Why Are Investors So Excited About Japan?

Japan has been one of the most unloved equity markets in the world for decades—it’s been a pariah of sorts.

One dollar invested in the MSCI Japan Index in 1990 grew to just $1.30 through the end of July. And that dollar was underwater for nearly 30 years—not inflecting positive until 2017.

Meanwhile, $1 invested in the S&P 500—with dividends reinvested—grew to $26 during that period.

It’s easy to take this data—30 years is a significant sample—and harbor the view that Japan is a low return place to invest.

However, investing is about what happens in the future, not what happened in the past. And many investors are turning a curious eye towards Japan.

Take Warren Buffett for example—who had this to say at Berkshire Hathaway’s annual meeting:

“We’ll just keep looking for more opportunities in Japan” while referencing Berkshire’s significant investments in five Japanese trading companies—which dabble in everything from auto parts to fish—and operate much like Berkshire as diversified holding companies.

Clearly, pointing out where Buffett’s investing might be interesting, but it’s also anecdotal. His investments should not serve as someone else’s due diligence.

But thinking deeper on Japan—and the potential opportunity—there’s interesting things bubbling up.

For one, performance is improving. Nothing changes sentiment like prices going up!

Japanese shares are flourishing this year. In May, their major equity indices—the Topix and the Nikkei 225—both hit their highest levels since 1989. Gains for Japanese equities have outpaced other developed markets, though the performance is not fully appreciated because a weaker yen has reduced those gains for overseas investors.

Thinking deeper than performance: what else could drive a brighter future for Japanese stocks?

One obvious factor would be structural changes happening in Japan.

Earlier this year, the Tokyo Stock Exchange (TSE) formally “ordered” all listed companies trading at below book value to raise their price-to-book multiples above 1x—or publish a plan to do so—otherwise risk being delisted.

Price-to-book is a valuation metric that compares a company’s stock price to its book value per share. Book value represents assets minus liabilities, divided by the number of outstanding shares.

Put simply, if a company’s price-to-book ratio is below one, the market is valuing a company at less than its assets are worth.

This was a significant dictum by the TSE—and made clear shareholders would be a priority going forward.

The TSE noted more than 50% of listed companies trade for below 1x price-to-book.

This an anomaly globally. By comparison, only 5% of S&P 500 companies trade at price-to-book’s of less than one and zero companies trade below 0.5.

When you think about valuations this low, it’s fair to assume many of these companies have the proverbial “hair on them.” This is likely true in some but cases, but there’s also recognizable global brands like Toyota, Mitsubishi and Honda—which collectively represent some $2 trillion in market capitalization—that fall into this group.

The question becomes: how do you make valuation’s increase?

The TSE specifically requested steps such as “pushing forward investment in R&D (research & development) and human capital that leads to the creation of intellectual property and intangible assets that contribute to sustainable growth.”

That sounds nice but it’s not exactly clear if it will directly translate into value for shareholders. In some cases, maybe it will—in others, maybe not.

Another method the TSE is pushing: increase direct returns to shareholders, either via dividends or buybacks This mandate holds a lot of promise.

The percentage of companies that are “net cash” (i.e., whose cash on the balance sheet is greater than their liabilities) is 50%. That gives those companies optionality to invest in their business, or increase returns to shareholders, or perhaps both.

One other interesting point factor in Japan: inflation might be a good thing.

Unlike the rest of the developed world where inflation has been met with a swift policy response (translation: increasing interest rates), Japan has spent considerable time the past few decades batting the opposite problem: deflation.

Deflation leads companies and consumers to delay investment and put off purchases; there’s little point buying something now if it will be cheaper tomorrow.

By contrast, moderate inflation gives companies the confidence to invest for the future, and also spurs consumers to spend.

Putting it all together, it does seem like Japan is turning a corner and could be fertile ground for investors.

Japan has a history of being booms and busts, but investors would do well acknowledge that material changes are occurring to reshape their markets. These changes have led to better fundamentals and could bode well for investors going forward.