Investment returns are a function of outcomes versus expectations. Expectations for Japanese companies were running extremely high in the late 1980s, as evidenced by nosebleed earnings multiples and rock-bottom dividend yields. In the subsequent decades, not only did growth and profitability fall short of those lofty expectations, they also fell behind growth and profitability in other regions. 
As a result, the Japanese stock market delivered an absolute return of virtually zero, and was a substantial underperformer globally. Nearly three decades were lost.
While the Japanese stock market has delivered underwhelming returns, the region hasn’t been devoid of opportunity. Over the years, we have come to regard Japan as an excellent stockpickers’ market.
As for the market as a whole – while it is far cheaper than it was three decades ago, it is also far from cheap. Expectations appear neither excessively high nor excessively low. Whether Japanese corporate growth will exceed these middling expectations is anybody’s guess. We don’t have a crystal ball, but there are some reasons for cautious optimism.
One such reason is the gradual improvements we are seeing in capital efficiency. It has been low in the past— an enduring issue that has been detrimental to both shareholders of Japanese companies and to the wider Japanese economy. Over the last three decades, we have often perceived companies to allocate capital inefficiently. Common examples include investing in low-return projects, holding other companies’ stock, and hoarding cash.
Why did these behaviours become so ingrained? It’s complicated. Hoarding cash is appealing on some levels, such as ensuring the business survives even if its competitiveness wanes. And having a chunk of your shares owned by a friendly peer company weakens the voice of minority shareholders and protects against takeovers.
While these habits may be negative for shareholders, they may be reassuring for other key stakeholders such as employees and the communities in which these businesses operate. It is natural and right for companies to consider their effects on other stakeholders. Yet even from an overall stakeholder perspective, these behaviours can have some negative side effects.
Capital should go to where it is most useful, and the most successful and enduring companies are those that look to allocate capital in creative ways. Companies with cash and exciting opportunities should invest it, while those with cash but no opportunities should pay it out so that investors can direct that capital to companies that do need it. The more cash gets stuck on companies’ balance sheets, the harder it becomes to fund innovation.
Given its shrinking population, the only way for Japan to sustain economic growth will be via the productivity gains that innovative companies help to drive. When prime minister Shinzo Abe speaks of reviving “animal spirits”, this is one of the things he has in mind. 
The recognition that improved capital efficiency is crucial for the economy has led the Japanese government to introduce a sweeping revitalisation strategy. Key elements of the strategy include a stewardship code and a corporate governance code.
The recent reforms are designed to formally encourage and strengthen dialogue across the corporate decision-making chain. The stewardship code obliges asset managers and asset owners (like corporate pension funds) to be engaged stewards of their clients’ capital. In practice, that means fostering an active dialogue with investee companies, and justifying votes based on clients’ or beneficiaries’ interests. Those votes become much more influential as corporations wind-down their “cross shareholdings” – large stakes held in other companies – which is encouraged by the corporate governance code. According to research by investment bank Jefferies, 40 per cent of Japanese firms are majority-owned by fellow corporates and other “allegiant” shareholders.
Helping that along is another provision of the corporate governance code – that boards should include independent directors. Before the reform push, most Japanese companies had zero outside independent directors, and few firms tied executive compensation to the long-term performance of the business. Following the introduction of this code, 85 per cent of TOPIX companies now have at least two independent directors.
Better corporate governance and better engagement with shareholders should encourage management teams to make better capital allocation decisions. There remains plenty of scope for improvement – for instance, 60 per cent of Japanese companies hold net cash on their balance sheets, compared to just 25 per cent of companies in the MSCI World index.
Decades of ingrained behaviours don’t change overnight, but there are some signs that reforms in Japan are creating a more dynamic and capital-efficient environment. Our hope is that the country continues down this path. Not only should that be good for Japan, but it should also provide opportunities to buy improving businesses like the trading companies at still-reasonable valuations.
Graeme Forster is a portfolio manager at Orbis Investments. The views expressed above are his own and should not be taken as investment advice.