Positive investment news continues to come out of Japan, including strong corporate profits, the end of crippling deflation, a rising stock market and a new corporate governance code that is making Japan a more investor-friendly destination for capital.
Yet American investors are still underinvested in Japan despite the fact that stocks there have the best valuations and fastest earnings growth of any developed market in the world. Even many international equity fund managers are still underweight the region. Why have so many U.S. investors discounted or misunderstood this buying opportunity? Examining the historical context and more recent reforms can help explain the skepticism.
The Japanese equity markets have seen tremendous gains over the past several years since Prime Minister Shinzo Abe came to office with a promise of awakening the Japanese economy through growth, reform and his so-called “Three Arrows.” The Three Arrows represented a comprehensive approach to Japan's decades-long stagnation and deflation through more active monetary policy, more robust fiscal policy, and new economic reforms.
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The first two arrows were critical and relatively easy to administer. They largely involved ramping up the Bank of Japan printing presses to create inflation via the Japanese version of quantitative easing. This had been previously attempted but never at such a level of intensity, and it had two primary effects: a quickly advancing stock market and a depreciating currency. This led market pundits to the logical conclusion that Japan's awakening was purely a top-down macro QE phenomenon – end of story.
Investors in the West then seemed to divide into two camps. The majority didn't believe the story had legs beyond QE. They had been burned by faux reforms in the past and so concluded it was not worth participating in. The second camp decided to jump on the asset inflation trade via QE but it was largely a trade – temporal not secular. Neither camp had much conviction in the Japan “story.” As a result, after the first two of the three arrows were in motion, the third arrow of economic reforms sounded a bit too sanguine for many investors' tastes and time frame. But that is exactly where the story gets interesting and why the biggest buying signal is being largely ignored.
MOST IMPORTANT ARROW
Of the three arrows, the third arrow is arguably the most important because it holds the best opportunity for lasting change and growth. However, it lacked the headline-grabbing attention of the first two, and more critically, the third arrow could more aptly be described as a “thousand needles.” That's because true economic reforms do not typically result from one big action, but rather from many discrete actions that when aggregated have a disproportionate impact. In 2012, Mr. Abe began quietly and deliberately laying the groundwork through a series of “carrots and sticks” to encourage companies to embrace a wide range of reforms that would truly awaken Japan economically, and have the added benefit of giving Western investors' confidence to buy Japanese stocks after a long hiatus.
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At first, the economic reforms didn't seem significant, and in some cases more like token changes. Hours of operation for restaurants and bars were relaxed in preparation for the 2020 Summer Olympics, some visa rules were relaxed for a small number of foreign workers, and there was talk about attracting more women into the workforce. But then came the introduction of a new stock market index, the Nikkei-400, which would include only companies that demonstrated good corporate governance, productive use of cash and improving returns on equity. In a homogenous and respect-oriented society, Mr. Abe provided a reward for those that met the criteria while effectively disgracing those that did not.
Then there was news that the BoJ and the sizable Government Pension Investment Fund would only invest in domestic equities that were part of the Nikkei-400. Next, the rationalization of antiquated industry regulations began. Mr. Abe stood firm on getting the nuclear reactors restarted and then allowed previously protected sectors like insurance and telecommunications to reprice and bundle services.
What started small began to grow. This led companies and investors into the conversation about why Japanese corporate balance sheets held so much cash and what to do with it. Set against this backdrop, the debate on corporate governance began. Institutional Shareholder Service (which votes proxies) announced it would begin voting against sitting directors in good standing who were part of companies that did not meet minimum return-on-equity targets. Ten years ago, this would have been unheard of in a polite Japanese culture where the efficiency of saving face was valued more than the effectiveness of results. And recently, a countrywide corporate governance code was issued, setting a minimum of two outside directors for each corporation, among other measures.
EFFECTS ASTONISHING
The practical effects of the third arrow are astonishing: The consequences from uniformity of negative actions are being replaced with positive results from uniformity of positive actions. Now companies are selling unproductive assets, reducing capital if underearning the cost of capital, laying off workers in unprofitable units and reallocating the savings into more profitable initiatives. Cash is being released from balance sheets via stock repurchases and dividend increases, demand for outside directors is rising, women are joining corporate boards and companies are setting new targets for return on invested capital. In a now well-known case, FANUC, a historically very private company without an investor relations department and no opportunity for communication with management, now offers both and gives factory tours. NTT is buying back shares and NIDEC is increasing margins. Even lumbering Hitachi has embraced the new religion of returns and accountability.
And so it goes, what were culturally embedded obstacles to change are now becoming culturally acceptable behaviors. As for the companies not embracing change? The results speak for themselves. Just compare the performance of Panasonic and Sony – which are reform minded – to Sharp and Toshiba – which are not. The differences are stark.
These reforms have shifted the Japanese market environment from a top-down macro story to a bottom-up fundamental company-by-company story. If U.S. investors are still looking East purely from the lens of central bank activity and yen depreciation, they are missing the bigger narrative unfolding. At this point, the story is much deeper and stronger, and Japan should no longer be viewed as a trade but as fertile ground for buying the stocks of great companies for years to come.
John L. Creswell is senior managing director at Euclid Advisors.
