Japanese shares are flourishing so far in 2023. In May, the 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, albeit the weaker yen has reduced those gains for overseas investors.
What’s behind this growing enthusiasm for Japanese shares? We think there were two key factors driving this momentum.
One is a cyclical aspect, with the Japanese economy being relatively late to reopen after the Covid-19 pandemic. This gives confidence in corporate earnings growth this year, alongside attractive valuations as a whole for the Japanese stock market.
Secondly, and this is more important as a structural development for the long term, the trigger was the Tokyo Stock Exchange (TSE)’s call earlier this year for companies to focus on achieving sustainable growth and enhancing corporate value. This call was particularly directed at companies with a price-to-book ratio of below one.
What is price-to-book ratio and why does it matter?
The price-to-book ratio (P/B ratio) is a financial metric that compares a company's stock price to its book value per share. The book value per share represents the company's assets minus its liabilities, divided by the number of outstanding shares.
What that means is that, if a company's P/B ratio is below one, the market is valuing the company at less than its assets are worth. Corporate finance theory says that if a company generates higher return on equity (ROE) over their cost of capital, then the P/B ratio should be higher.
Basically, a P/B ratio below one indicates that investors have a very sceptical view of the company’s future profitability and growth potential and thus, TSE specifically pointed out that a company should seek higher ROE while measuring and managing cost of capital.
These are exactly the topics global investors wish to talk about with company management, and we think this is finally gaining official acknowledgement by Japanese companies.
Indeed, there are a lot of companies listed in Japan with P/B ratios below one. That means there are lots of companies with the potential to be revalued more highly - if they can convince investors that they should be.
TSE has urged companies to make plans to be revalued by focusing on cost of capital and share price. Companies are expected to announce their plans within a year and renew them annually.
How can companies increase their P/B ratio?
There are many ways companies can try to improve their P/B ratio. The request to companies from TSE specifically mentions steps such as “pushing forward initiatives such as 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, investment in equipment and facilities, and business portfolio restructuring.”
Another method is to increase returns to shareholders, either via dividends or buybacks (whereby the company repurchases its own shares).
The good news is that Japanese companies are well-placed to take some or all of these steps. 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 scope to invest in their business, or increase returns to shareholders, or perhaps both.
There are already encouraging signs that many Japanese companies are heeding TSE’s call and are increasing their returns to shareholders. We started to see a number of examples during Japan’s full year earnings season in May to June, which was a welcome surprise.
For the last fiscal year, finishing March 2023, the amount of share buyback plans announced by companies has recorded historical high, far exceeding the level in the past two financial years.
We are also seeing companies announce new medium-term business plans which include more aggressive dividend pay-out policies. Notably, this has been the case more from small and mid cap companies, including some in old-fashioned industries such as construction and chemicals. We even saw a case where a company decided to pay out 100% of its profits by making use of its idle cash on the balance sheet. Such actions tend to be associated with activist investors engaging with companies, and such activities are also booming in Japan and that also supports the momentum of corporate governance reforms.
Reopening post-Covid is also boosting Japanese shares
TSE’s call for Japanese companies to increase their P/B ratios is far from the only factor helping to support shares this year. The country’s delayed reopening from the pandemic is another.
Japan was under some form of pandemic restrictions for much longer than the US or Europe. The country only reopened its borders to foreign tourists in October 2022. Domestic travel is also recovering. We think this can help benefit smaller, domestically-focused companies operating in sectors such as travel, leisure, and hospitality.
Another important point is that China’s lifting of pandemic restrictions was even later than Japan’s. Trade with China is important for Japanese companies, and Chinese tourists were a sizeable proportion of total visitors to Japan (making up a third of the total in 2019). China’s belated post-Covid reopening is another positive influence for Japanese shares this year.
Welcome return of inflation
Of course, the benefit from lifting pandemic restrictions is a one-off. There are other longer-term factors supporting the Japan story too.
Among these is the return of inflation. After three decades of low inflation, and even deflation, the current return of mild inflation is very welcome in Japan. 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.
Rather than facing a downward deflationary spiral, Japan may now be entering a sustained period of higher corporate investment, wage growth, and increased consumer spending.
The challenge for consumers will be whether wages keep pace with this higher inflation, otherwise their purchasing power will be eroded. There were, however, positive signs from this year’s spring wage negotiations, with major firms agreeing a near 4% pay rise for employees, the highest pace over the last 30 years. This only affects a limited number of companies but is still encouraging because companies need to be confident about the business outlook if they are going to commit to pay rises.
Another factor is that, even after the rally so far this year, Japanese shares look attractively valued when compared to their own history and to other regional equity markets (see end of article for glossary of valuation terms).
All of the above has helped to make Japan an attractive hunting ground for investors this year. Indeed, signs of foreign investors reassessing their view of the market were confirmed in April when legendary investor Warren Buffett told the press that he intended to add to his investments in Japan.
Small caps poised to benefit
We would highlight small companies in particular as the likely winners. This is partly because of their exposure to domestic services sectors that will benefit from reopening.
The unwinding of pandemic investment trends is also a factor. The uncertainty caused by the pandemic tended to see equity investors retreat to the safety of larger companies. However, the improved economic backdrop and renewed investor enthusiasm for Japan will bring higher liquidity, which is beneficial for smaller companies as it makes them easier to trade.
An existing valuation gap has widened over the quarter, given the fact that Japan’s recent rally was very much driven by large cap stocks. This was mainly due to overseas investors buying index futures and liquid large cap stocks. Smaller companies remain attractively undervalued. If we look at P/B ratios, historically, smaller companies in Japan are generally more lowly valued than larger companies, and there should be greater scope to improve their P/B ratios upon the TSE initiatives and investors’ engagement.
All in all, we think the mix of short-term cyclical factors, plus long-term structural changes, adds up to a encouraging outlook for Japanese shares.
The cyclically-adjusted price to earnings (CAPE) multiple attempts to overcome the sensitivity that the trailing P/E (see below) has to the last 12 months’ of earnings. It does this by comparing a stock market’s value or price with its average earnings over the past 10 years.
Forward P/E multiple
The forward price-to-earnings multiple or forward P/E involves dividing a stock market’s value or price by the aggregate earnings of all the companies over the next 12 months. A lower number may represent better value.
Trailing P/E multiple
Similar to forward P/E but takes the past 12 months’ earnings instead so involves no forecasting. However, the past 12 months may also give a misleading picture.
Price-to-book (PB) ratio
A company’s ‘book value’ is the value of its assets minus its liabilities (net asset value), at a set point in time. Aggregated to the market level, it can be used to assess a stock market’s value, or price, relative to its net asset value.
The dividend yield is a stock market’s value or price divided into aggregate dividends. Because dividends are cash actually being paid out to investors as opposed to earnings, which are an accounting concept, it may be a more reliable valuation metric.
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The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.