Executive Summary
Enthusiasm for Japanese equities picked up in 2023 as evidenced by the 28% rally in the TOPIX (local) index through November. Supportive headlines regarding shareholder-friendly policymaker initiatives along with earnings upsides from companies propelled stocks higher. Most active managers and investors, however, remain underweight and skeptical of Japanese equities. Perhaps the more pedestrian U.S.-dollar (and euro) returns due to yen depreciation have failed to excite them, but more likely many worry that improved company fundamentals will not persist.
We believe Japan is undergoing durable fundamental improvements and lasting change in attitudes toward shareholders. GMO's 7-Year Asset Class Forecast framework sees Japan small value equities poised to deliver strong absolute returns of 12%, ranking them amongst our highest forecasts. Four “4s” make us particularly excited about small value equities in Japan right now:
- 4% Real Returns due to Fair Valuation: Japan broad equities look about fairly valued and priced to deliver 4% real returns.
- 4 New Initiatives: Four recent policymaker initiatives should provide support for company fundamentals and shareholder returns.
- 4% Alpha from Tilting to Small Value: Active managers who dial into cheap small value stocks stand to capture an additional 4% of returns.
- 4% Tailwind from Cheap Yen: If the yen reverts slowly back to fair value, USD-based investors stand to pick up a 4% tailwind.
This paper details the key observations regarding the opportunity in Japanese equities which we presented at GMO's 2023 Conference in November. 1
4% Real Return Forecast Supported by Improving Fundamental Performance
Two key drivers underpin GMO's forecasts: valuations and fundamental growth. After the recent run in Japanese equities, valuations look fairly valued for the broad universe. The interesting part of the story lies with fundamentals. While many believe recently strong fundamentals are a head fake and will revert to lower levels, evidence suggests otherwise.
Most investors do not realize that Japan has been delivering superior fundamental growth for years. Exhibit 1 charts the returns shareholders earn from distributions and fundamental growth, ignoring the effects of valuation change. The smooth 4.5% annualized return line is consistent with what we expect stocks to earn in our “Low” base-case forecast scenario, and it's roughly what we think equity markets should have delivered over the last 10 years.
Interestingly, it is almost exactly what U.S. companies earned over this period. Japanese companies, however, did much better delivering 6.5% fundamental performance. This might be surprising given the U.S. equity market outperformed the Japanese market when measured in dollars, but that is because valuation changes and currency movements more than offset the fundamental advantage Japan delivered. While investors did better owning U.S. equities over the last decade, underlying corporate performance was actually better in Japan.
Investor skepticism about the durability of Japan's relatively strong fundamental performance makes sense given past experience. As the bars on the right of Exhibit 1 indicate, over the prior 30 years, corporate Japan earned a disappointing 3% real return. Thirty years of fundamental disappointment is a long time to forget.
The key question is what is more relevant going forward – the past 10 years or the 30 years before? Are we going back to the old normal of 3% real fundamental performance, or has Japan changed in an enduring way where we should expect something better? Understanding our estimates of return on capital (ROC) in Japan helps answer these questions. Afterall, it's return on capital that generates the cash flow that can either be distributed to shareholders or reinvested for growth.
Not surprisingly, Japan's disappointing fundamental return in the eighties, nineties, and aughts corresponded to a period where returns on capital were disappointing. During those decades, Japan's ROC, shown in red on the left of Exhibit 2, averaged only about half of what we estimate companies in developed markets should deliver (i.e., the blue line at 4.5%). Indeed, up until about 2018 our base case when forecasting Japanese market returns (the flat green line in the ROC chart) was to assume that ROCs would mean revert around this level of half of normal profitability. But by 2018 we had seen a change in ROC that was hard to ignore – ROCs had, for the first time on our data – exceeded what we assume to be normal. Further, after years of stronger returns on capital, we believed Japan had reached a permanent inflection point.
The chart on the right of Exhibit 2 represents a structural break model which asks how likely is it that ROCs were no longer mean reverting around the flat green line. By 2018, the model had put the odds of a structural break as a near certainty. We therefore changed our forecast model by assuming that profitability in Japan was slowly transitioning toward developed market norms (the stairstep section of the green line on the left.) In our view, Japan's ROC improvement was not a head fake and would continue to converge toward the developed market norm, not fall back toward the old flat line.
Over the last five years since we made the change, ROC has remained high, except during the depths of Covid, and is very close to the developed market norm today. If we roll our structural break model forward, it still sees roughly a 95% chance that ROC is not reverting around that old historical norm. If profitability slowly continues to improve toward global norms, fundamental performance should be better in Japan going forward than it was before Abe's reforms.
What does that mean for our forecasts? Today Japan trades right around what we would consider fair value, so our forecast from valuation change is immaterial. Essentially all the return that we expect comes from fundamentals, which we model to deliver 4.2%. Combining these effects, Japanese equities should deliver 3.9% in real terms (as of 10/31/23). Not particularly exciting, but not bad, either. 2
4 Policy Initiatives Should Support ROC Improvement
The recent rise in ROCs has been propelled by policymaker initiatives and reforms striving to augment Japan's corporate governance. We believe four recent policy initiatives will continue the progress seen to date.
We have written previously about how the aggregate impact of policies implemented following the burst of Japan's bubble in the 1990s intensified with the re-election of Abe in 2012 and changed the Japanese corporate mindset and results for shareholders. 3 In many ways, Japanese policymakers, who have long studied the economic and market systems of the United States and Western Europe, are emulating the shareholder-friendly evolution that occurred in the United States which began in the 1970s and culminated with the “Reaganomics” era of the 1980s. We believe four new and pending initiatives could positively impact Japan's corporate ecosystem and equity markets and may very well accelerate adoption of shareholder-friendly corporate behaviors. They include:
- Kishida's “Asset Management Nation” Initiative
- Labor Market Reforms
- Consolidation & Market for Corporate Control
- TSE's 1x Price to Book Initiative
AN “ASSET MANAGEMENT NATION”
Prime Minister Kishida recently announced the goal to turn Japan into an “asset management nation” to improve capital allocation and capital efficiency. In essence, Japan is embarking upon reforms like those that sparked the shareholder revolution in United States with the passing of ERISA and the introduction of 401(k)s in the 1970s. Japanese leaders' first aim is to unlock the $14 trillion of household financial assets tied up in cash deposits through a revised “NISA” program offering tax benefits and portability similar to the U.S. 401(k) program. The new NISA would make the program permanent and the tax-exempt holding period unlimited while tripling the annual investment limit and raising the tax-exempt limit. Goldman Sachs estimates that the launch of the new NISA program in January 2024 could lead to individual investors buying ¥5–9 trillion in Japanese stocks over five years. 4
Secondly, the government seeks to double down on a tailwind that has been in place for some time – pushing institutional investors to focus more on their fiduciary duties. Just as institutional investor representation of U.S. equity ownership grew from about 10% in the late 1960s to over 50% following the passage of ERISA and 401(k) regulations in the U.S., the ratio of proxy-voting-institutional investor ownership in Japan has increased to a critical threshold. Rather than passively approving management proposals, more investors are voting their proxies as responsible fiduciaries, as this year's high-profile Canon case illustrates. Canon's revered CEO Mr. Mitarai survived a vote to remain on the company's board by a mere 60 bps because Canon's board failed to meet institutional investor proxy voting requirements. The impact of this near miss for such a widely admired and followed leader has been palpable. Every CEO knows about Mr. Mitarai's close call and is saying “if it could happen to Mitarai-san, it could happen to me!”
Like in the U.S. following changes in the 1970s, investors in Japanese equities are becoming more vocal and pushing for stronger corporate governance. Until recently, Japanese company boards were insular and unrepresentative of shareholders, just like those in the U.S. before the advent of ERISA. But similar to the U.S., companies are responding to pressures for investor representation and have increased the number of independent directors on their boards. As the display on the left of Exhibit 3 suggests, a decade ago most companies had no or limited independent directors, but today almost all companies have at least one-third independent directors. Institutional investors moreover have begun to vote down poison pills and support the growing number of initiatives put forth by activists (see center and right charts of Exhibit 3).
Continue reading with charts here.
