Japan: a new dawn?

Japan: a new dawn?
By Freddie Fuller, European Equity team and David Soh, Asian Equity team

Freddie Fuller  00:03

Freddie: Good morning, everyone. My name is Freddie Fuller, and I'm the Product Specialist on the RBC European Equity team. I'm joined today by David Soh, Head of Research on our Asian Equity desk in Hong Kong, and with whom we manage a number of international equity strategies. Welcome, David.

David Soh  00:19

David: Morning, everyone. Thanks for having me, Freddie.

Freddie Fuller  00:20

Freddie: David, we thought we'd spend some time this morning discussing Japan. This feels especially timely, given that Japan's main stock market index has climbed past its all-time high. For context, last time that was reached was in the late 1980s. Specifically, maybe we'd look at how the recent change in sentiment towards Japan may be – to an extent – due to changes in how Japanese corporates themselves are being managed. In our international equities portfolios, governance has long played a key part in how we look at businesses.

We've been talking about how there are some important correlations between how Europe's governance credentials have been a tailwind to that region, and then how this may translate into Japanese performance in the upcoming years. Maybe, we could start with you giving us a quick look at how Japan has performed in the last decade or two, and why you think this may have turned a corner in the last 12 months.

David Soh  01:23

David: Right. Thanks, Freddie. To set the scene, Japan's backdrop has not been conducive to attracting investor attentions over the past few decades or so. It's experienced lengthy periods of challenges since the real estate bubble in the late 1980s, including a heavily indebted economy, favourable demographics, as well as other issues within corporate Japan. For example, the Keiretsu system, which without going into too much detail, was essentially a network of interlocking businesses involved in messy cross holdings.

The country has faced a relatively constant state of deflation since the 1990s. Things have been changing from 2021, maybe 2022. Last year, in 2023, both the TOPIX and the Nikkei index began to renew historical highs. The recent pandemic brought its own challenges to Japan as well. In hindsight, it was also a big wake-up call for the Japan economy, I think.

Freddie Fuller  02:26

Freddie: Yes, it's an interesting point. All the evidence seems to suggest that while the pandemic created a lot of turmoil for markets, it's been different for Japan. It seems to have created this form of exogenous shock, I suppose, pulling the economy out of decades of deflation. On the face of it, that provides a macro tailwind, which obviously, subject to how inflation progresses from here and taking into account the decisions of the BoJ, which we can't forecast, and could theoretically continue for some time. But, we are fundamental investors. The more interesting shift, perhaps, that's going on at the moment is at the governance level when it comes to Japanese companies.

David Soh  03:12

David: Indeed, Freddie. Japanese companies are known for great products, but historically, they didn't score well on profitability or governance. There was this long-standing respect that Japanese corporate culture gave to the so-called three walls of hierarchy. In this framework or structure, it was always the customer over company, employer over employee, and company over shareholders. These walls were holding corporate Japan back in many ways, but with global inflation and domestic labour shortages, the walls just may be collapsing.

In our recent meetings with Japanese firms, we've seen a notable shift in the way that management think about their businesses. Across sectors, we're seeing a renewed focus on setting and meeting effective targets, as well as increased desire and interest to compete in a global context. If previously, they had a preoccupation with domestic peer group, now we're seeing a meaningful shift away from that.

Freddie Fuller  04:20

Freddie: Sorry to interrupt, but, Japan, it's a relatively economically conservative society, isn't it? How do you think policymakers feel about this change?

David Soh  04:30

David: It's a great question. The government is also pushing to attract foreign capital and transform the country into a global financial hub. There are initiatives to reduce regulatory bottlenecks, ease language barriers, and improve market entry applications for overseas managers. These are just some examples, but we also saw the UN PRI in Person 2023 conference last year being hosted in Tokyo. That was, specifically targeted at foreign investors to promote Japan. The Tokyo Stock Exchange, as well, is also pushing to drive change, particularly when it comes to increasing shareholder value. It really looks like Japan Inc is waking up.

Freddie Fuller  05:16

Freddie: These elements matter, don't they? Especially, when it comes to company valuations. Just looking at some of the statistics, the median price to value ratio of the MSCI Japan constituents came in at 1.5x, and that is 25% lower than that of Europe and 53% lower than that of the US. There's this very large valuation gap between Japanese equities and their counterparts elsewhere. I think the point that we've spoken about before is particularly evident amongst the 30% of MSCI Japan and 50% of TOPIX constituents, still trading below book value amidst this sort of greater scrutiny on those companies that are just not meeting their cost of capital.

David Soh  06:00

David: That's right. That's right. Around 180 companies in the TOPIX continue to trade below book value. That compares with just 17 or so in the S&P 500. There's a lot of progress to be made here, but we are already seeing positive signs. It looks like the direction is changing. As I've mentioned, increasing shareholder value is top of mind for Japanese corporates today.

Freddie Fuller  06:23

Freddie: You've touched on it a couple of times now, but this is not only coming from corporates themselves. There's this concerted effort from government and regulators, policymakers to promote a shift in behaviour, I suppose, in recognition of its potential benefits. When we've always looked to Europe, there's a sense that its regulators have ultimately driven shifts in behaviour rather than a market-led approach. Do you think that's the same in Japan? Also, do you think perhaps, Japan has just been slightly late to the party?

David Soh  06:57

David: Yes. A few examples here. I briefly mentioned the Tokyo Stock Exchange and how they have efforts to drive change. It's worth looking at this in more detail. Last year, it launched a PBR one-time campaign to encourage companies to disclose their initiatives to improve capital efficiency. It's coming through in our conversations with management. They are bringing up topics like RoE and their P/E multiples. They're seeking advice on how they can improve value. The other initiative from the exchange was the Prime Index, something it describes as designed to highlight top value-creating Japanese companies. Both of these initiatives, they're very explicit, top-down nudges for companies to think differently about governance and shareholders.

Freddie Fuller  07:53

Freddie: Interesting. Perhaps, we can change tack at this point and talk to a few other catalysts that might be supportive for the region, especially in the short to medium term. The first of which is the household savings pool in Japan, of which over 50% is held in cash; clearly, a very high watermark and also a very large untapped opportunity. It does appear from the outside that policymakers have earmarked this to an extent as an area to try and incentivise redeployment into equities.

David Soh  08:25

David: Sure. This is the government's NISA program, Nippon Individual Savings Account, Japan's tax-free savings scheme that you're referring to here. This has been really a focus because it increases the account limit for retail investors, and this should incentivise them to redeploy large cash and savings into equities.

Freddie Fuller  08:49

Freddie: That's interesting. Also, because here in the UK, yesterday our budget announced that there's a new British ISA theoretically, being produced very soon. Clearly, this is a movement from regulators, from policymakers to try and encourage investment into local equities, albeit slightly different perhaps, in the UK. The second catalyst, I suppose, is more a point on how Japan treats foreign investors, both from a cultural perspective, but also from an investment one. Would you mind sort of elaborating on that aspect a bit more?

David Soh  09:29

David: Sure. Management teams are increasingly more open to engage with foreign investors. I could see that renewed effort for transparency. In fact, we recently had a meeting with a company that really went out of its way. They were broadcasting their board meeting on YouTube. This is an initiative that we think is happening across large caps and small caps alike. They are willing to discuss shareholder value, working to better align their goals with those of their shareholders.

Last year, we had an interesting experience, where through a major US investment bank, we were invited to speak virtually to over 100 senior corporate executives in Japan. This was specifically on the topic of global best practices on corporate productivity and corporate governance. We were just so surprised at how strong and genuine the response was from Japanese companies. With these efforts at the corporate level being supported by the government-led efforts that we discussed, the potential for change here can be bigger than we think.

Freddie Fuller  10:41

Freddie: I suppose the point that was being alluded to, Japan has had a bit of a bad rep from an investment standpoint in areas. For example, the history of poor experience with activists, for example, leading to this overt sense of suspicion, perhaps between the two sides. There's a recent headline highlighting that Japan recently overtook Europe to become the second largest market for shareholder activism globally after the US. What do you think is happening here?

David Soh  11:13

David: You're right. Historically, there has been some apprehension towards activist investors in Japan, but we're actually seeing more openness now. This is changing even towards activist investors compared to what it was previously. Shareholder voices appear to be heard more clearly, whether they are from activists or otherwise. At RBC, we're not activists, but we do a lot of bottom-up research on a company's ESG characteristics when we study its fundamentals. Firms are keen to talk with us about governance. They sound earnest in trying to improve corporate profitability and transparency. The market also looks inexpensive.

Freddie Fuller  11:59

Freddie: That's even after the 30% rally over the last year.

David Soh  12:02

David: That's right. The valuation case is still there. Japan equity also looks very much under-owned. If we think about global institutional investors, also domestic retail. In addition to the valuation case, flow should also be a structural positive.

Freddie Fuller  12:22

Freddie: Interesting. Perhaps, we could conclude by zooming out a bit in Asia more broadly and ask whether this progress in governance reform is happening elsewhere. For example, places like Korea and China, and maybe ask whether you think these regions could also benefit in the same way that Japan appears to be benefiting.

David Soh  12:47

David: That's an interesting point, Freddie, because Korean equity has seen a lot of foreign investor interest just year-to-date exactly for this expectation on better corporate governance and shareholder return policies. Local investors have been somewhat cynical to government initiatives trying to benchmark Japan's success. I think in the long run there is progress with governance in Asia.

It can feel slow. It can feel like two steps forward, one step back. The key thing we focus on is how capital allocation is done. Emerging Asia in early lifecycle stage economies, capital allocation can be weak, especially if the state is driving this. As markets develop further and the private sector takes lead, capital allocation and corporate governance tends to improve.

Freddie Fuller  13:41

Freddie: From our perspective, from the international equities perspective, and I should clarify that by that we mean EAFE or developed equities ex-US, the changes could have a profound effect for investors, especially in North America. There's been a lot of discussion about growing concerns in recent years over US market concentration. That's both names and from a sector standpoint, high valuations, geopolitical disruption, et cetera, et cetera. I suppose people would argue that there's been a lack of an obvious alternative.

One would hope that there's an increasing argument that with Europe continuing to offer good long-term returns, people forget that Europe has been returning 7-8% per annum over the last 10-15 years and not a shabby return at all. To have Japan coming back into favour and perhaps, some of these other countries you mentioned, hopefully this would be a case for diversification, a way where people feel like it's necessary. On that hopefully positive note, we should conclude.

Thank you very much, David, for joining us and for our listeners for tuning in. Goodbye.

David Soh  14:57

David: Thanks again. Goodbye.