Although the Japanese equity market is the second largest among the world's developed markets, it still has the inefficiencies of an emerging market. For investment managers, there are many opportunities to generate alpha.
Large, but inefficient
As the world's second-largest stock market in a developed nation after the USA, the Japanese stock market offers investors a large and broadly diversified investment universe.
At the same time, however, it exhibits inefficiencies that are otherwise only found in the equity markets of emerging countries.
If a market is very inefficient, i.e. many companies are misvalued, this naturally creates investment opportunities for market experts. The chances of an investment manager outperforming a corresponding benchmark index are much higher in the Japanese equity market than in other parts of the world.
One reason for the inefficiency of the Japanese stock market is that, although Japan is home to several global market leaders in various industries and is therefore internationally positioned, it is also a very local market in many respects.
For international investors, many nuances are lost when talking to Japanese companies due to language and cultural barriers alone.
Inefficiencies are also caused by the low coverage of the Japanese equity market by analysts. There is a considerable amount of good coverage on the mega caps in Japan. But this coverage decreases significantly the smaller the stocks become, even though the Japanese equity market is dominated by companies with a medium market capitalisation. As a result, the Japanese equity market is less well covered on both the sell and buy side.
There are also historical reasons for the lack of interest from international investors.. In 1989, the Japanese stock market was the largest market in the world and made up around 45% of the MSCI World Index. Eight of the 10 largest companies in the world were Japanese banks, which is why Japan was a well-known and overvalued market for a long time.
After the bubble burst, a devaluation followed that went far beyond what would have been justified by the relative earnings growth of Japanese companies. As a result, Japanese equities are now trading at a significant valuation discount to their counterparts in other developed markets, and international investors are still heavily underweight Japanese equities despite the recent revival of interest.
A new view of Japan is needed
The existing narrative surrounding the Japanese stock market needs to change. In terms of earnings per share (EPS) growth, for example, Japan has outperformed not only Europe and Asia ex Japan, but also the US over the past 10 years.
There is another success story in the area of corporate governance. Under prime minister Shinzo Abe, structural reforms had already been initiated to improve the capital efficiency of listed Japanese companies and to strengthen the focus on shareholders.
These reforms have recently received further impetus from initiatives by the Tokyo Stock Exchange (TSE). These efforts are now bearing fruit. The data shows that Japanese companies have indeed improved their corporate governance in recent years and this is already having a positive impact on company performance.
As a result of decades of deflation, Japanese companies have also significantly reduced their debt levels, as debt would incur real costs in a deflationary environment. Around 45% of companies in the MSCI Japan Index that do not belong to the financial sector now have a net cash position. In addition, the non-financial sector's net debt to equity ratio is now lower than in the rest of the world and only half the historical highs.
However, these successes are not being recognised by global investors because they have not yet been reflected in spectacular returns, as is the rule with similar developments in the US.
In Japan, we see that profits are rising, but multiples are continuing to shrink. This is completely different from the US, where multiples are climbing along with earnings. For this reason, many investors are overlooking the fundamental improvement.
Return of inflation
And there is another factor that is having a positive effect on the Japanese economy and the country's stock market: the return of inflation. Following the end of the deflationary phase, Japanese companies and private households are now rethinking.
Companies are investing more again and are also prepared to take certain risks for strategic reasons, which is reflected in an increasing number of mergers and acquisitions, among other things.
There is a similar change in private households. The mindset of many Japanese, characterised by decades of deflation – as little debt as possible, as little consumption as possible, restraint in investments – is gradually reversing.
Consumer spending is increasing and investments in their own stock market have multiplied, supported by government subsidies.
The size of the market, its inefficiency, undervaluation, attractive companies and changing consumer attitudes – together these factors create an attractive environment for investors. If you are looking for undervalued stocks, you will find them in Japan.
June-Yon Kim is lead portfolio manager for Japanese equities at Lazard Asset Management. The views expressed above should not be taken as investment advice.