This article was originally published via the AFR.
Japan as an investment destination is back on the radar for global equity investors.
In fact, investors over the past year were rewarded with local currency equity returns that matched the all-flying Nasdaq and have even beaten the Nasdaq in the post-COVID-19 era.
For investors accustomed to the deflation and stagnation narratives that have long dogged Japan's economy, this is welcome news.
Japan's resurgence has been underpinned by two of the three "arrows" implemented by former prime minister Shinzo Abe - aggressive monetary easing and fiscal consolidation.
Investors are now embracing a period of inflation in Japan. This week the Bank of Japan raised rates for the second time this year and unveiled plans to slash in half its bond purchases after a debt-buying binge of more than a decade.
Although still a relatively modest rate of 2.6 per cent, and low relative to the inflation rates of other economies, it is nonetheless a welcome development compared to the 0.1 per cent rate Japan averaged for most of this century.
There are signs that the private sector may be starting to embed greater inflationary expectations in their everyday planning. One example is the latest Tankan business survey, where firms' three to five-year inflation outlook increased due to currency, input cost and wage-price pressures.
For the corporate sector, this means a greater focus on margins and value, rather than simply volume. Households are bringing forward purchases, rather than delaying them.
Compensation per worker in Japan is at its highest since the 1990s, increasing the consumers' willingness to spend. A scarcity of labour is underpinning higher levels of wage growth. With wages moving higher, in turn, firms are taking the opportunity to pass these on in the form of average higher selling prices (ASPs) and taking additional margin at the same time.
But it is the third "arrow"- structural, bottom-up corporate reform - that is now fuelling renewed global interest in Japanese equities.
With its equity market finally breaching the highs it last saw in 1989, there is growing evidence Japan's bottom-up structural reforms are becoming entrenched in the corporate cultural psyche.
Examples of the Abenomics-led micro reforms include Japan's stewardship code, adopted in 2014 and revised in 2017 and 2020. This code was a guide for institutional investors to "promote sustainable growth of investee companies and enhance the medium- and long-term investment return for clients and beneficiaries".
Japan's corporate governance code, adopted in 2015 and revised in 2018 and 2021, was an important follow-up to this. It established fundamental principles for effective corporate governance at listed companies in Japan.
More recently, the Japan Exchange Group (JPX), owner of the Tokyo Stock Exchange (TSE) and Osaka Exchange, has embarked on its own corporate reform. In a radical departure from the typically conservative region, JPX has adopted what can only be described as a "name and shame regime" to drive better corporate governance and in turn, greater corporate value.
Hiromi Yamaji, the chief executive of the Japan Exchange Group, commented that "peer pressure or a nudge is a very important method to push people to go forward".
In March last year, the TSE told companies that progress on delivering corporate value for shareholders was non-negotiable and that companies trading below book value needed to deliver "action to implement management that is conscious of cost of capital and stock price".
On January 15 this year, the TSE published its inaugural list of companies that have responded to their directive. It highlighted that at the end of last year, only 40 per cent of companies had responded to TSE's request for actual plans that were designed to improve shareholder value.
By the end of June, over 80 per cent of companies had outlined plans to increase their share price.
For a stock market where almost 50 per cent of companies trade below book value, the inference is clear - show tangible proof of how they plan to remedy this, or risk being shamed off the exchange.
The good news for investors is that the results of this particular focus on shareholder value are already apparent. Many companies are implementing more shareholder-friendly measures, improving disclosures, growing dividends and announcing share buyback programmes.
According to Mizuho Securities, the net buying of Japanese stocks by companies reached a record high of ¥966 billion ($9 billion) in May this year. Buybacks (as a proportion of market capitalisation) have increased to a rate that is slightly above that of the US.
On JPMorgan estimates, FY2023 saw ¥9 trillion in buybacks and ¥4 trillion in sales of strategic shareholdings. Cross-shareholdings (when companies own shares of other companies) are also being dismantled, freeing up capital that can be used to improve returns.
According to data from MSCI, the percentage of constituents in the MSCI Japan Index flagged for cross-shareholdings in 2023 dropped to 36 per cent from 43 per cent in 2019. Toyota Motor reduced its stake in telecom company KDDI; Fujitsu sold its chip packaging subsidiary Shinko Electric; and Nippon Steel and Hitachi have announced similar restructuring plans.
These tangible signs of improvement are replicated when one looks at earnings transcripts and examples of enhanced governance. The number of independent directors on Boards is increasing, as is the level of activism from shareholders. Mentions of "dialogue with investors", "cost of capital" and "shareholder returns" are more frequent.
Despite the pace of recent progress, let's not forget that Japan's "renaissance" is over a decade in the making.
It was not long after commencing his second term as prime minister, in 2012, that Abe introduced Abenomics. Then, a year later, the former prime minister famously stood on the floor of the New York Stock Exchange and urged investors to "buy my Abenomics".
The three-pronged strategy ("three arrows") of Abenomics was centred upon aggressive monetary easing, fiscal consolidation, and structural reforms to boost corporate competitiveness and economic growth.
While the first two "arrows" garner the most attention, it is the final "arrow", real structural reform, that will probably promote the next leg of Japanese equity market performance, value and growth.
It might also prove the most powerful and enduring.
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