We all know that the truth hurts, and never more so than when it comes from friendly quarters. So Japan’s managerial class must have been stung by the uncharacteristically blunt assessment by the Tokyo Stock Exchange (TSE) in its blandly titled Summary of Discussions on Measures to Improve the Effectiveness of the Market Restructuring published at the start of the year. 1  “In Japan, there are many cases where management is unaware of the cost of capital and stock price” and “in Japan’s economy, the lack of a smooth transition of personnel and capital resources to growing areas has led to a prolonged slump in productivity” were just two of the zingers.2

Particularly offensive to the TSE are the low valuations of Japanese stocks. About half of Japanese listed companies attract a price to book multiple (a measure of market capitalisation to the equity recorded on a company’s balance sheet) of less than one.3 Similar stats have been used for years by Japan bulls to tempt wary investors, the cheapness of the market implying rich returns. To the exchange though – and presumably to the Japanese economic and financial establishment as a whole – the fact is lamentable, a symptom of meagre financial returns and minimal expectations for change or growth.

For the TSE, enough is enough; corporate Japan must smarten up its act for the good of the country. If it does so, investors will be delighted beneficiaries. This piece examines this theme – firstly we assess whether Japan is good value or just cheap, before going on to discuss what might be changing for the better amongst Japan’s listed companies and the opportunities and challenges investors face when hoping to profit from the theme.

Why would a business be cheaper in Japan?

That Japan is a cheap market is almost beyond argument. Valuation multiples versus balance sheet or profit measures are almost universally at discounts to other developed markets. The proportion of listed stocks in the very lowest valuation brackets – as highlighted by the TSE – is extraordinarily high. But does the latter point entirely explain the former? No – we think Japan has value across the board. Allow us to explain.

The chart below shows price to book multiples for Japan, the US, Europe (and for our strategy) across the spectrum of returns on that equity.4 Japan certainly has lots of companies on low multiples making low returns, and relatively few making high returns attracting rich multiples. But it is also true that at any level of return on equity, Japanese companies appear to be cheap versus their US peers. The comparison with European companies is less stark, but even here at most levels of ROE, Japanese companies are cheaper. To us, this is an indication of value and not just cheapness. It maintains that the valuation argument can be made by investors of almost all stripes – us included – and not just our deep-value seeking peers.
Japan equities trends

Source: Bloomberg, as at 31 March 2023

Why would a business be cheaper in Japan than a comparable one elsewhere? Part of the answer is probably growth expectations; a mature domestic economy and a dwindling population dampen investors’ expectations for corporate profit growth. History tells us to question this assumption – indeed, growth in Japanese corporate has actually outpaced the S&P in aggregate since 1995, albeit with far greater volatility. Why would a business be cheaper in Japan than a comparable one elsewhere? Part of the answer is probably growth expectations; a mature domestic economy and a dwindling population dampen investors’ expectations for corporate profit growth. History tells us to question this assumption – indeed, growth in Japanese corporate has actually outpaced the S&P in aggregate since 1995, albeit with far greater volatility. 5

Another reason for Japan’s discount is, in our view, pure opportunity. We have spoken and written much about the Japanese market’s inefficiency, it has many causes but one of the most arresting is the relative absence of analytical effort applied to it. For example, almost 80% of TOPIX-listed stocks have fewer than 20 analysts covering them, compared to just over 40% for the FTSE All-Share and under 20% for the S&P. 6 The streets of the Japanese market are dimly lit indeed.

What is in the bargain basement?

The above statistic comes from a CLSA report entitled “What would Buffett buy?”, one of a number written in response to the first visit to Japan by Warren Buffet since 2011. The breathlessness of some of the media commentary – keen to promote Japan’s value appeal – bore little resemblance to the sober tone of what Buffet actually said. In fact, he reiterated his lack of interest in low price to book stocks. 789 Still, who would argue that Buffett has not got a good nose for an investment opportunity? For the man who famously wrote that “it’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”, is Japan’s bargain basement well stocked with “wonderful” companies?,10 This is to where we turn our attention next.

For ease, we will focus upon Japan’s largest listed companies – the Topix500 – some 200 of which are currently trading at a discount to the book value of their equity.11 Of these, and for which meaningful data is available, just under 60% have seen earnings per share decline over the last five years, almost half have had operating profit margins below 6% over the last three, and some 44% have generated average return on equity shy of 6% over the last half decade. It is not obvious that many of Japan’s cheapest companies are by any reasonable definition “wonderful”. Of these sub-book stocks, thirty-five are financials – battered by the Bank of Japan’s ultra-loose monetary policy. Forty-one are chemical or basic materials manufacturers and thirty-three are capital goods companies. The bargain basement might be well stocked, but the choice is poor for anyone looking to compose a well-diversified portfolio.12 We would advise extreme selectivity when scouting for investments amongst Japan’s many very cheap companies, and we aim to practice what we preach.

Change is afoot, but don’t get carried away

To return to the Tokyo Stock Exchange, their argument is not of course that investors should load up on the country’s cheapest stocks. Rather, it is to suggest that with some bold management action many of these companies could become better – if not quite ‘wonderful’ – and in so doing attract richer valuations. The exchange is urging companies to think of ways to boost returns and bump up valuations. They will require explanations if companies fail.13 Little here is truly new but the good news is that there are early signs that this approach may be working.

In February, Citizen Watch’s share price melted up after it announced that it was buying back a quarter of its shares to run down the cash reserves which had weighed upon returns. In the same month, Dai Nippon Printing teased a new mid-term plan calling for ROE more than 10% and a price to book multiple above one. Here too, the shares popped having already bounced in January on the news that activist US investor Elliott had taken a disclosable stake.14 Last month, rubber seal and electronic component maker NOK announced that it would buy back stock, boost dividends and sell off strategic shareholdings, sending its share price north.15

Many investors are understandably keen to catch the next company to blow. The problem here is one of the needle and the haystack – of those Topix 500 companies trading below book, around a third are in a net cash position. If the market capitalisation hurdle is lowered, the proportion of cheap companies with excess cash reserves only rises. We are not averse to seeking investment opportunity through improved shareholder returns – we were invested in and engaging with low-price, cash-rich construction company Hazama Ando before any activists appeared on its register. But inertia is a hell of a thing, especially for Japanese managers so a diligent assessment of whether change is really on the cards is crucial. The huge weight of passive ownership, boosted by the Bank of Japan’s years of equity buying could also diminish pressure on managers to change.16

There is a risk that this focus upon capital management distracts from the pressing need for operational reform – a business with no or negative growth and thin margins is a poor company, never mind a wonderful one, and likely a poor investment in the long term no matter how smartly the balance sheet is rearranged. That Japanese return on equity lags its international peers is as much an issue of sub-par profit margins as it is bloated balance sheets. We like companies which are becoming more capital efficient, but we love businesses which are becoming structurally more profitable.

We believe that Japan is both cheap and good value. A still poorly understood market, Japan has some wonderful companies available at big discounts to their global peers – we like to buy them. But the country is home to some decidedly ropey businesses too; a lack of creative destruction has allowed too many unprofitable businesses, stuck in reverse, to survive. The good news is that the Japanese economic and financial establishment appears to have had enough. The latest round of public flogging, following the Ito Review and the establishment of Governance and Stewardship Codes in the last decade, is being led by the Tokyo Stock Exchange. Early signs are that their campaign to get corporate Japan to help itself is having some success. We are delighted and believe that a number of our investments can and will boost returns through better management of capital, as well as their own operations. But we are wary of the premature euphoria – it would be an error to be intoxicated by the fear of missing out and to loosen selection criteria in hope of a big short-term win. Not all companies that could change will. We aim to keep a clear head, and urge our clients to do so too.

1 Summary of Discussions of the Follow-up Council Regarding the Market Restructuring and TSE’s Future Actions in Response to the Summary of Discussions | Japan Exchange Group (jpx.co.jp)

2 ibid

3 ibid

4 Data has been harmonised, eliminating top and bottom 5% to avoid distorting outliers. TPX-500 is used to increase comparability with US and European indices. Fund includes businesses for which 5-year ROE data is available.

5 Smith, Benthos – Superior growth at a knockdown price, CLSA, March 2023
6 Smith, Benthos – What would Buffett buy?, CLSA, April 2023
7 Buffett effect: Overseas investors buy over $7bn in Japan stocks in week – Nikkei Asia
8 Warren Buffett leads global investors into ‘cheap’ Japan – Nikkei Asia
9 Transcript: Warren Buffett speaks with Nikkei Asia – Nikkei Asia
10 Chairman’s Letter – 1989 (berkshirehathaway.com)

11 Note that any value trend observed in Japan’s largest companies will be even more prevalent in smaller companies
12 Bloomberg, April 2023
13 dreu250000004mpf.pdf (jpx.co.jp)
14 Elliott and other activists shake corporate Japan into action on investor returns | Financial Times (ft.com)
15 Bloomberg, April 2023
16 How Bank of Japan Became Largest ETF Holder in the Country With Billions in ETFs – Bloomberg

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