12th May 2023
From an investment perspective there is a widely held misconception that Japan has been more a land of false dawns than rising suns. Those who invested in the market around the height of the late 1980’s super bubble might be forgiven for their scepticism, but returns from Japanese equities in more recent years have been perfectly acceptable. In fact, in local currency terms Japan is the best performing major equity market in the world over the last 3 years and, with total returns of 107%, ranks only second to runaway US equities over the past decade (performance of MSCI Japan and MSCI USA).
Interestingly, stock market returns in Japan over the course of the last decade have been driven exclusively by earnings and dividend growth, which might come as a surprise to those who focus myopically on the moribund economy. Price to earnings multiples have actually contracted and therefore detracted from headline returns which is in stark contrast to the US where multiple expansion has been an important factor. As a result, and in spite of the good investor returns delivered, the market remains attractively valued today, trading on 1.1x price to book which represents a 10% discount to its own long run average, and an even more significant discount to other developed markets (i.e. MSCI World on 2.5x). Importantly, the headline index metrics conceal significant valuation dispersion below the surface, with 50% of companies listed on the Tokyo Stock Exchange (TSE) prime market trading with a price to book ratio of below 1.0x. Value is particularly apparent amongst smaller companies with 56% of small and mid-caps trading at less than 6x EV/EBITDA. Apologies for the stats bombardment, but they do make an important point. Regular readers will know that at the core of our investment approach lies the aim of owning assets that possess a margin of safety, typically via valuation support. We believe that parts of the Japanese equity market have this in abundance which should help create the foundations for attractive returns going forward.
In terms of unlocking this value, a degree of cynicism regarding the extent to which corporate governance reform might act as a catalyst has prevailed, with some of it no doubt warranted. Ever since the late Shinzo Abe un-quivered his third arrow back in 2013, those trying to flog Japanese equities have leaned heavily on this easy narrative. After a long period of germination, including the introduction and revision of things like the Japan Stewardship Code and Corporate Governance code, we do at last seem to be gaining traction with the latest impetus coming from the TSE’s recent statements regarding measures to improve capital efficiency. By way of history, back in April 2022 the TSE introduced the prime segment of the market which many Japanese companies rushed to migrate to. In what might have come as a surprise to many of these companies, the TSE are now baring their teeth, asserting that all constituents with a price to book (P/B) below 1x must ‘disclose their policies and specific initiatives for improvement’. Non compliers will be named and shamed, a powerful incentive in Japanese culture, with the ultimate punishment being demotion from the prime segment.
Against this backdrop, management teams should be motivated to think harder about cash flow management and the efficiency of balance sheets, with one of the easy wins in terms of boosting P/B being the use of excess cash to buy-back shares. Given the huge number of companies with net cash on the balance sheet and trading below 1x book value, the opportunity is significant and is starting to show up in the data where dividends and buybacks are on an unequivocally upward trend. This is the low hanging fruit, but the culmination of reforms is also having the powerful impact of making Japanese management teams more receptive to other avenues of investor engagement. These might be around strategy and M&A, investor relations and disclosure, and other aspects of capital allocation. Reductions in share crossholdings and an increase in unsolicited takeover bids and MBOs offer further evidence that the increasing number of activist funds operating in Japan are starting to see tangible success. Crucially, these individual activist wins tend to result in significant upside to the specific share price in question in a way which is uncorrelated to the broader market.
Care, however, needs to be taken to not overegg the extent of the change in corporate Japan. There is still a lack of proactivity on behalf of management teams and there are still plenty of corporate leaders who place shareholder interests someway down the pecking order. It doesn’t yet feel like a case of the tide lifting all boats but more like, to horribly mix metaphors, a situation where activist investors have gone from banging their heads against a brick wall to one where they are pushing on a somewhat stiff door (as opposed to a swinging open one). Against this backdrop, we think the best way of optimising the opportunity in Japanese equities is to back managers who place active, constructive engagement at the heart of their process.
To us, Japanese equities currently look interesting on a number of levels. Cheap valuations, decent anticipated earnings growth, and the potential for improving capital allocation to drive a broad re-rating augers well for index level returns. In addition, high levels of valuation dispersion and a more conducive environment for activist shareholders suggests scope for significant alpha on top of this. We are particularly excited by the prospects for our small-cap focussed Japan funds whose active approach to engagement leaves them well placed to capture attractive, idiosyncratic drivers of return. After a number of false dawns, the sun finally seems to be rising on a new age for corporate Japan which should act as a powerful tailwind for returns. If our optimism is misplaced, we take comfort from the fact that prevailing valuations seem to be ascribing little potential upside from improved governance, offering us with plenty of margin of safety if we’re wrong.
Ben Mackie – Fund Manager
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