring strategies.

Industry consolidation in more consumer-facing businesses is a two-stage process. First, the rollup of the industry and then the opportunity to further monetise the customer base through cross-selling services, driving enhanced scale in both revenues and cashflow. Corporate beneficiaries of this industry consolidation reward shareholders through higher profit levels and stronger cashflow which is then recycled into higher dividends and share buybacks.

Delivering dividends

Looking ahead, we believe that there is scope for companies to introduce two-tier dividend policies that are more closely aligned to annual cashflow levels. Many managements are also further implementing broader restructuring measures, which was a process initiated in 2009 following pressure from the banking sector over insufficient cashflow. With many companies already paying 4 to 5 per cent dividend yields, any further uplift will compare very favourably to other developed markets given the likely sustainability of these returns in Japan.

We see these improved shareholder returns as one of the most significant shifts in behaviour, certainly in the post-war period, in driving wealth transfer from the corporates to shareholders. The emergence of activist pressure on managements and the arrival of foreign private equity funds are contributory factors to the improvement in shareholder returns and changes in the corporate landscape.

This year has proved a watershed moment for the labour market with emerging wage growth at larger corporates, the main employers of tomorrow, likely to develop into a secular multi-year trend. This is not purely a function of corporate tax breaks. Mid-career mobility has reached new records. A tight labour market is also confronting an unexpected further pressure from the manufacturing sector reshoring initiatives, the current reopening of the economy and the revival in foreign visitor numbers. Imported labour remains at low levels, which has been more recently affected by the yen depreciation. Younger consumers – backed by the prospect of future sustained wage growth – are now becoming a more interesting contributor to the domestic consumption story after decades of almost no sustainable wage growth and therefore a complete reliance on the elderly and more affluent consumer.

Inflation worries

In common with Western economies, near-term inflationary pressures are present and resulting in margin pressure. This is especially the case for companies that rely on imported materials that are experiencing underlying price inflation, which is also compounded by the weak yen.

However, Japan has considerable domestic energy supplies from their nuclear plant resources and a gradual reopening of these facilities. This is a stated priority for the Kishida administration and will ensure sufficiency and prevent the risk of much higher prices for domestic users. There are no indications to suggest their Sakhalin LNG assets are at risk.

The recent corporate results season has demonstrated the extent of the current margin deterioration in certain sectors. The shortage of parts and semiconductors, another material issue, appears to be normalising, which bodes well for 2023 margins. Fears of a global slowdown have affected certain share prices but there are no signs of material slowdown in order levels and managements remain optimistic looking through 2023 and beyond, especially towards the US, given robust private and public sector capex trends.

At present, there are a record number of Japanese manufacturers considering new capacity expansion in the US even though they have serious concerns over the shortage of skilled labour. Potential changes to current Bank of Japan monetary policy will lead to higher interest rates, though only on a gradual basis, and the so-called foreign bond vigilantes lack sufficient capital to pose a meaningful challenge to domestic bond markets.

New reality

Historically, Japan was correctly perceived as a global cyclical investment and to many nothing has changed. The reality is very different today. After the post-war decades of building and sustaining large conglomerates, which were intent on labour preservation over operational returns and shareholder interests, this façade is crumbling.

Changing demographics and a structurally tighter labour market are now applying additional forces for change within corporate Japan. We can see that, from a strategic perspective, highly liquid balance sheets and low domestic funding costs further provide an opportunity for overseas acquisitions, despite the current level of the yen, due to weakening international asset prices. Foreign capital, principally private equity funding, is providing a fresh and much needed buyer of assets which in turn allows the consolidation and restructuring within the industrial landscape to evolve. Would anyone a few years ago have imagined that Toshiba might fall into the hands of these PE buyers?

A stealth equity rally is taking place.

Rupert Kimber is manager of Quaero Capital Funds (Lux) – Taiko Japan