Japan’s Renaissance

Japan’s equities have rallied strongly. Is it too late to buy?

We don’t believe it is too late. Japan’s story is structural. Its main macro driver is the shift from deflation to inflation. For 30 years, households and companies dealt with the pain of falling prices. Savings grew but not spending and investing,¹ causing wages, corporate profits and economic growth to stagnate. Not anymore. Japan’s consumer prices rose 3.2% in 2023, have continued to climb this year,² and we see a high probability for inflation to hover around the Bank of Japan’s 2% annual target.

The yen’s slide since January 2024³ is hardly the emerging-market-style falls we’ve seen in the past. The exchange level creates much noise in the market, but it isn’t the top priority for monetary authorities and the real economy, in our view. Corporate earnings are less exposed to currency risk thanks to offshoring Japanese production. And the weaker yen has boosted exports of goods and services, recently soaring to almost double the share of GDP relative to the mid 1980’s.⁴

How should investors participate in the market?

About a year and a half ago conversations focused on the macro and corporate shifts underpinning opportunities in Japan’s stock market. Many investors flocked to index and exchange-traded funds⁵ and benefited from easy access to the broader market at lower-costs. As much as this approach may have worked, our conversations with investors have turned into what’s next and how to invest in Japan’s stock market going forward.

We believe the next leg won’t be as easy and will be more nuanced as stock prices fluctuate on individual company performance. A more hands-on and adaptable investment strategy could be better. Market inefficiencies offer the potential to outperform the market, especially with smaller and medium-sized companies. About half the companies report in Japanese only and many CEOs passing on the baton feed uncertainty about their companies’ future. A positive sign is that investing tactically in Japan has resulted in excess returns above those associated with broader investment universes.

How does your team seek to beat the market’s return?

Our portfolios change dynamically based on our highest conviction ideas. Bottom-up selection is the cornerstone of our process and has traditionally been the main source of above-market returns.⁶ The portfolio mix and relative position size matter. We may sell or reduce holdings of a well-managed company that we like to increase something else, based on multidimensional analyses of the portfolio and market conditions.

Flexibility and breadth are core to our approach. Recently, many investors who focused only on 'value' or 'growth' investments may have found themselves frustrated because the market kept changing leaders. If the goal is to beat the market average, we believe that style flexibility has paid off. But style leadership is just one dimension of our flexible approach. We regularly stress test⁷ our bottom-up assumptions across multiple dimensions and dynamically adjust portfolios accordingly. What could alter the mix? 

Relative style positions — Bottom-up selection may lead to unintended overweight/underweight positions.

Style factors — Frequent changes in style factor leadership may leave portfolios vulnerable to performance swings.

Relative earnings trends — Corporate earnings reliance on domestic/overseas sources may shift the attractiveness of stocks based on the currency effect.

Relative valuations — Market inefficiencies can lead to mispricings, and we seek to understand the gaps and exploit them.

Macro catalysts — Stocks have different sensitivities to changes in monetary policy and currency fluctuations.

Macro policy decisions —Decisions, such as the rate policy by the Bank of Japan can affect a stock prospect and having a view helps portfolio construction.

As active investors, how do you see the current and future opportunity set in Japan?

The economy is expanding, and companies are spending more money than ever on improving their businesses. This spending spree uncovers fear of profit squeezes amid rising costs, as well a push to gain competitiveness domestically and abroad. We believe Japan’s corporate reforms are moving from aspirational and nice-to-have to crucial for survival.

The Tokyo Stock Exchange recently tightened rules on listed companies, urging monthly disclosure on value-creation plans, such as increased dividend payouts, share buybacks, merger and acquisitions and capital spending plans. Today’s capital efficiency mindset seems more pervasive than ever before. And because the culture is prone to peer pressure, firms happy with the status quo may find themselves in the minority. We’ve noticed traditional cross-shareholdings unwinding fast and believe past critics of Japan’s corporate governance are more open to reassessing.

We believe the impressive returns from broad market exposures are largely behind us. We don’t see a possible further depreciation of the yen as a great call to buy Japan’s stock market, but believe in a structural, broad-based reform story that resonate with global themes that may persist for years and possibly decades, including:

Semiconductor industry revival — Chip makers and the broader ecosystem required to deliver on the AI revolution and supply chain revival.

Electric vehicles — Battery makers and growing demand for hybrid vehicles in which we believe Japanese companies possess strong competitive advantages.

Decarbonization — We believe Japan produces efficient and reliable equipment that can help reduce the footprint of harmful gas emissions.

Factory automation — We see Japan frontrunning the global demographic challenge, optimizing demand for its advances in robotics and automation.

Digital transformation — Digital monitoring/controls touch on modernization across industries, and we believe Japan’s health care industry applications standout.

We believe Japan’s new inflationary equilibrium offers a favorable environment for active investment approaches willing to reevaluate at the stock level and adjust as needed at the portfolio level.