Mending fences

With his chickens scattered and fence repairs added to the list of weekend activities, Multi Asset fund manager Will McIntosh-Whyte ponders whether previously traumatised investors in Japan’s stock market will finally feel safe returning to the coop.

By Will McIntosh-Whyte 27 March 2024

Having recently turned 40, my weekends look very different to how they were a decade or so ago. Once upon a time, weekends were filled with team sports, all-day pub sessions, late-night parties and long lie-ins; last weekend I found myself running, half-naked, into the garden at 7am to stop a fox attacking my chickens. 

Other notable events of the week included going to the tip, topping up the car’s windscreen wash and Japan’s central bank ending the world’s long dalliance with zero interest rates. And so I spuriously bring us round to the point of this blog.

Since its stock market popped in 1990, Japan’s investment landscape has been akin to the chickens in my back garden: investors either disappearing never to return, damaged beyond repair or adrift on the pond in shock from the experience. Every few years investors are lured back by the promise of a new dawn, only to find no one has repaired the fence, and so repeating the trauma. And yet, once again, the lure of Japan is calling. 

The world’s third-largest economy and fifth-largest stock market is once again back on the menu. The stock market has rallied handsomely, adding almost 50% since the start of 2023, and approaching levels not seen in several decades when Japan was all the rage, before the market burst spectacularly, taking most of my lifetime to recover.

The Japanese economy has been plagued by low growth and deflation (falling prices), aided and abetted by terrible demographics. Often, the attraction of Japan was around valuation. Stocks trade cheap, with 30% of Topix stocks still trading below book value – this implies that investors believe almost a third of the index is likely to destroy capital in the future. And to be fair, many Japanese companies have duly delivered that destruction over the past few decades. Valuations arguably reflect the weak fundamentals, as well as being a function of sector exposure – autos and banks are key parts of the Japanese stock market. But there are other factors to consider. 

Escaping zero rates

Corporate governance is a phrase that often induces yawns from my younger colleagues. Increasingly seen as a hygiene factor, much like a chicken fence, it goes unnoticed day to day, but can have serious consequences if holes appear. Japan’s fence has been in disrepair for decades, and despite steady progress in recent years it still boasts one of the worst regimes found in developed markets. There are a number of issues at play. Companies have high levels of cross holdings, meaning they own big stakes in each other’s companies. Capital allocation can be extremely inefficient, with many companies sat on excess capital (in some cases cash is worth half the value of the company), which reduces returns on equity. Management teams still have limited share ownership and are therefore less aligned with shareholders than in other markets, and employees have a job for life. Good for employees; a death sentence for productivity.

But Japan is mending the fence. Reforms began as far back as 2013 – part of Prime Minister Shinzo Abe’s “Abenomics” – so have been going on a while. But they have more recently picked up pace, with the Tokyo Stock Exchange last year altering listing rules to push companies to become more conscious of cost of capital and stock price – especially in cases where stocks trade below the book value of their assets. The bourse has also published a ‘good list’ of those putting capital efficiency plans in place – a more Japanese version of naming and shaming. 

This is bringing genuine change. Companies are selling down their cross shareholdings at a record pace, in theory improving the effectiveness of shareholder engagement. Companies have also used their cash piles to increase dividends and buybacks (2023 was a record year on latter). Through 2023, the proportion of companies trading above their book value has gone from 50% to 59%. In the US, 97% companies trade above. It’s 80% for the Euro Stoxx 50. Plenty of runway for Japan then.

The Japanese economy is still relatively weak, but there have been some improvements. House prices have increased, and Japan has finally seen some positive inflation, helped by reasonable wage growth, supporting the consumer. Many Japanese wages are set via a process called ‘shunto’, whereby management and unions of major corporates meet to agree pay hikes for the year. This year’s wage increases are far higher than the previous year, and the strongest since 1991. There’s also a push from government to encourage households to invest in equities (currently it is estimated around 75% of average household savings are in cash – in the US 75% is in equities). We are starting to see international investors return to Japanese companies, reversing decades of outflows – including from domestic Japanese investors. 

So some tangible changes look to be occurring, and this is reflected in the aforementioned increase in interest rates – a small move from -0.1% to 0-0.1% – but symbolically much bigger. With the Bank of Japan exiting zero interest rate policy, perhaps finally Japan can return to an element of normality. This could also help support the yen which has been in freefall for the last decade, and been a significant headwind for unhedged investors. Currency is something to be wary of though, as a weaker yen has been supportive for Japanese exporters, which make up a significant portion of the Topix. However, a stronger yen could well encourage Japanese investors to repatriate some capital back into domestic investments, providing a further tailwind. 

It won’t be plain sailing from here, and hence we have added to our exposure through a structured product – which we discussed in more detail on our latest The Sharpe End podcast. As for fences, well I am mending mine too. Hopefully both hold steady! 

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