Japanese equities have once again captured investors’ attention after finally surpassing the highs of the bubble era. Naturally, the primary question for new investors now is whether they’ve missed the boat or not. From our perspective, the journey is just beginning.

On 4 March 2024, Japan's Nikkei 225 Index closed above 40,000, marking another milestone after the previous month's climb to levels not witnessed in 30 years. The TOPIX Index, a market-cap weighted index, has not quite surpassed the bubble era highs, however it stands tantalizingly close.

In truth, drawing parallels between these two periods thirty years apart lacks merit as they share few fundamental similarities. In the 1990s, the market was built on very little earnings support as well as unsustainable valuations, buoyed by a real estate bubble. In contrast, today’s market rests on a robust foundation of strong earnings and undervalued assets.

Is the Japanese market rally sustainable?

As with any stock market rally, there have been several drivers. The nation is transitioning toward an inflationary economy following decades of deflation, and ongoing corporate governance reforms are reshaping the business landscape, the combination of which has caught the attention of global investors and resulted in increased demand for Japanese equities.

The first of those drivers, the transition out of a deflationary environment, has been a long time coming. After decades of trying, it appears the Bank of Japan (BOJ) is finally set to begin its journey to policy normalisation. This may come with short-term headwinds for the Japanese market, as investors digest the new normal, and it is possible it leads to a stronger yen, putting pressure on segments of the market including Japan’s blue-chip exporters. However, in the long term, the positive impact that will come from a normal inflationary environment cannot be emphasised enough. It is highly likely to drive long-term changes in consumer behaviour and create a virtuous cycle between wages and prices, all of which are positive for the economy and stock market in the long run.

The second key driver, corporate reform, has also been a long time coming. Efforts to improve corporate governance in Japan started just over 10 years ago when the late Shinzo Abe took office in 2012. The past decade has been about setting the landscape for the improvements we are seeing today. The combined effect of the Stewardship Code and the Corporate Governance Code has resulted in a more financially motivated shareholder base. The friendly cross-shareholders, who often protected failing management teams, have made way for a more engaged shareholder.

The forthcoming decade will pivot on leveraging this new landscape to effect change. The Tokyo Stock Exchange (TSE) entered the fray last year, emerging as a potent agent for change. Their message is unequivocal: Japanese companies boast operational excellence but must refine their capital structures. Returns on invested capital often rival the best in class, however the crux lies in how management teams deploy these returns. Historically, they have accrued, dampening returns on equity, and yielding subdued valuations.

The TSE's request for companies to implement management plans addressing stock valuations and capital structures is the most significant development in the Japanese equity market in many years. As of now, many companies are formulating plans, and the vast majority will be disclosing them alongside full-year earnings results in the May reporting season. There will be companies that embrace the changes wholeheartedly and there will be those that don’t, however the risk for the latter is that the past 10 years have created a more engaged and aggressive shareholder. This new shareholder may well look to respond.

Japanese large caps have been popular so far, small caps could be next

It is no surprise the Japanese market has attracted attention given these two long-term drivers. It has resulted in international investors quickly increasing exposure and, naturally, they have used the more liquid large caps to do so. Since the start of 2023, Japanese small caps have returned 34.3% compared to 49.7% for the TOPIX 100 Index.

Ironically, the most significant opportunity for reform-driven benefits lies within the small-cap arena, which has underperformed. In our view, this area of the market teems with corporations boasting operational excellence but suffering from financial mismanagement. Unlike some of their debt-laden large-cap counterparts, they often harbour substantial cash reserves awaiting deployment.

As such, while we believe the long-term outlook for Japanese equities is extremely strong, in our view the case for focussing on small-cap, cash-rich companies is even stronger.

With c80% of the portfolio currently exposed to small and mid-cap names, a make-up we find sets us apart meaningfully from peers, in our view we are particularly well positioned to take part in any subsequent rerating further down the cap scale.

As such, we have readied the Fund to target the following thematic opportunities, already bearing fruit in some cases, which we believe have the potential to provide an outsized tailwind to smaller companies not yet explored by investors focusing on larger stocks:

• TSE capital allocation: As mentioned, our primary focus is on identifying companies with substantial capital reserves and high-quality operations. We anticipate current external pressures will force these companies to optimise their capital management strategies. This shift towards efficient capital allocation is expected to result in increased shareholder returns and bolstered investment in growth opportunities.
• Listed subsidiaries: Ongoing corporate governance reforms have introduced challenges in maintaining listed subsidiary relationships. We believe this structure may not be sustainable in the future. As a result, listed subsidiaries, including smaller firms, may need to be either fully acquired or spun off to adapt to the evolving regulatory landscape.
• Activist engagement: The Japanese market has witnessed a notable rise in activist investors. The reduction of cross-shareholdings and increased engagement from institutional investors have left management more susceptible to activist pressures. Our portfolio includes investments in several companies where activist investors are engaging with management to unlock untapped potential.