September 2021 | B2B | Diego Föllmi

Japan may seem an unusual country in which to target investment returns. However, we would like to challenge this view. The facts we have discovered all point in the same direction – the Japanese corporate world is undergoing a transformation, which in turn is boosting the stock market.

USD 6.7 billion, or more than three times Netflix’s annual net profit, was invested by Warren Buffet through the acquisition of shares in large and listed Japanese trading companies. The news, released in August 2020, was very surprising to many, as Japan has long been shunned by investors. In fact, Japanese stocks have still not recovered from their highs reached in the late 1980s. The value of the Topix index is still 34% lower than in the early 1990s, when the stock market had a P/E ratio of more than 70 and was unsustainably overvalued.

The era of the “lost decades” finally seems to be coming to an end. The average growth of the Japanese economy has improved in recent years and is now close to the average growth rates in Europe. Over the last ten years, the Topix has returned 124% (in JPY), outperforming European equities (in EUR), but without matching the performance of US equities (in USD).

What’s behind the market turnaround?

One of the reasons for the market turnaround is the monetary stimulus provided by the Bank of Japan (BOJ), which is supporting the equity markets. However, we believe that there is also a tandem of other factors that have facilitated the regaining of confidence in the Japanese equity market: a) an ultimate improvement in corporate fundamentals and b) a general improvement in corporate governance, which was considered to be very traditional, not very transparent, inflexible and outdated (1).

Support from the BOJ

In 2010(2), the Bank of Japan initiated comprehensive monetary easing measures as part of a stimulus package to revive the economy. A securities purchase program was an integral part of this policy. In addition to government bonds, covered corporate bonds, real estate investment trusts, ETFs and money market securities were purchased with the aim of stabilizing the stock market, lowering risk premiums and boosting investment.

Declining debt levels

Since the peak of debt in 2009, Japanese corporate debt to GDP has fallen by 7%, while it has risen by 1.5% in the US and 5% in Europe. The successful deleveraging of Japanese companies after the financial crisis was one of the reasons why more Japanese companies are now found in the top 100 worldwide.

Growing profitability and returns

Improving balance sheet quality is not the only positive development in the Japanese corporate world, as companies are also becoming more efficient in managing their capital to achieve higher returns. In this regard, there seems to have been a true revolution in financial management. For example, the higher return on equity of Japanese companies was mainly due to higher margins.

Shift in focus in corporate management

In addition to better-looking fundamentals, it is also worth mentioning the improvement of the corporate governance system, which has always been very traditional in Japan and has tended to have a negative impact on corporate development. When Shinzo Abe took office, he focused not only on fiscal and monetary policy, but also on structural reforms to improve the competitiveness of Japanese companies and attract foreign investment.

A market full of opportunities

While the Japanese economy tends toward mature sectors like manufacturing, the stock market has a fair share of innovative, fast-growing companies that represent an enticing investment opportunity. This is supported by the fact that Japan’s R&D spending as a percentage of GDP is among the highest in the world: The ratio was 3.24% in 2019, which is even higher than the U.S. figure(3) of 3.07%. The Japanese stock market offers another advantage – valuation. Based on key metrics, it is still at a relatively low level compared to the US or Europe. Careful stock selection focusing on appropriate companies is at the core of our approach.

Investing in hidden Japanese jewels

The performance of a Japanese quality portfolio (for example, the Aramus Japan fund) illustrates the attractiveness of the Japanese equity market. By focusing on corporate excellence – identified through disciplined bottom-up analysis – significant outperformance was achieved even during the pandemic-related sell-off. This was achieved via proven and diligent research focused on identifying companies that have a clear competitive advantage, are led by competent management and have strong financial metrics.

We believe that the fundamental developments in the Japanese corporate sector – keyword: fundamental strengthening and improvement of corporate governance practices – will lead to sustainable success and that selected Japanese equities offer an attractive portfolio addition for investors, especially against the background that the overall market has not yet been able to convince this year.