Will Improved Corporate Governance Unlock Opportunities in Japan?

Introduction

Japanese equities have long been out of favor with investors due to a prolonged deflationary environment and sluggish economic growth over the past decade. Concerns over weak corporate governance and a lack of shareholder value creation have given investors little reason to focus on this region. However, given critical policy changes and following our series of trips to Japan, we believe the tide is about to turn. During our latest trip, we witnessed concrete signs of a shift toward a more pro-shareholder mindset both from the Japanese government and corporate management teams. We believe this shift could be an essential catalyst to propel Japan into a new era of economic growth.

In this article, we dive into why the latest corporate governance reforms have roused the world’s third-largest stock market from decades of economic lethargy and how they have rekindled our enthusiasm for Japanese equities.

Better Corporate Governance Can Be the Key to Unlocking Earnings Potential

For decades, Japan’s issues with corporate governance, capital management and sustainability have cast a shadow over the country’s business landscape, and investors often overlooked, or even avoided, its stock market because of a failure to prioritize shareholder interests. Japanese companies would favor market-share gains at the expense of financial performance, for instance, or hoard unnecessarily high cash levels rather than deploy capital productively or give it back to shareholders. Accordingly, nearly half of TOPIX-listed Japanese stocks are currently trading below their book value, indicating clear underpricing by investors.

Japan’s Improved Governance Has Led to Improved Corporate Performance

Source: Tokyo Stock Exchange, Bloomberg, Japan Financial Services Agency

While there has long been talk of reform to revive the Japanese economy and markets, we believe the current desire for change is gaining more momentum than ever before among both policymakers and corporations. The Japanese Financial Services Agency (FSA) and Tokyo Stock Exchange (TSE) have each enacted significant changes to reinforce the role of sound corporate governance and capital efficiency in efforts to improve shareholder value.

For example, this year, the Tokyo Stock Exchange asked all listed companies to put policies in place to bolster profitability, long-term returns and valuations — and if companies fail to meet the TSE’s updated standards by 2026, they could risk delisting.

We believe these changes will likely serve as a crucial impetus for Japanese companies to adopt a more shareholder-friendly mindset, which can help more of them unlock greater shareholder value. As depicted above, the corporate governance changes already executed have helped many Japanese firms achieve enhanced profit margins and return on equity compared to a decade ago.

Given the number of Japanese stocks currently trading below book value, we believe the Japanese market offers extensive room for stock price appreciation and ample opportunity for managers to uncover companies unloved by the market but with high potential for a remarkable turnaround. We have already seen some of this play out in our current portfolio of companies — and most strikingly in Hitachi.

Case Study – Hitachi: Sharper Focus on Governance Changed Its Business for the Better

During the global financial crisis, Hitachi was on the brink of bankruptcy, and it subsequently underwent a massive overhaul to transform its business. The company employed strategic divestments from underperforming businesses, implemented cost-cutting measures, and expended concerted efforts to fortify profitability in its core business areas. Hitachi also embraced a more diverse board structure that included foreign board members and women – uncommon in Japan.

While early gains were slow to materialize, Hitachi has steadily gathered momentum in recent years, delivering higher profitability and generating strong cash flows and returns on capital. These improvements in financial performance and valuation multiple expansion have translated into outstanding share-price appreciation since 2016.

The Dual Impact of a Weak Currency and Low Valuations

Global inflation concerns have prompted the U.S. Federal Reserve and other central bankers worldwide to curb price pressures by aggressively raising interest rates. On the other hand, Japan has also had inflationary problems recently, although not as pronounced as in other economies. For decades, Tokyo grappled with deflation and lethargic economic growth. Given this backdrop, Japan’s recent modest inflation levels have not sparked immediate worry, allowing the country to maintain low-interest rates relative to other economies. Due to this disparity in monetary policy between the U.S. and Japan, the yen significantly depreciated against the dollar in 2022, rendering the currency significantly undervalued, in our opinion.

One silver lining to a weakened yen is that it may prompt more foreign investment into Japanese equities, which have low valuations compared to other global stock markets. As seen in the chart below, the one-year forward price-to-earnings ratio of the TOPIX Index has been trailing the S&P 500 Index by a wide margin, especially coming out of the pandemic over the last three years. Given the combined effect of a weakened yen and discounted Japanese stock prices, we believe the current environment offers a compelling entry point for investors seeking upside return potential.

Japanese Stocks Are Relatively Undervalued

Source: Bloomberg

Breaking through the Value Trap

We’ve long believed many Japanese companies possess strong overall “investment DNA” — attributes underpinning earnings durability, such as high and sustainable market share, identifiable competitive advantages, strong balance sheets, good management teams, and exposure to growing end markets. Unfortunately, many Japanese corporate leaders have historically lacked the incentive to strengthen corporate governance and prioritize shareholder value creation, and that has left equity prices in a rut over the past decade.

Looking ahead, we anticipate improved managerial alignment with shareholders to translate into corporate equity performance more consistent with the return expectations of other high-caliber multinational companies in developed markets. We believe the likelihood is higher than ever that Japanese equities will finally break free from a slow-growth era. The significant ongoing governance reforms should help bolster the pace of change and momentum needed for Japanese firms to eventually reach their fullest earnings potential, creating enormous opportunities for Japan’s equities.