Capital Ideas^TM

After toiling for years in relative obscurity, Japan has certainly captured investor attention again this year. The Nikkei 225 has hit all-time highs in 2024 and there are signs of an end to long-term deflation; in the wake of an unexpected Bank of Japan (BoJ) rate rise in August and a spike in the yen, however, the index suffered its biggest ever daily loss and entered bear market territory, with the broader Tokyo Stock Price Index (TOPIX) similarly battered.

Both then quickly retraced these losses, with the Nikkei 225 registering its largest ever single-day gain and the TOPIX close behind on 6 August.

What should investors make of such violent market moves? In the short term, returns from the yen and Japanese equities overall will depend not only on local monetary policy but also on what the US Federal Reserve decides to do and what happens with macro data, especially in the US. As ever, we are keen to look through such noise and establish whether Japan’s recent resurgence can become a sustainable trend with strong foundations.

As long-term investors in the region, we do see major fundamental factors turning in favour of Japanese equities: one is corporate governance reform and another is reflation, in many forms, and this combination could ultimately drive increasing capex and higher domestic consumption.

Perhaps the most obvious factor behind the resurgence is the government’s efforts to modernise the country’s business landscape and eliminate long-running resistance to prioritising shareholder interests. Broadly speaking, Japanese companies have considerable cash on their balance sheets and, unlike in the past, many are now willing to return some of this to shareholders via buybacks, better capital allocation and rationalisation.

We believe these improvements in corporate governance will stay on track and, if anything, recent volatility will put more pressure on companies to protect their share price.

Back in March 2023, the Tokyo Stock Exchange (TSE) asked listed companies to submit and implement policies to improve profitability, long-term returns, and valuations – focusing on return on invested capital (ROIC), return on equity (ROE) and raising price-to-book (P/B) ratios above 1x.

So far, larger, lower P/B businesses have broadly led equity markets as the initial epicentre of reform, leading Goldmans to coin the ‘Samurai 7’ definition to include Screen Holdings, Advantest, Disco, Tokyo Electron, Toyota Motor, Subaru and Mitsubishi Corp. As governance upgrades spread, however, we would expect to see improving returns across a wider spectrum of stocks, including many of our favoured higher-quality names, as factors like earnings growth and increasing dividend payout ratios potentially become more relevant.