Are Japanese equities a good investment?

We have witnessed the largest buyback programmes ever during a quarter – around $50bn (£39.5bn) – and dividends reaching record highs, while the structural dynamics of corporate governance reform remain intact, with year-to-date buyback announcements up by 23 per cent and dividend increases by 29 per cent. 

A few months ago, the Bank of Japan announced a significant change in monetary policy – it put an end to negative interest rates and yield curve control.

We have reached base camp and the easier money has been made in large caps. Now the real opportunity beckons.

The BOJ is likely to incrementally tighten policy, possibly again next month. The driving force behind this change is the emergence of nominal wage growth and a normalised inflation level.

Companies, the Tokyo Stock Exchange and Prime Minister Fumio Kishida are all keen to raise productivity. The labour market is extremely tight, and we expect to see further increases in real wage growth. 

The deglobalisation of the global economy bodes well for Japan.

During the 1990s, capital expenditure was curbed and debt deflation has given way to mild inflation, but there is a sea change taking place that should not be underestimated.

A virtuous cycle for domestic capex seems likely as companies strive to raise productivity. Domestic capital expenditure has been flat for most of the past 30 years, with the focus during globalisation being on overseas capex. However, this is changing as the tectonic plates shift.

According to the Tankan survey, large companies plan to increase capital expenditure by more than 4 per cent in 2024.

From Toyota to Denso, Shin-Etsu to Komatsu, there are significant domestic capex plans.

Japan's demographics are poor, with labour in short supply and the threat from China ever-present. All of a sudden Japan is relevant. During our recent trips to southern Japan, we witnessed the profound changes brought about by the rollout of TSMC semiconductor plants.

Chipmakers globally need Japan, especially Taiwan. This is good news for the semiconductor, construction and machinery sectors. 

Small caps playing catch up

Earlier in the year the Tokyo Stock Exchange asked companies trading below book value to explain their cost of capital workings and return on invested capital.

Up until the end of April 2024, 57 per cent of prime companies have responded to the TSE requests while 31 per cent have not disclosed and 11 per cent are “studying”.

The standard market, which provides a platform for mid-caps, is a different story, and 72 per cent has no disclosure. 

We still find that many of the companies we follow underestimate the cost of capital, and their large cash holdings inflate the cost dramatically.

We have a large exposure to mid and small caps in the Zennor funds. Small caps have been lagging for six years. There are some explanations for this.

Big value stocks have responded more significantly to the TSE demands with some enormous share buybacks announced during the earnings season from the likes of Toyota, MS&AD and Eneos. 

The "learning" process still has a long way to go with smaller companies, but therein lies an opportunity.

Small-cap stocks have a forward price-earnings ratio of 12x and a price-to-book ratio of 1.1x, while the core 30 have a forward P/E ratio of 17.3x and a price-to-book ratio of 1.8x.

Taking into account the balance sheets, it seems to us that large caps trade at twice the multiple or more, which suggests a big gap has emerged. 

With the Nikkei record, investors may think they have missed the opportunity, but the reality is that we are still at an early stage of management teams finally becoming aware of the cost of capital. We have not even begun to reduce what are clearly excess balance sheets.

We anticipate a surge of mergers and acquisitions (both divesting and investing) as well as outsourcing of non-core activities as firms realise how costly those operations and assets are in terms of capital.

Firms must both decrease total assets and be more selective in how they are used. The result will be a significant increase in return on invested capital along with valuations. 

Other catalysts could be the weakness of the yen versus forecasts, further corporate governance news and a recovering Chinese economy combined with strength in the US economy.

There is a strong correlation between small caps and US interest rates, which if they begin to fall from mid-year could act as a tailwind for the sector.

So too will the corporate governance story as it trickles down the market-cap scale.

We have reached base camp and the easier money has been made in large caps. Now the real opportunity beckons for investors who can find those small and mid-sized companies, which can carry on the climb. 

James Salter is chief investment officer at Zennor