The Japanese stock market is booming in 2023, up 21% for the year to date, outperforming all other major developed market indices. Global investors have net-bought ¥7.2 trillion (US$50 billion) this year in a major reversal of recent trends. So, what has changed, and more importantly for investors, is this rally sustainable?
Global investors avoided Japan for the best part of a decade, with cumulative net selling of Japanese equities by foreigners to the tune of ¥29 trillion (US$200 billion) over the period 2015-2022. This was likely a factor in the underperformance of Japanese stocks relative to major markets such as the US over the period.
The last time foreign investors were this enamoured with Japan was coincident with the appointment of the reformist Shinzo Abe as Prime Minister in late 2012. His plans to restructure the Japanese economy and end deflation via massive monetary stimulus caused investors great excitement and led to the stock market doubling over a two-year period (see Fig. 1). This was helped along by a dramatically weaker yen, which generally implies higher aggregate profits for Japan’s export-oriented corporations.
This excitement turned to boredom and ultimately disillusionment as structural reforms were more gradual and took longer to deliver results than initially hoped. However, what global investors were missing was the real fundamental change taking place under the surface of the stock market headline: A reform snowball that slowly gathered size and speed until it built the momentum to achieve breakout velocity on the back of two key incremental occurrences:
- First, the call by the Tokyo Stock Exchange (TSE) for companies to publish plans to improve corporate value so as to trade above a price-to-book valuation of 1.0x.
- Second, the storm of press coverage around Warren Buffett’s visit to Japan and his holdings in the four major Japanese trading companies.
Reforms provide foreign shareholders with more power
Investor complaints about Japanese business practices have been consistent for the last few decades. Decisions are not made with shareholders in mind; rather, companies pursue growth, even where it is unprofitable to do so, and hoard capital as it is viewed as costless. Entrenched management teams adopt whatever strategy they wish, with flowery language and little regard for shareholder wishes or basic economic realities.
This situation arose from the model adopted for post-war reconstruction and development, which involved an alliance between government and corporate management against the power of labour. Companies were financed by state-directed lending rather than equity markets, with a focus on the growth of the enterprise and Japan as a whole rather than returns on shareholder equity. This was supported by significant cross-shareholdings between members of “Keiretsu” groups, which curtailed the influence of outside shareholders, as management could always count on a high level of voting support from these friendly parties. This model worked well for Japan until the end of the 1980s boom, but by the 2000s, key parts of the government realised it had outlived its usefulness and sought reform. We can observe a significant decrease in the levels of cross-shareholdings since this time.
In recent years, the focus of reform has been to give power to foreign shareholders to push for improvement via twin Governance and Stewardship codes. Compliance with these codes is voluntary, but a significant nudge element is involved, which is quite effective in the Japanese context where peer pressure can be especially motivating. The Governance Code outlines best practice that companies should move toward and provides reference ammunition for dissatisfied shareholders in conversations with management teams. Asset managers who sign the Stewardship Code (includes all the Japanese majors) must disclose their voting records, and as a result, are gradually moving to voting behaviour that benefits their unitholders, rather than the relationship the asset manager’s parent bank may have with the investee company. Daiwa Financial Services, for example, recently announced it voted in favour of 49% of the shareholder proposals filed at its portfolio companies’ AGMs in 2023 after having voted against all such proposals in 2022.
Shareholders are being heard
Putting this together, management teams now feel significantly greater pressure to listen to shareholders’ views and respond to requests for improvement. Recent, very public examples have outlined the potential consequences when managers behave badly or are not acting effectively. In the case of elevator manufacturer Fujitec, the founding family lost control of the company after an activist investor succeeded in replacing the majority of the company’s independent directors. In the case of Seven & I Holdings, the parent company of the 7-Eleven convenience store chain franchise, management had to defend a public campaign where, even though the activist’s extraordinary general meeting (EGM) proposals were voted down, the company’s management team suffered the embarrassment of a significant portion of shareholders expressing their displeasure with the company’s strategy via their votes.
Increasingly, companies are trying to get ahead of this dynamic, announcing plans to rationalise business portfolios, increase balance sheet efficiency, and return cash to shareholders before a public campaign is launched or even in the absence of activist involvement. We are seeing a record level of cash returned to investors via dividends and share buybacks in 2023 (see Fig. 3), and it appears likely that this trend will continue, spurred by growing shareholder activism (see Fig. 4) and the ongoing push by the Tokyo Stock Exchange.
Dai Nippon Printing and Citizen Watch are clear examples of where commitments to major capital returns drove a levitation of their respective share prices. Other more moderate changes elsewhere have seen more muted but still positive responses. These initial steps are very encouraging, but there is a lot more that can be done, and this seems likely to play out over a multiple-year timeframe with the potential to continue to support stock market performance.
Ironically, the biggest winners from recent foreign buying of the market have not been the stocks most exposed to this theme of improving governance. The “Buffett effect” has seen the large trading companies outperform even as commodity prices have declined, which implies a reduction in future profitability for those companies. Larger, more liquid stocks present in the major indices have been the natural first destination for foreign capital seeking greater Japan exposure, despite generally already having much better governance and profitability than the market average and thus less scope for potential improvement. It may take some time for mainstream global investors and, indeed, local investors to become more adventurous in their pursuit of the major beneficiaries of the governance reform story.
Potential for more M&A
The final shoe to drop may be the opening up of the market for corporate control. Japanese businesses have largely failed to consolidate, and the lack of takeover risk allows weak businesses and lazy balance sheets to persist. There are initial signs that the level of M&A activity may step up, but as yet we have not observed a wholly unsolicited takeover bid by a strategic acquiror where a target was not already “in play” (the typical case would be where a company has agreed to a merger with another, then a third party comes in with a higher, unsolicited offer). While this is somewhat disappointing, even five years ago, an unsolicited bid occurring at all, even in relation to a target already “in play”, would have been almost unthinkable. Should unsolicited bids become more common, we would expect to see Japanese equities re-rate to higher levels as the prospect of realising latent value becomes more tangible to investors.
A recent event perhaps represents a breach in the anti-takeover dyke. Half of Japanese stocks trade below book value due to lazy balance sheets and lacklustre profitability, so there are potentially huge implications if takeovers of these companies become a possibility. The family office of Nintendo's founding family (Yamauchi-No. 10 Family Office) succeeded in gaining a majority of the Board of Directors of Toyo Construction after putting forward an alternative slate at Toyo's AGM. Toyo's Board had previously agreed to a friendly deal with minority shareholder Infroneer at ¥770 per share. Yamauchi FO then made an indicative proposal at ¥1,000, which the Board refused to consider. The Infroneer tender was rejected by shareholders due to the higher offer, but the Board continued to refuse to engage with Yamauchi. So, not to be beaten, Yamauchi nominated a slate of directors and won a majority, partly due to their large voting power (they had bought 27% of Toyo) and also shareholder dissatisfaction.
Winning control of a company via hostile action at an AGM in Japan was unheard of until recently, but the implications in this particular case are even more wide-reaching. Management teams now have to worry that if they fail to properly consider a bid, they may be replaced. If they fail to agree to a value-creating bid, even if unsolicited, they may be replaced. So, there is an incentive to agree to avoid a public admonishment from shareholders. Now the really interesting thing is that banks in Japan are unwilling to finance hostile deals, which has historically prevented any leveraged buyouts (LBOs) taking place. However, they are willing to finance deals agreed to by a company's Board.
The Toyo Construction precedent shows that a potential buyer may get two bites at the cherry. Either the Board negotiates a deal or it fights. If management loses a shareholder vote and is replaced, presumably the new Board will be more shareholder-friendly and agree to any deal that delivers value to shareholders. So, there are now two roads to an agreed, bank-financed LBO. At what levels will Japanese stocks trade once investors wake up to the reality that LBOs of these cheap-as-chips companies are a real possibility? Our guess would be a lot higher than the market’s current pricing.
Reasons for optimism
When we consider the picture holistically, we see many reasons to support the view that the current Japanese stock market boom has a solid fundamental basis and can persist for some time. The extent and persistence of current strength will ultimately be determined by myriad factors, but ongoing management attention to profitability and cash returns to shareholders will likely prove supportive, and should the market for corporate control truly open, the results could be exceptional. There are reasons for cautious optimism here, with initial signs that the government is nudging things in this direction.
 TOPIX, local currency terms. Source: FactSet Research Systems, calendar year to date, as at 30 June 2023.
 Source: Osaka Stock Exchange, Tokyo Stock Exchange, Nomura. Two cash markets plus futures, in net terms this year from 1 January to 16 June 2023.
 Source: https://www.jpx.co.jp/english/news/1020/dreu250000004n19-att/dreu250000004n8s.pdf
 https://asia.nikkei.com/Business/Markets/Shareholders-to-demand-more-from-Japan-companies-at-annual-meetings. Shareholder proposals are a key mechanism via which (activist) shareholders can push for changes at companies via binding resolutions of shareholders, or, in the event the proposal fails, which is the outcome in the vast majority of cases, at least showcase the extent to which a portion of shareholders are unhappy with the status quo.
 Source: https://www.cnbc.com/2023/06/13/investing-is-japan-inc-finally-serious-about-corporate-governance-.html
 Source: Company filings, Platinum analysis.
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