Japanese equities “overdue for re-evaluation” as better corporate governance opens growth opportunities

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The tide may be starting to turn for Japanese equity funds, as Japanese companies’ cash-rich balance sheets and improvements in corporate governance reduce scepticism from global investors.

International investors have been net sellers of Japanese equities in recent months, as the global economic outlook and a surge in European coronavirus cases weighed on investors’ appetite for higher risk assets. 

In the week ending 16 October, foreigner investors net sold USD2.81 billion of Japanese stocks, according to data from Japanese exchanges.

“Many investors have shown their indifference to Japan by consistently underweighting the country in their global portfolios, while foreign investors have been net sellers of Japanese equities for nearly five years,” says Makoto Ito, senior portfolio manager of Nomura Japan Small Cap Equity Fund. 

Nomura’s Japan Small Cap Equity Fund was among the highest performing funds of the last month, delivering returns of 10.3 per cent in September.

Ito says that value investor Warren Buffett’s USD6 billion bet on Japan’s equity market, revealed in September, is “evidence” that the country is “overdue for a re-evaluation”.

Buffett has bought up large chunks in Japan’s five largest trading houses – Itochu, Marubeni, Mitsubishi, Mitsui, and Sumitomo. 

Ito explains the opportunity: “Japan remains the world`s third largest national economy, and its companies continue to offer the world a disproportionate share of innovations in areas like robotics, automobiles, fashion, speciality chemicals and advanced electronics.” 

“In a post-pandemic world, the conservative nature of these corporations that have maintained cash-rich and crisis-resilient balance sheets has been regarded as a virtue, just as much as its talents for product innovation and cultural adaptation.”

JPM Japan, Morningstar’s top-performing fund of the last month, delivering returns of 10.7 per cent, noted in a recent commentary that over 50 per cent of Japanese companies have net cash positions that are “significantly higher percentage than companies in Europe and the US”.

Ongoing growth in Japanese equities is likely to be driven by the ongoing corporate governance reforms begun by former Prime Minister Shinzo Abe, which included mandating large companies to hire independent directors, with the aim of improving outcomes for shareholders and attracting more foreign investment.

“In addition to the hiring of external directors and better reporting, companies have become much more shareholder-friendly. We see a strong investment case for Japanese smaller companies that are boosting shareholder returns through corporate restructuring,” says Ito. 

Prime Minister Yoshihide Suga, who succeeded Abe in September, has promised significant fiscal and monetary stimulus, as well as further structural reforms, in order to support Japan’s economy against the ongoing blow from coronavirus. 

“Japan’s new Prime Minister Yoshihide Suga is likely to push for further structural reforms including deregulation, as well as policies to promote digitalisation and boost consolidation among regional banks and SMEs. These are likely to accelerate the pace of innovation and help to raise Japan’s productivity,” says Ito.

In August, Japan’s Ministry of Economy, Trade and Industry produced comprehensive guidelines for corporate restructuring, intended to help companies navigate the crisis by facilitating mergers and acquisitions, including spin-offs.

Ito believes that the reorganisation and consolidation will open up new opportunities in Japan “particularly among small and medium cap stocks”. 

“History proves investors cannot ignore smaller companies,” he adds. Ito points out that returns on the Russell Nomura Japan Small Cap index have been over three times those seen on the TOPIX index over the past 20 years, at 164 per cent and 53 per cent respectively, as of August 2020. 

Junichi Takayama, an investment director at Nikko Asset Management, says that in the past Japanese companies have been slated by foreign investors as being slow to change, because of their strong inclination for “uncertainty avoidance”.

“Such “uncertainty avoidance” can be found everywhere in Japan, with risk-averse bureaucrats and corporate managers sticking to their lowest risk options at the expense of potential gains,” says Takayama. 

“However, given the dramatic changes to their operating environment currently taking place, corporate managers are faced with a situation in which risks from inertia outweigh risks from implementing change. We thus believe companies are in a position to accelerate change in order to best prepare for the new uncertainty. In other words, the very reason Japan was perceived as slow to change is now a factor that is expected to drive change in the new normal.”

Takayama points out that Japanese companies are increasingly choosing to divest legacy business, with divestitures rising 64 per cent year-on-year in the first half of 2020, reaching the highest level in ten years. 

Japan has also seen all-time-highs in mergers and acquisitions for three consecutive years through to 2019, driven by the reforms to corporate governance.

“While making decisions to divest legacy businesses may be difficult under normal circumstances as it would undermine past management decisions, the dramatic change in the operating environment will make it easier to take drastic measures to combat the crisis.”

According to Takayama, the global pandemic will be remembered as “a wake-up call” and a catalyst for change in Japan’s companies. “We believe portfolio transformation will be at the front and centre for corporate managers at Japanese companies, and is due to gain momentum amid the coronavirus outbreak.”