Fast restructuring Japanese companies are currently asset-rich and well-priced for investors, though the market remains subject to risks from both geopolitics and geology.
While many eyes have been on Japan’s ‘moon sniper’ craft 240,000 miles away in space, back on Earth the Nikkei continues to confound sceptics, rising to 34-year highs as a corporate governance revolution begins to take effect.
Following new guidelines by the Tokyo Stock Exchange (TSE) last year, Japanese companies have begun to restructure, and focus on capital allocation and a return on invested capital. At the turn of this year, the TSE announced that 41 per cent of Tokyo Prime companies had announced or were considering the cost of capital and steps to address undervaluation.
Not that the TSE is taking its foot off the gas. It has updated guidelines on the cost of capital and undervaluation, which include real examples from the likes of Mitsubishi Corp and templates on improving capital efficiency. In a conservative group culture such as Japan, being a follower is far easier than leading the way, and we now have clear precedents. The TSE also recently wrote to more than 2000 companies to assess whether their existing operational and governance structures are still appropriate. We believe this will focus the boards’ attention and lead to further corporate action.
Cheap and asset-rich
Change is happening – and so far, the biggest changes have been at the firms that very few investors, especially not global investors, have cared about for many years. These companies are typically very cheap, asset-rich and overlooked – and they are, albeit from a low starting point, striving to improve their governance, return on equity and bolster valuation.
What’s more, last year management buyouts (MBOs) in Japan accelerated at their fastest pace for 10 years – there were 26 MBO announcements in 2023, with a combined value of $2.4bn, according to data from LSEG – and the pace of such activist events is likely to continue in 2024.
Japan-focused fund managers may be enjoying the wind in their sails today but we have endured prolonged periods when the outlook was bleak. The cynics, of which there are many, justifiably question whether this time really is different. The Nikkei stood a little shy of 29,000 on February 8 2021, when we launched our Japan fund and, naturally, I continue to believe that we are not entering another false dawn. But some risks challenge my optimism.
Earthquakes and tsunamis
First, Japan's geopolitics and geology are always inherent risks. As we saw at New Year, Japan remains subject to earthquakes and tsunamis. The impact of these can be mitigated but not eliminated. A damaging quake in Japan is always a question of when and not if. Meanwhile, Chinese and Russian military assertiveness is also a risk factor. Japan has rapidly been increasing defence expenditure, but is highly likely to be impacted by events in Taiwan and Korea through its tight alignment with US policy. Either of these exogenous events could create negative shocks for Japan, albeit ones that Japan is preparing for.
The big risks for the corporate governance revolution investment case are that the consequences for vested interests in Japan become too impactful or that Japan becomes complacent after achieving only modest progress. This so-called ‘crisis response improvement complacency cycle’ has played out several times in Japan over the last 30 years. Such complacency or pushback could see steps taken to slow down or even reverse the progress made.
While some company management teams love the new pressure to perform many prefer the comfortable ‘managed decline’ that pervaded for so many of the last 30 years. This neglects the majority who suffered under this approach – no growth, low wages, poor returns on savings and constant government budget pressure. The negative consequences of sustained failure have been externalised to the whole of society to protect the insiders.
In contrast, creating an active market for corporate control means that there will be winners and losers. We believe that the upside for Japanese workers, businesses and the economy justify a more ruthless but focused approach to corporate management. Not everyone wins and not everyone is going to like it.
Competitive positioning
The Japanese market remains over-reliant on global demand, although less so than historically, and a US recession would have a big impact on globally exposed sectors' short-run earnings. However, we don’t believe there is a ‘strong’ yen risk. At current levels, very far below the yen’s fair value, we think a moderate appreciation in its currency is more likely helpful to Japan. Some exporters may see slightly lower profits, but we do not believe that this changes their competitive positioning. A structurally weak currency is a sign of underlying weakness – not strength. Foreign investors should welcome a stronger yen.
Finally, Japan must address labour productivity and real wages to begin to put 30 years of stagnation behind it. Wages have barely risen for three decades, while economy-wide productivity has been declining at an alarming pace. Changing the dynamics of corporate Japan’s profitability can be the catalyst for change – and there are clear signs that this is the intention of prime minister Fumio Kishida. He has publicly declared that he wants to ensure that the growth in disposable income exceeds price rises, promising on New Year’s Eve that his government “will mobilise all of its policies to achieve this goal”.
For those looking at Japan from afar, it is difficult to appreciate how cheaply valued companies are; how asset-rich firms are; how poorly focused they are on core business activities; and how inefficiently they use equity capital compared to those in Europe, let alone the US. As firms address these challenges, they will spin off dramatic quantities of free cash flow which we believe will be returned to shareholders.
Buybacks, higher dividend pay-out ratios, MBOs, tender offers – Japan has it all, and now domestic activists are joining foreign investors in demanding change. From a bottom-up perspective rich pickings are there to be found in mid and small-cap shares, as more than half of the listed market in Japan has virtually no analyst coverage. This means true specialists in this market will have opportunities to add significant alpha.
David Mitchinson, fund manager, Zennor Asset Management
