WHY THE TIME HAS COME TO BUY INTO JAPAN
In June, Nikkei Inc held a session on investing in Japanese equities called: "Unlocking the Potential of Japanese Equities; Capturing the value of the Nikkei 225".
The session's centre piece was "Japan in the Reiwa Era – New Opportunities for International Investors", a keynote speech by Paul Sheard, Senior Fellow of the Mossavar-Rahmani Centre for Business and Government, Harvard Kennedy School.
A lively panel discussion involving some of the leading economic and market commentators on Japan then followed, with participants concluding that now is the time to invest in Japanese equities.
For the best part of three decades, investors have tended to overlook Japan's equities market as the multiple and well-trodden stories around deflation, population decline and arcane corporate governance pushed them elsewhere.
But in the last few years, a quiet and multi-faceted revolution has taken place in the world's third-largest economy that has ended the country's long-running deflation, boosted economic growth and raised productivity.
At the same time, the return on equity, a key measure of how effectively companies employ shareholder funds, has doubled since 2012 to about 10 per cent. That has helped narrow the gap that long existed compared with other global markets and made Japan's listed companies internationally competitive.
All of which begs a question that is becoming difficult to ignore: is this a new dawn for Japan?
The Nikkei has gained nearly 50 per cent in dollar terms in the five years to May vs just 5 per cent in Europe
It is said that at least two events have helped thrust Japan into the spotlight, including the new “Reiwa” era under Emperor Naruhito that began in May this year and Tokyo’s role as host city of next summer’s Olympic Games.
But Yoichi Shinohara, president of Nikkei America, notes the development in recent years of internationally listed exchange-traded funds (ETFs) linked to Japan's Nikkei 225 Index, the country's price-weighted index of blue-chip companies. "It's helping to unlock the potential of Japanese securities in the midst of an exciting time," he says.
Richard Co, executive director of equity products at CME Group, says that Nikkei futures, which are traded both in dollars and yen as well as in Japan, Singapore and the US, have grown tenfold in the past 20 years. "It's an understated success story," he says. "There has been a very steady growth, and it's a phenomenon that has been largely overlooked by the public."
According to John Vail, Nikko Asset Management's chief global strategist, the Nikkei has gained nearly 50 per cent in dollar terms in the five years to May compared with just 5 per cent in the case of Europe. He adds, “This should push global equity allocators to have much more confidence in investing there.”
Behind the transformation is structural reform. When Prime Minister Shinzo Abe took office in 2012, he spurred growth by introducing a three-pronged economic policy based on monetary easing, fiscal stimulus and structural reforms – in particular, corporate governance.
In 2014, the Financial Services Agency, the government's financial watchdog, introduced a new corporate stewardship code to combat the widely held view that institutional investors were too aligned with company management. Then, two years ago, a second wave of corporate reforms helped increase transparency and keep tabs on corporate practice.
The combined result has boosted corporate profit margins and raised capital expenditure of listed companies as they invest to become more productive. It has also underpinned a drastic change in the relationship between Japan's listed companies and their shareholders, argues Paul Sheard of the Mossavar-Rahmani Centre for Business and Government at the Harvard Kennedy School. "People think that corporate governance in Japan is still virtually non-existent; it's not true," he says.
One clear change, he says, is the dismantling of the complex web of cross shareholdings that used to characterise Japan's listed companies – and which created a nucleus of friendly shareholders who were keen to maintain the status quo. In 1990, for example, the country's city and regional banks owned about 16 per cent of listed stocks compared with just 3.1 per cent today. For their part, non-financial corporations owned about 30 per cent of the country's listed stocks – a figure that has fallen to 22 per cent. Meanwhile foreign investors have lifted their ownership share from less than 5 to 29 per cent.
"The whole equation of balance of power in the capital markets is shifting," says Sheard. "It's a slow-moving process but there has been a dramatic change over the past 15 to 20 years."
Jesper Koll, senior advisor at WisdomTree Investments Inc, says that further evidence of Japanese companies' changing relationship with investors came in the most recent earnings season when more than 60 activist investors tabled propositions at company shareholder meetings. "Value is being unlocked," he says.
There has even been headway in sweeping away so-called poison pills, which are defensive tactics used by companies to ward off hostile takeover attempts: as many as 75 Japanese companies have actively withdrawn their poison pills recently – a sign of greater transparency and openness.
For all the progress, however, foreign institutional investors continue to be as underweight on Japanese equities as they were prior to all the reforms. Sheard of Harvard's Kennedy School suggests that this may stem from several widely held views about the country's economy that have been either exaggerated or misunderstood.
For example, while it is true that Japan has the oldest population of any country, it is less known that the number of foreign workers entering the labour market has been growing at about 15 per cent a year in recent years. Moreover, the five fastest-growing sources of foreign labour – Vietnam, Indonesia, Nepal, South Korea and the Philippines – have a combined population of 537m. "Japan has the ability to bring more and more people into Japan," says Sheard. "There has been a huge transformation in the way the country has adopted immigration."
People think that corporate governance in Japan is still virtually non-existent – it's not true
A second misconception, he argues, surrounds the country's debt, which tends to focus on government debt while ignoring the fact that the nation as a whole, including the private sector and households, runs a current-account surplus of approximately 3.5 per cent of gross domestic product (GDP). "Japan does not have a debt problem," Sheard insists. "It is accumulating net financial claims on the rest of the world and Japan is saving for its future by doing that."
Meanwhile, quantitative easing in Japan, which has consisted of the Bank of Japan retiring government debt securities and refinancing them as central bank reserves, has acted like a debt refinancing operation of the consolidated government, thus easing fiscal pressure.
Challenges remain. Vail argues that while Japanese companies' have been ramping up their practice of share buybacks, which help shareholders because they help boost earnings per share, they have not been so bold on increasing dividends - a fact that has kept many domestic retail investors away from Japanese stocks.
"Dividends have to grow faster to make them irresistible to the country's older population," he says.
Koll of WisdomTree agrees. "Why should global capital commit to Japan when Japan's largest sector of savings, the household sector, is not investing?" he asks. He says that one reason they do not invest more is that the cost of entry remains extremely high – with the average, all-in cost of retail investment products at about 430 basis points last year. "To develop a truly mass market, you have to put pressure on the Japanese asset management industry to provide more competitive instruments and more transparency."
Yet even here, there are signs of changing attitudes, particularly among the new middle class in Japan. Many observe that younger generations are opening up to investment and the concept of investment is becoming more mainstream.
There is no doubt that more has to be done to encourage investors – both domestic and foreign – to participate more in the Nikkei 225. But as the reforms – both economic and corporate – stemming from Abenomics start to take hold, there is increasing confidence that Japan's long slumber may finally be over. As Sheard of Harvard's Kennedy School puts it, "Japan is a value stock".