A New Dawn for Japan’s Stock Market
34 years is an awfully long time to wait. Cleveland Browns fans will probably agree—that is how long it’s been since their team has made an appearance in the NFL Conference Championship game. That’s also how long investors in Japan’s widely followed Nikkei 225 market index have waited for a fresh all-time high. But unlike in Cleveland, that streak is finally over. On Thursday February 22, the Nikkei 225 closed at ¥39,098.68, finally overtaking the prior high set in December 1989. This tremendously lengthy downturn appears even more stark when compared to the “mere” 25 years it took for the Dow Jones Industrial Average to fully recover from the Great Depression (1929-1954).
Japan’s Nikkei Share Average Crosses All-Time High
Japan’s decades-long swoon was brought on by loose fiscal and monetary policies that led to the bursting of an incredible real estate and stock market bubble in the early 1990s (the appetite for Japanese real estate was so exuberant that the grounds under Tokyo’s Imperial Palace were assessed at a value greater than the entire state of California). The financial quagmire that followed was prolonged by multiple factors including stubborn deflation, low investor confidence, and extremely conservative capital allocation principles. Japan’s cultural aversion to debt (at both the corporate and consumer levels) is reflected on corporate balance sheets, where hoarding cash is common. In fact, as of August 2023, 49% of the TOPIX 500 (a market-cap weighted index that features the largest and most liquid stocks in Japan) held net cash balance sheets versus just 12% of S&P 500 constituents.
Oddly enough, while the market is hitting all-time highs, just last week Japan reported 4Q 2023 GDP that shrank by an annualized 0.4% (although it grew by 1.9% for the full year), marking its second-consecutive quarterly GDP decline—the unofficial definition of an economic recession. Weak domestic consumption and currency devaluation were the driving causes of the unexpected print. (Economists had anticipated growth of ~1%. It’s worth noting that the reported GDP decline is considered preliminary, and an upward revision could potentially erase that “recession” label.)
Yet despite this negative GDP print, corporate earnings in Japan are reaching new heights, unemployment is low, and interest rates remain extremely accommodating—some of the key ingredients that can engender a persistent rally in an equity market. Taken in that context, Japan’s stock market strength looks decidedly rational, far from bearing resemblance to the bubble characteristics of the late 1980s-to-early 1990s when price-to-earnings ratios were sky high. Instead, some investors might even say that Japan’s TOPIX looks attractively valued relative to the S&P 500.
Forward P/E Ratios of the S&P 500 and Tokyo-Based TOPIX
What makes the situation even more interesting, in our opinion, is a paradigm shift happening across the corporate sector: A slew of newer Japanese governance codes and proposals will promote M&A activity, support minority shareholder interests, incentivize actions to improve valuations, and assess the appropriateness of cross-shareholdings (large stakes in partner companies that are extremely commonplace in Japan to cement long-term relationships but are also decried as a way for management teams to dissuade takeovers, reduce the pressure of serving minority shareholders, and—in instances where the cross holding is a competitor—limit competition). One particular directive from the Japanese bourse is for companies with a valuation below a price-to-book value of 1.0 to disclose specific policies and initiatives to lift this ratio above 1.0. This affects a whopping 39% of the TOPIX 500, with just 5% of the S&P 500 trading at a similar level.
Percentage of Index Constituents at Various P/B Ratios (as of 8/13/23)
The Japanese market has been highly inefficient partly due to cross shareholdings but with those untangling, activists and U.S.-based hedge funds are seeking to eliminate discounts to intrinsic value by pushing for a variety of actions which could include increased shareholder returns (dividends and/or buybacks), restructuring, spinoffs, divestitures, and M&A. As Peter Landers of the Wall Street Journal writes, “What these foreign investors want is return—and they are getting it thanks to Japanese companies’ enthusiasm for dividends and share buybacks. The size of buybacks quadrupled in the decade to 2023, reaching the equivalent of nearly $60 billion, and companies have ratcheted up dividends in line with their soaring profits.”
With such a long list of potential tailwinds, the Japanese market looks like a fertile hunting ground for value investors, particularly as American markets look increasingly expensive.
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