The Nikkei 225, one of the flagship indices used to measure the performance of the Japanese market, hit a new all-time high in February and has carried on climbing since. That is a big deal because the previous high was set in 1989 and was followed by a prolonged and deep slump.
There have been many false dawns since, but the cumulative effect of far-reaching corporate governance reforms and more favourable economic conditions finally seems to be feeding through into Japanese equity markets.
The market’s tale can be told by following the fortunes of two very different funds focused on the country. With a market cap of £780m, JPMorgan Japanese is the largest investment company specialising in Japan. The trust has been managed since 2010 by Nicholas Weindling and, for many years, he has been assisted in this by Miyako Urabe.
Their management style is to identify fast-growing companies that can thrive by opening up new markets or by taking market share from incumbents. Such businesses are relatively rare, but once the managers have found great companies, they back them for the long term and so portfolio turnover tends to be quite low as a result.
The point here is that they place little or no reliance on economic growth within Japan, which is held back by a shrinking workforce and ageing population.
The JPMorgan Japanese approach does seem to work over the long run (all four Japanese large-cap trusts have very similar returns over 10 years), and we only have to go back to 2020 to find a period when it was by far the best-performing of all Japanese trusts. However, in retrospect, valuations were probably overstretched.
Like most other growth-focused funds, it had a difficult period over the first few months of 2022, a period that coincided with sharply rising interest rates in the US (which more recently look to have peaked but have not yet started to fall).
For many years, the Japanese authorities have sought ways to encourage growth. Just over a decade ago, a new Prime Minister, Shinzo Abe ushered in an environment of ‘easy money’, government stimulus, and crucially structural reform, that has expanded into a comprehensive shake-up of corporate governance.
On the ‘easy money’ front, very low interest rates were a core part of that. This has put downward pressure on the Japanese yen, which in turn makes the returns that Japanese funds have generated look worse than they otherwise would do.
Despite having low interest rates, for a long time a backdrop of deflation encouraged investors (and many companies) to hoard cash. Many companies built up cross-shareholdings too. However, these unproductive parts of balance sheets tended to be discounted by investors and many companies ended up trading at less than the value of this cash and unnecessary investments.
The majority of the 4,000 or so listed Japanese companies have no analyst coverage and are not particularly investor-friendly. That enabled some pronounced value opportunities to emerge.
Over time, efforts to improve corporate governance have strengthened and this is having a material impact on Japan’s stock market.
One of the drivers of this has been the Tokyo Stock Exchange; last March it asked companies with a price/book ratio of less than one to explain how they were going to tackle this, for example. Cross-shareholdings are being unwound, dividend pay-out ratios are rising, and share buy backs are proliferating. Nevertheless, some companies are still dragging their feet.
As corporate governance reforms started to bite, funds were launched to take advantage of the many bargains on offer. In the investment company market, a pioneer in this area was AVI Japan Opportunity, which was launched in October 2018.
This £184m market cap trust was the brainchild of the team behind AVI Global Trust, which had already had some success targeting undervalued Japanese companies. That success has continued with AVI Japan Opportunity, which since launch is amongst the best-performing of all Japanese-focused investment companies.
AVI Japan Opportunity estimates that there are about 470 companies that have net cash and securities greater than 30% of their market cap. Its managers have constructed detailed models on approximately 60 companies.
Once it has built a stake (big enough to be influential but it is not seeking control), the team will approach the company with ideas of how it can unlock value. This often involves streamlining the balance sheet but sometimes the team has suggestions about improving business efficiency too. These approaches take place behind closed doors, but if target companies prove intransigent, AVI may go public with its proposals and put forward resolutions at company meetings.
In these situations, AVI Japan Opportunity needs to be patient, but the rewards for success – which often flow through to all stakeholders – can be significant. Hence returns tend to be lumpy.
International investors have been encouraged by the commitment to reform in the country. There are signs of positive change in the economy too. Inflation has returned and wages are rising in some sectors. Domestic investors are taking more of an interest in equities but for these funds, a real boost could be a strengthening yen.
James Carthew is head of investment companies at QuotedData. The views expressed above should not be taken as investment advice.