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Japan is a slowly aging economy stuck in low rates of inflation and comparatively low GDP growth rates. There is even a term called “Japanification” referring to how other developed economies are gradually facing similar demographic and economic quagmire that Japan finds itself in. But despite such development, does it really mean that Japan will have a few people left in 200 years and there is no point at even looking at Japanese equity market, including ETFs focusing on Japan, such as iShares MSCI Japan ETF (NYSEARCA:EWJ) or WisdomTree Japan Hedged Equity ETF (NYSEARCA:DXJ)? In this article I will try to present counterarguments to the prevailing view and hopefully convince readers to take a closer look at Japanese stocks that can offer strong returns in the future.
Is the Demographic Problem That Bad for the Corporate Sector?
While Japan’s working age population has been on a gradual decline, this does not necessarily translate into corporate weakness. After peaking in 1997 at 86.8 million, the working age population in Japan declined to 74.2 million in 2021. However, Japan’s corporate profit surprisingly showed an upward trend for the past 40 years.
While there are many factors behind the increasing profits, among most notable are a likely expansion in foreign markets, growth in labor productivity and strengthening corporate governance that put profits in focus.
While down the road in 40-50-100 years Japan may indeed have fewer than 100 million people, what matters to me as an investor is what happens within the next 5-10 years. For instance, if you look at demographic projections for China, its working age population is projected to decrease by a double-digit percentage by 2100, yet this does not prevent investors from searching and investing in Chinese equities with strong profit potential.
There are several factors that can be favorable for investment prospects in Japan. First, Japan has a wealthy middle class when compared to other countries with relatively large amounts of savings:
Historically, Japan experienced a trend of reliance on part-time employment, whereas Japanese companies would shun long-term contracts to cut labor costs. As a result, full-time employment (something called “regular employees” in Japan) was on a decline up to 2014. However, as labor shortages began to bind, many Japanese companies began offering workers full-time work and full-time employment has grown since 2015. Even since the Covid-19 pandemic, Japanese companies have continued hiring people on a full-time basis. This matters for the Japanese economy, because full-time employment strengthens further the country’s middle class, provides stable income, job security and better access to credit for consumption or purchase of real estate assets.
On the flip side, a large proportion of the senior cohort in Japan (60 year and older) is asset rich, has no debt and owns homes. This presents a valuable spending source for the Japanese economy. For this reason, many companies in Japan reorient their marketing tactics and product design to appeal to senior citizens.
Corporate Governance Improvement
Despite lackluster economic growth, corporate margins staged a strong improvement after the 2009 recession.
Moreover, net profit margins have improved even further due to corporate tax cuts in 2017. While it is impossible to pin down the exact reasons behind the rise in profitability, one likely key factor is an improvement in corporate governance.
Historically, the Japanese corporate sector shunned dialogue with its shareholders and was opposed to corporate activism. However, after the introductions of shareholder stewardship code of 2014 and corporate governance code of 2016, things began rapidly changing. Before 2014, there was no legally binding requirement for public companies in Japan to have independent directors. According to Japan Times, only 21.5% of companies listed at the first section of the Tokyo Stock Exchange had at least two independent directors. In 2020, the proportion of such companies increased to 95.3%.
In 2016, Japan’s Ministry of Economy, Trade and Industry (METI) changed the tax code and introduced restricted stock compensation for senior management. In their guidelines, METI recommended Japanese companies to offer their management and board of directors restricted stock compensation that is several multiples of their annual salary. While stock options have been previously unpopular among firms in Japan for their unfavorable tax consequences, there is no tax on restricted stock until it is sold. Hence, since 2016, many Japanese companies have introduced restricted stock in their annual compensation plans, which in principle will further align interests of management with interests of shareholders.
In 2022, the Tokyo Stock Exchange announced revisions to its requirement for companies to be listed under its top section. Specifically, a listed company will have to have at least one-third external directors, at least 35% of its shares to be free-floating, more dialogue with investors and disclosures in English. Unfortunately, these changes were almost immediately watered down by allowing companies to continue to be listed as “Prime”, if they make promises to comply with such requirements at some point in the future with no deadline.
Japan’s stock market has experienced much higher involvement of foreign investors for the past 10 years. While 1980s holdings and trading volumes by foreign investors were both below 10%, foreign holdings account for about 30% of the total and foreign trading volumes on Tokyo Stock Exchange ranges from 50% to 70%. With this came activism and pressure from foreign investors on Japanese companies to improve profitability and shareholders’ returns.
In 2020, activist investors sent their shareholder proposals to a record of 55 publicly-listed companies with demands on changing the capital structure, management pay and overall transparency in disclosures. Surprisingly, a large portion of such proposals were approved. And even those proposals that were not approved put companies’ management on notice that the change is required and pressure will likely persist. Historically, Japanese companies have been known for their large cross-holdings, especially between companies that cooperate between each other. This led to unnecessary capital tie-up that would sit on companies’ balance sheets for years. Other issues that attracted activist investors to Japanese companies are their large cash balances and unwillingness to distribute it in the form of buybacks or dividends.
Investor activism does not necessarily originate from foreign institutions only. Further corporate governance reforms are being promoted in a top-down manner by Japan’s Government Pension Fund, which is one of the largest owners of Japanese equities. The fund has the ESG and shareholder reform mandate and introduced specific return on equity targets. If a particular company would not be able to achieve at least 8% ROE in the medium-term, the fund could pressure the company for a management change. Also, there are a growing number of domestic investment funds with deep knowledge of Japanese corporate culture that invest and pressure companies’ management for change.
Despite the rise of investor activism, Japanese companies continue to resist the pressure and do not have a framework to deal with activists and their demands. Also, the law amendment adopted in 2020 prohibits foreign investors to obtain 1% or higher voting interest in designated companies operating sensitive businesses without a prior notification and approval from the Japanese government. The 10% ownership threshold for all other non-designated companies still remains in place. While this rule’s intended goal is to prevent the transfer of sensitive information or technology to hostile hands, it appears that its secondary effect is to help certain Japanese companies to avoid foreign activist campaigns.
Overall, there is an ongoing generational change in Japanese management, where post-1980s defensive CEOs are being replaced by a younger cohort of managers who are more open-minded, seek growth opportunities and better returns, and who can be properly rewarded with restricted stock compensation for their efforts. One thing is for sure that the change in the Japanese corporate culture is a slow and very gradual process that will take years to take hold.
Should You Invest in EWJ or DXJ?
While it may be easy to invest in ETFs such as iShares MSCI Japan ETF (EWJ) or WisdomTree Japan Hedged Equity ETF (DXJ), investors would be unable to take a full advantage of what Japanese stock market can offer. There are many fantastic Japanese companies that slip through the screening cracks of these ETFs or their holdings of such stocks are too small to make any difference.
The path I propose to investors is to more actively engage in researching Japanese stocks. This is of course not possible for everyone. But for those who have access to data and time to do the necessary due diligence, it is a worthy effort that will likely reward you with above-average returns and outperform ETFs or Japan’s major stock indices. However, you have to look beyond Japanese stocks on the American OTC and connect to Japanese stock exchanges to take full advantage of stock liquidity. For now, Seeking Alpha allows analysis on its platform for Japanese stocks that trade on American stock exchanges only. Hopefully, this changes in future because I was able to identify strong investment opportunities for Japanese companies with attractive risk/reward profiles that trade on Japan’s stock exchanges only and for which I am unable to present my analysis here.
Based on my research, Japan still has a lot of companies that horde cash and show relative underperformance in terms of returns on invested capital. These companies are prime targets for domestic or foreign investors that will engage and clamor for change. Also, there are companies that continue showing strong growth, but are misunderstood by the market and trading below their expected intrinsic value based on their fundamentals. As an example, I wrote two top ideas on Nikon Corporation (OTCPK:NINOY) here and Yamato Holdings (OTCPK:YATRY) here, if you are interested in further reading. While Nikon’s thesis has largely played out, Yamato is still in the game.
Because of cultural quirks, Japanese corporate culture is still undergoing change and it will take time for certain mispricing to disappear due to management change or external pressure. But mounting foreign and domestic pressure is growing. Japan’s stock market offers fantastic returns opportunities for those who are willing spend time and look at companies that can be targets of investor activism or that the market ignores or misunderstands.