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Japan: hiding in plain sight

Just quietly, whilst most global investors have been comfortably underweight, Japanese equities have been performing rather well in recent years. In fact, over the ten years to 31 December 2021, the TOPIX generated a compound annual total return of 13%, in local currency terms. Outside of the S&P500 Index, which returned 16.5% compound, this is well above the mid-single digit returns of other markets.

This decade of solid returns has been defined by significant corporate reform, unleashed by Abenomics. This co-ordinated campaign saw various government agencies pressing the corporate sector for higher profits and improved governance. It has worked. Over the past ten years, both operating profits and earnings per share growth for the MSCI Japan Index has outpaced every major market globally, including that of the S&P500 Index. Whilst significant profit improvement has taken place, Japanese profit margins are still half of those in the US, suggesting further scope for structural improvement.

Margin improvement, however, is only part of the story of corporate reform. The real change, which has been understandably slow in the making, is the change in mindset that we see taking place in board rooms across Japan. As companies re-assess what is required to win and be the best, extra-ordinary changes are taking place including wholesale re-assessments with respect to business lines, product portfolios and balance-sheet composition. The upshot is that the corporate sector is undergoing an optimisation project of impressive proportions…seeking to deliver more with less.

This has positive implications not just for margins, but also for revenues – from more competitive positioning, and improved unit economics through better optimisation of assets and reduced capital investment.

We do not believe this optimistic backdrop is being fairly reflected in the share prices of Japanese companies. As the reform agenda continues to gather pace, prospects for ongoing earnings outperformance and capital return appear to be very good. This is at odds with the prevailing perception of Japan as a ‘leveraged play on global growth’. Rather, we see it is a ‘mis-priced, un-levered play on continued self-help’.

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