Japanese Equities | Special Situation

Land Of The Rising Sun Is About To Be Land Of Rising Equity Markets

Japanese 10,000 Yen With Benjamin Franklin $100 Dollar Bill

• Japanese equities have stagnated for years, but that’s changing fast

• The Nikkei 225 peaked at 38,916 in 1989 but today its only 29,388 (-25%)

• In the same period the Dow surged from 2,144 to 34,302 (+1,600%)

• The pendulum is now swinging the other way due to key reforms

• This is a pivotal moment for the Tokyo Stock Exchange

• This is a huge opportunity for investors

Huge Opportunity

It’s been a miserable 35 years for Japanese equity investors, generating little or no return. By contrast, US investors have enjoyed one of the longest bull runs in history.

The chart below demonstrates the stark difference between price returns for those invested in Japan relative to the US since 1989.

Why has this happened, and what changes will act as a catalyst for a major pivot?

The Backstory

First, the Japanese market was massively over valued back at the end of the 1980s, so that skews things a little. A strong rally in that period can only be described as a stock market bubble.

Japan had lowered its interest rates, bank lending was reckless and cheap money resulted in a misallocation of resources and subsequent asset price bubbles (not too dissimilar to the response of the West from 2009 to 2022.)

To make matters worse Japanese land and property prices had increased 5000% in the thirty years to 1986 and banks offered cheap debt against the security of land and property on the assumption that this growth rate would continue forever. So as property prices had run ahead of themselves, so too had debt which was directly correlated in value to the land and property against which it was collateralized (there are also parallels here with the West in the period 2009 to 2022!)

Cheap money was used to speculate on the stock market and valuations were pushed to eye-watering levels (sound familiar?)

In 1987 the average PE multiple of a Japanese public company was 90. Fishery and forestry stocks were trading at 319 times earnings. Nippon Telegraph & Telephone reached 1,200 times earnings (this sounds a lot like US tech stocks over the past decade, and Tesla’s ridiculous peak valuation!)

They say history doesn’t repeat, but it rhymes. I’ll stop drawing parallels with the West because the point has been sufficiently well made. Suffice it to say that the West will need to pay for the excesses of the past 15 years and we ought to heed the warning of this Japanese precedent. If the West stagnates for a while, perhaps the East is the best place to look for Alpha returns in the short term, particularly in light of the fundamental changes that are occuring there.

By 1989 the Nikkei index peaked at almost 39,000 which was up 27% on the year and 500% on the decade. Despite predictions that the index would double again over the next five years, instead the bubble burst.

By August 1992 the Nikkei index was 14,309 having lost 65% of its value. Tokyo property prices similarly dropped 60%. The net result was that Japan had dug itself into a recessionary hole where there was too much productive capacity as the result of excessive capital expenditure prior to the crash against a backdrop of too little consumer demand.

The recession that followed is still being felt over 30 years later.

So now you are up to speed on the market fundamentals. Now it is important to make you aware of some cultural distinctions that are key to your understanding of this opportunity.

Japanese corporate management is a world apart from that seen in the US.

• Decision-making: In Japan, decision-making is often more consensus-based, with input from a variety of stakeholders, while in the US, decision-making is typically more top-down. This means that capital allocation decisions are not being managed by people adriot at doing so.

• Risk-taking: Japanese companies are generally more risk-averse than US companies. This is due in part to the fact that Japanese companies have a long-term focus and are more concerned with maintaining stability than with taking risks. Again this impacts capital allocation decisions. Empirical evidence shows how Japanese companies hoard cash rather than putting it to work.

• Communication: Japanese companies tend to be more indirect and hierarchical in their communication style, while US companies are more direct and egalitarian. This results in sycophantic behaviour where people tend to say what they believe others want to hear rather than introducing constructive challenge. While this introduces political stability, it does nothing to help the business evolve.

• Collectivism vs. individualism: Japanese culture is more collectivist than US culture. Japanese companies have a strong emphasis on teamwork and collaboration. This means that Japanese businesses are often run as a collective for the benefit of employees. Shareholders are often not a consideration and worse, sometimes appear to seen as an convenience. This Japanese corporate culture leads to a lack of transparency as companies have historically been reluctant to disclose key information to investors.

By way of example, allow me to introduce Imagineer, a $76m market cap video game developer, based in Japan, trading under the ticker TYO: 4644.

• They have a net current asset value of $84m USD equivalent which is larger than their market cap…they have zero long term debt!

• Over 90% of it net current assets is cash and accounts receivable.

• The Enterprise Value is only $11m USD equivalent

• They have a long history of profitability and have a TTM P/E of 10.15

• They also have a dividend yield of 3.4% with a history of growing their dividend steadily for 17+ years

• Top line and earnings growth has been good

• Imagineer stock price has moved sideways for a decade but book value per share increased over 50% (largely due to the hoarding of cash), all while paying a reasonable dividend.

As you can see, this is an insane way to run a company. Either put the cash to use in a manner that is accretive to shareholders, or else release the capital to shareholders.

The changes that I am about to explain to you will achieve this outcome.

The Catalyst for Change

The Tokyo Stock Exchange (TSE), in concert with the Japanese Government, is facilitating change. There are huge stock market reforms taking place in Japan.

“In order to ensure the sustainable development of the Japanese economy in the
future, it is important to promote industrial metabolism and innovation in business and society. It is important for TSE to create a framework to encourage such efforts and thereby contribute to the improvement of productivity in the Japanese economy as a whole”

Tokyo Stock Exchange

More particularly, the Japanese government has decided to fundamentally expand and make permanent the NISA program.

NISA stands for Nippon Individual Savings Account, a tax-advantaged investment account for retail investors in Japan. It was introduced in 2014 to encourage individual investors to save and invest for the long term.

One of the key objectives is to achieve financial inclusion, whereby the benefits of the financial and capital markets are widely available to all Japanese citizens, and the foundation has been established for households to actively shift their assets from savings to investments.

In order to procure this outcome, the TSE has undertaken significant changes to its cash equity markets. This began in April 2022, but has since been accelerated. The objective is to support sustainable growth and to improve corporate governance (particularly in relation to capital allocation).

One of the core problems was that there have always been stringent listing criteria for Japanese companies. But post IPO, once capital has been raised through the public sale of equity, continuing eligibility to operate as a public company was never questioned. Metaphorically, management would say what they needed to say and do what they needed to do in order to win a bride, but after the marriage the husband largely ignored his wife and treated her with contempt.

This is all changed now. There are ongoing eligibility criteria and a real risk that companies will be delisted if they fail to comply. This has resulted in a huge change.

One of the key areas of focus is the return on capital. Because Japanese firms are used to hoarding cash, the asset side of the balance sheet swells (mostly unproductive cash) while the liabilities shrink (many have no long term debt) and so equity values grow.

This is an issue because the return on invested capital and on equity is low and decreasing. This manifests itself in continual contractions in the price to book ratio which, for many Japanese companies is well below one.

As such, this is a particular focus of the TSE. It has announced initiatives to enhance the mid- to long-term corporate value of listed companies. These initiatives cover four themes:

1. Raising awareness and literacy about the cost of capital and stock price, particularly among companies with a Price to Book ratio below 1x.

2. Improving the quality of corporate governance, including emphasizing the importance of the "Explain" principle in Japan's Corporate Governance Code.

3. Further expanding English-language disclosures.

4. Improving the effectiveness of dialogue with investors.

The details and implementation timings for each measure are provided in the Response Policy.

Essentially, if a listed company fails to meet the regular continued listing criteria within one year of the record date (six months for trading volume standards), its shares will be designated as "Securities Under Supervision" and "Securities to Be Delisted" and ultimately delisted from the TSE.

In order to monitor progress, the TSE established an expert council called the "Council of Experts Concerning the Follow-up of Market Restructuring" (the "Follow-up Council") in July 2022.

A transition period was announced during which companies were afforded a period of grace so that they would not be penalized for non-compliance before they had been given a reasonable period of time to adapt to the changes. During the transition phase listed companies that do not meet the regular continued listing criteria are eligible for relaxed criteria if they disclose a plan to meet the regular criteria.

In January 2023, TSE published a draft amendment to the listing rules, which proposes the termination of transitional measures. The proposed amendment sets the timing for the termination of these measures as March 1, 2025.

The proposed amendment also includes provisions for exceptional treatment of listed companies that have already disclosed a plan to meet the continued listing criteria with an end date after the first record date falling on or after March 1, 2026. Such companies will have the time of delisting extended until the end date of their plan, and their shares will be designated as Securities Under Supervision until it is confirmed whether they have met the criteria or not.

How Have Companies Responded?

Japanese companies are scrambling to utilize their capital or to return it to shareholders in order to reduce their book value and to boost their return on equity. Allow me to demonstrate:

Stock repurchases in April/May 2023

• Aisan Industry (7283) to buy back up to 2.18% of shares for 1b yen

• Amano (6436) to buy back up to 1.09% of shares for 2.4b yen

• Daiwa Securities (8601) to buy back up to 2.41% of shares for 25b yen

• Dip Corp. (2379) to buy back up to 1.57% of shares for 3b yen

• Hitachi (6501) to buy back up to 2.13% of shares for 100b yen

• Koito (7276) to buy back up to 4.98% of shares for 35b yen

• Komeri (8218) to buy back up to 1.83% of shares for 2.7b yen

• Kikkoman (2801) to buy back up to 1.04% of shares for 10b yen

• Makita (6586) to buy back up to 1.14% of shares for 10b yen

• Misumi Group (9962) to buy back up to 1.41% of shares for 10b yen

• Nomura Research Institute (4307) to buy back up to 3.38%, for 50B yen

• Nomura Holdings (8604) to buy back up to 1.1% of shares for 20b yen

• Shimizu (1803) to buy back up to 4.32% of shares for 20b yen

• Mitsubishi Electric (6503) to buy back up to 1.89% of shares for 50b yen

• Sekisui Chemical (4204) to buy back up to 0.93% of shares for 8b yen

• SG Holdings (9143) to buy back up to 1.03% of shares for 10b yen

• TechnoPro (6028) to buy back up to 0.93% of shares for 3b yen

• DTS Corp (9682) to buy back up to 1.16% of shares for 1.6b yen

• Marubeni Corp (8002) to buy back up to 2.1% of shares for 30b yen

• Sumitomo Corp (8053) to buy back up to 1% of shares for 20b yen

• Kissei Pharma (4547) to buy back up to 4.34% of shares for 6b yen

• Mitsubishi Corp (8058) to buy back up to 6% of shares for 300b yen

• Nichiden (9902) to buy back up to 3.18% of shares for 2.5b yen

• Sun-Wa Technos (8137) to buy back up to 4.52% of shares worth 1b yen

• Nippon Yakun Kogyo (5480) to buy back up to 4.5% of shares for 2b yen

• Marui (8252) to buy back up to 11.62% of shares for 40b yen

• Nagase & Co (8012) to buy back up to 5.11% of shares for 8b yen

• TIS (3626) to buy back up to 7.4% of shares for 6.2b yen

• Net One Systems (7518) to buy back up to 4.26% of shares for 7.5b yen

• Yokohama Electric (6841) to buy back up to 6% of shares for 20b yen

• Nissin Corp (9066) to buy back up to 6.55% shares for 2b yen

• Rinnai Corp (5947) To Buy Back Up To 2.73% for 10b yen

• Orix Corp (8591) To Buy Back Up To 3.4% for 50b yen

• SoftBank Corp (9434) To Buy Back Up To 1.19% for 100b yen

• K's Holdings Corp (8282) To Buy Back Up To 5.46% for 10b yen

• Sankyu Inc (9065) To Buy Back Up To 6.41% for 15b yen

• Yamato Holdings (9064) Says It Will Buy Back Up To 6.06% for 50b yen

• Tocalo Co Ltd (3433) Says To Buy Back Up To 3.29% for 2b yen

• Hokuhoku Financial Group Inc (8377) To Buy Back Up To 3.9% for 4b yen

• United Arrows Ltd (7606) To Buy Back Up To 4.6% for Up To 2b yen

• Japan Lifeline Co Ltd (7575) To Buy Back Up To 3.9%, 4 Billion Yen

• Elecom Co (6750) Says To Buy Back Up To 4.7%, 5 Billion Yen

• Gunma Bank (8334) To Buy Back Up To 3.07%, 5 Billion Yen

• Kddi Corp (9433) Says It Will Buy Back Up To 4.26%, 300 Bln Yen

• Honda Motor (7267) Says It Will Buy Back Up To 3.8%, 200 Bln Yen

• Morinaga & Co (2201) To Buy Back Up To 2.97%, 6.7 Billion Yen

• Kadokawa Corp (9468.T) To Buy Back Up To 5.64%, 20 Billion Yen

• San-Ai Obbli Co Ltd (8097) To Buy Back Up To 2.99%, 2.8 Billion Yen

• Comsys Holdings Corp (1721) To Buy Back Up To 1.65%, 4 Billion Yen

• Funai Soken Holdings (9757) To Buy Back Up To 1.7%, 2 Billion Yen

• Neturen Co (5976) To Buy Back Up To 7.21%, 1.5 Billion Yen

• Fuji Corp (Aichi) (6134) To Buy Back Up To 6.22%, 10 Billion Yen

• Tokyo Electron (8035) To Buy Back Up to 2.1%, 120b yen

• Santen Pharmaceutical (4536) To Buy Back Up To 5.0%, 24.5 Billion Yen

• Wacom Co Ltd (6727) To Buy Back Up To 2.56%, 2 Billion Yen

• Hibiya Engineering (1982) To Buy Back Up To 2.60%, 1.5 Billion Yen

• Press Kogyo (7246) To Buy Back Up To 1.9%, 1 Bln Yen

• Atrae (6194) To Buy Back Up To 5.2%, 1 Billion Yen

• Casio Computer (6952) To Buy Back Up To 3.14%, 10 Bln Yen

• Ajinomoto (2802) To Buy Back Up To 2.36%, 50 Billion Yen

• Takara Standard (7981) To Buy Back Up To 3.38%, 3.8 Billion Yen

• Tsugami Corp (6101) Says To Buy Back Up To 2.08%,1.4 Billion Yen

• Subaru (7270) Says It Will Buy Back Up To 2.9%, 40 Billion Yen

• Infroneer Holdings (5076) To Buy Back Up To 4.77%, 10 Billion Yen

• Dream Incubator (4310) To Buy Back Up To 15.36%, 3 Billion Yen

• Ushio (6925) Says To Buy Back Up To 17%, 30 Billion Yen

• Taisei Corp (1801) To Buy Back Up To 3.19%, 20 Billion Yen

• San-In Godo Bank (8381) To Buy Back Up To 1.02%, 1 Billion Yen

• Daiwa House Industry (1925) To Buy Back Up To 1.52%, 35 Billion Yen

• Nippon Beet Sugar Manufacturing (2108) To Buy Back Up To 4.49%, 1bn Yen

• Vital KSK Holdings (3151) To Buy Back Up To 1.93%, 1.2 Billion Yen

• Tsurumi Manufacturing (6351) To Buy Back Up To 4.49%, 2.5 Billion Yen

• Nippon Express Holdings (9147) To Buy Back Up To 1.79%, 10bn Yen

• Olympus (7733) Says To Buy Back Up To 4.39%, 100 Billion Yen

• Mebuki Financial Group (7167) To Buy Back Up To 3.28%, 10 Billion Yen

• Toppan Inc (7911) To Buy Back Up To 6.4%, 40 Billion Yen

• Yamaguchi Financial Group (8418) To Buy Back Up To 8.88%, 10b Yen

• Kumagai Gumi (1861) To Buy Back Up To 2.1%, 2 Billion Yen

• Azbil Corp (6845) To Buy Back Up To 2.9%, 1 Billion Yen

• Mixi Inc (2121) To Buy Back Up To 5.14%, 7.5 Billion Yen

• Kureha Corp (4023) To Buy Back Up To 6.15%, 10 Billion Yen

• Asahi Diamond Industrial (6140) To Buy Back Up To 3.73%, 2.2b Yen

• Toyo Seikan Group (5901) To Buy Back Up To 7.1%, 20 Billion Yen

• Saint Marc Holdings (3395) To Buy Back Up To 0.97%, 450 Million Yen

• Amada Co Ltd (6113) To Buy Back Up To 5.2%, 20 Billion Yen

• Maezawa Kyuso Industries (6485) To Buy Back Up To 6.36%, 1 Bln Yen

• NSK Ltd (6471) To Buy Back Up To 4.8%, 22 Billion Yen

• Hosiden Corp (6804) To Buy Back Up To 3.0%, 3 Billion Yen

• Hirogin Holdings (7337) To Buy Back Up To 1.6%, 3 Billion Yen

• Wacoal Holdings Corp (3591) To Buy Back Up To 6.60%, 10 Billion Yen

• Kawada Technologies (3443) To Buy Back Up To 3.74%, 1 Billion Yen

• Tenma Corp (7958) To Buy Back Up To 5.06%, 2 Bln Yen

• Exeo Group (1951) To Buy Back Up To 1.55%, 3 Billion Yen

• Toyo Kanetsu Kk (6369) To Buy Back Up To 5.3%, 1.2 Billion Yen

• Resona Holdings (8308) Says It Will Buy Back Up To 1.05%, 10b Yen

• Toa Corp (1885) - To Expand Share Buy Back Up To 19.44% from 5.52%

• Sumitomo Bakelite (4203) Says To Buy Back Up To 1.59%, 3 Billion Yen

• Kajima Corp (1812) To Buy Back Up To 1.4%, 10 Billion yen

• Morinaga Milk (2264) Says To Buy Back Up To 5.08%, 10 Billion Yen

• Mochida Pharmaceutical (4534) To Buy Back Up To 2.96%, 3.5b Yen

• Dai-Ichi Life (8750) Says To Buy Back Up To 9.11%, 120 Billion Yen

• Japan Post Holdings (6178) Says It Will Buy Back Up To 10%, 300b Yen

• Suzuki Motor (7269) Says It Will Buy Back Up To 1.2%, 20 Bln Yen

• T&D Holdings (8795) To Buy Back Up To 7.31%, 40 Billion Yen

• Nissan Chemical (4021) Says To Buy Back Up To 0.89%, 5 Billion Yen

• Komori Corp (6349) Says To Buy Back Up To 2.73%, 1.5 Billion Yen

• Macromill (3978) To Buy Back Up To 3.79%, 1.2 Billion Yen

• Mirait One (1417) To Buy Back 4.71%, 5 Billion Yen

• Alfresa Holdings (2784) To Buy Back Up To 10.4%, 35 Billion Yen

• Kyocera Corp (6971) Says It Will Buy Back Up To 2.25%, 50 Billion Yen

• Nac Co Ltd (9788) To Buy Back Up To 5.8%, 1.3 Billion Yen

• Akatsuki Inc (3932) To Buy Back Up To 16.49%, 4.8 Billion Yen

• Mitsui Matsushima Holdings (1518) To Buy Back Up To 15.39%, 3b Yen

• Okinawa Financial Group (7350) To Buy Back Up To 5.65%, 2.9b Yen

• Aoki Holdings (8214) To Buy Back Up To 1.18%, 1 Billion Yen

• UT Group (2146) To Buy Back Up To 3.22% Worth 2.8 Bln Yen

I cannot guarantee that this list is complete, but I think that I have made my point.

Suffice it to say that the total value of share buybacks reached a record ¥9.7trn in the year to March according to Japanese Investment bank Nomura, substantially higher than the previous record of ¥7.3trn.

More particularly, advisory group IR Japan expects the number in 2023 to exceed the record set last year.

What’s The Angle For Investors?

This is not a ‘pie-in-the-sky’ investment theory that may or may not come to pass.

Change is there for all to see.

There are so many undervalued Japanese companies, many trading well below their net asset value (the Benjamin Graham favourite approach to investing), that it is difficult to see how this will not result in impressive shareholder returns in the years to come.

You may find that the release of capital to shareholders covers most of your purchase cost and you then have investments in your portfolio that cost next to nothing that are yielding impressive returns.

Better still, when you consider that Japanese rates are super low, you can borrow Japanese Yen to buy stock for way less than the annual dividend, so you have negative carry on this trade.

Conclusion

We have a perfect combination of an under performing asset class with a great deal of value locked up, and the TSE revealing the key to unlock that value.

Balance sheets are fortresses due to the hoards of cash, so no big concern there.

As foreign investors see this opportunity and rush in, alongside domestic Japanese investors encouraged by the NISA initiative, demand will push price multiples higher.

Improving returns on invested capital will also justify expanded valuation metrics and so all of this ought to act as a nice tail wind for Japanese equities.

Add to this all of the repurchase activity happening in the market and the skew on the demand and supply equilibrium for Japanese equities will turn the tailwind into a hurricane force gail.

Hold tight. This is going to be one hell of a ride!

Additionally, Japan has been out of favour with foreign investors and the Japanese yen has been weak. Both of these are changing and so foreign investors today will benefit with any appreciation on the yen magnifying equity gains in their domesic currency.

The outlook for Japan is, arguably, more positive than it has been for some time. Inflation in Japan has been modestly above target (so far better than the west) and the central bank has only softly begun to tighten monetary policy (again, from a corporate perspective, better than the west).

Finally, with Japan having only recently abandoned its last pandemic restriction, there is likely to be a spurt of domestic economic activity similar to that already experienced in the west.

The assymetric skew for investing in Japan seems very favourable at the moment. But this is not investment advice. It is merely an opinion of the author, so please do not base your own investment decisions on the content of this article. Do your own analysis and seek professional advice.