Japanese equities have enjoyed strong returns in recent years. Have investors missed the boat? We think not and remain constructive on the outlook from here.
At the beginning of last year, we sat down and put pen to paper on a thought piece which argued this was Japan’s decade of sustained economic momentum. The events of 2024 certainly strengthened our case. Japan’s revival story continues to be underpinned by strong earnings for both international and domestic demand companies, corporate governance momentum, sustained inflation, rising wages, and improving merger and acquisition (M&A) activity. Following a period of strong performance over the past two years, some investors are questioning whether they have missed the boat; we don’t believe so. Our constructive long-term view on Japan’s equity market remains intact. We believe we are still at the start of Japan’s long-awaited transformation.
Corporate governance reform bolsters shareholder returns
Similar to last year, we remain most excited about corporate governance reform as we move through 2025. The drive to improve profitability and valuations for Japanese corporates is far from over. We frequently tell our clients that the keys to Japan’s bull case is better allocation of capital by companies and a greater focus on investor returns. Japanese companies are more profitable versus previous decades; they’re converting operating profit into net profit more efficiently and returning more cash to shareholders than ever before! The share buyback bonanza continues; during the first half of the fiscal year (April – October 2024) a record ~¥15 trillion buybacks were announced versus just ~¥8 trillion at the same time the previous year. Using a conservative assumption of the same level of buybacks from the previous year over the remainder of the fiscal year (November 2024 – March 2025); full year buybacks would equate to ~¥17 trillion. That’s a 70% surge year-on-year!1
Figure 1: TOPIX share buyback bonanza continues2
Source: Jefferies, FactSet, November 2024.
Alongside the spike in share buybacks, Japan’s cross shareholdings unwind is accelerating, and those companies at the forefront of the unwind are generating strong returns. This archaic shareholding structure has been a chronic drag on capital efficiency in Japan for decades. However regulatory reforms are swiftly changing that trend by encouraging Japanese companies to divest value-destructive equity holdings. Insurance, banks and autos are at the forefront of the unwind, however, we are witnessing this theme in other pockets across the market. Companies with large equity holdings (as a percentage of their market cap) and who are already undergoing this process are more likely to continue this shareholder-friendly activity, and more importantly, outperform the index. In fact, companies that have reduced equity holdings by more than 20% have outperformed the Tokyo Stock Price Index, or TOPIX, by around19% year-to-date. We believe this theme is still in its infancy stage and we continue to exploit high quality beneficiaries in portfolios.
Figure 2: The cross holding unwind has significantly boosted returns in 20243
Source: Jefferies, FactSet, November 2024. For companies with market cap more than $2 billion.
“Savings to Investments” - structural shift in retail purchases of Japanese equities
Improving M&A activity - a positive catalyst for business restructuring
Politics
For the first time since 1905, every incumbent political party in a developed economy that faced re-election in 2024 lost vote share. In Japan, the ruling Liberal Democratic Party (LDP) lost its majority in the election, however, the ruling coalition remains the largest bloc in the lower house. We can expect some market volatility going forward due to uncertainty, however, we believe it is highly unlikely that the pro-market policy agenda will be derailed. For some background, the LDP brought stability to Japanese politics throughout the previous decade and has implemented a series of corporate governance and labour reforms – irreversible structural legislation – that will be transformational for corporate Japan in the next decade.
Figure 3: Percentage price hikes needed to cover Trump automotive tariffs: Toyota and Honda would be less impacted by Ford7
Source: Source: CLSA. January 2024. Percentage price hikes needed to cover Trump automotive tariffs – assuming 25% tariffs on autos and components coming from Mexico and Canada, 60% for China and 20% for everywhere else.
A virtuous cycle of wage growth and inflation
In our last piece, we mentioned our excitement around the Bank of Japan’s (BoJ) commitment to achieving a positive cycle of wage growth and inflation which we believed would kick-start Japan’s new era of economic growth. Many sceptics doubted this could be achieved. Over the past 12 months, we have witnessed a sustainable inflation rate above 2% and a wage increase rate slightly above 3%. We now have good reason to believe that Japan’s inflation is not a temporary phenomenon, and instead evolving into a more sustainable format based on a virtuous cycle of wage and prices which indicate sustained nominal GDP growth. This should continue to support a positive economic cycle, as it will spur corporates to increase growth investment and improve capital efficiency. Some investors argue that a stronger yen in 2025 – a likely scenario – will undermine Japan’s beneficial inflation trend. We believe this is unlikely. Japan’s labour supply is limited – the retirement age has gone up, female labour participation rate has risen, and a significant change in immigration policy is highly unlikely – so labour supply should remain below labour demand. We expect this to support sustained wage growth and inflation even if the yen strengthens, which is unlikely to return Japan’s underlying price trend to deflation. Japan’s nominal GDP has escaped the deflation equilibrium and has begun a moderate growth trajectory with sustainable wage increase as a tailwind.
Strong underlying wage-price dynamics are expected to lead to further policy normalization by the BoJ, and we anticipate incremental hikes as we move through 2025. Against the backdrop of central banks easing globally, this should cause the yen to strengthen. While foreign exchange (FX) bets are not our skill set, we remain cognisant that the Japanese yen plays a role in corporate fundamentals, as a weaker yen benefits export orientated sectors and pressures domestic businesses, and a stronger yen has the reverse effect. Throughout the deflationary years, Japanese companies made a significant effort to bring down the breakeven sales ratio, so companies are still able to produce profits in a stable manner when external factors — like FX — fluctuate.
Figure 3: Percentage price hikes needed to cover Trump automotive tariffs: Toyota and Honda would be less impacted by Ford7
Figure 4: Japan’s nominal GDP is taking off into a gradual growth trajectory8
Against the backdrop of central banks easing globally, this should cause the yen to strengthen. While foreign exchange (FX) bets are not our skill set, we remain cognisant that the Japanese yen plays a role in corporate fundamentals, as a weaker yen benefits export orientated sectors and pressures domestic businesses, and a stronger yen has the reverse effect. Throughout the deflationary years, Japanese companies made a significant effort to bring down the breakeven sales ratio, so companies are still able to produce profits in a stable manner when external factors — like FX — fluctuate.
Japanese companies are in much better shape than in previous decades and the market remains attractively valued relative to history and the global average.
The bottom line
We believe Japan’s economy is well positioned to reaccelerate in 2025 given the focus on reflation, rising wages, better corporate governance, and a pick-up in M&A activity. Unlike in the past, the earnings growth of domestic demand-driven companies is also likely to support Japan’s market. From a macro perspective, we believe Japan will be among the least impacted by US tariff threats of major economies due to extensive offshoring and geopolitical relations. The long-term story also remains intact, corporate Japan has transformed from the market-share-chasing, low margin, high capex model of the 1980s, to one with a focus on returns and capital efficiency. We believe Japanese companies are in much better shape than in previous decades. Furthermore, the market remains attractively valued relative to history and the global average. In sum, this is a very exciting time. We are witnessing a market driven by solid fundamentals, where growth is expected to accelerate, which provides a deep, attractively valued opportunity set for active investors like us.
