Corporate Performance and Capital Deployment Will Drive Increasing Shareholder Value for Japanese Equities

No one can dispute that the Japanese equity market has had a great run over the past decade. The MSCI Japan Index posted an annualized return of 9.17% (yen-denominated) for the 10 years that ended in November 2024 and delivered a 12.49% return year-to-date. The broad Tokyo Price Index followed a similar trajectory. That winning streak was interrupted this past summer, following the decision by the Bank of Japan to hike interest rates, which coincided with weak U.S. economic data. The resulting rise in the yen and rapid unwinding of the carry trade (investors borrowing in cheap yen to fund investments in other assets) caused the MSCI Japan Index to fall 12.48% on August 5.

Japanese equities have recovered much of their losses since August, but the market remains volatile due to concerns about additional BOJ rate increases, less-than-robust global economic conditions and the impact of policies that may be adopted by the incoming administration of President-elect Donald Trump in Washington, D.C.

MSCI Japan and TOPIX Indices, 10-Year Performance (2014-2024)

Corporate Fundamentals Outweigh Macro Developments

I believe the performance of Japan’s equity market offers solid evidence that corporate fundamentals are more important than broad domestic and international trends in generating investment returns. So, while Japan’s equity market is sensitive to macro developments and is experiencing a period of volatility, the strong fundamentals of Japanese equities helped to support the market in 2024—and I believe will do so in the future.

This positive outlook is based on the dynamic nature of Japan’s corporate sector, which has dramatically improved its productivity and has deployed more capital to drive increasing shareholder returns in recent years. I believe Japanese equities can maintain and even accelerate their momentum, provided that corporations are willing to become even more disciplined about capital efficiency—deploying their massive cash hoards to drive further increases in shareholder value.

Better Capital Allocation Can Drive Higher Valuations

While many Japanese stocks historically suffered from low price-to-book value multiples, this situation began to improve as a result of governance reforms mandated by the Tokyo Stock Exchange. In 2021, the exchange required all listed companies to enact policies to improve profitability and long-term returns in order to correct chronic undervaluation. Specifically, companies trading below book value were required to adopt strategies to achieve an above-book valuation and to disclose their capital allocation policies to make that happen.

This initiative has already raised valuations for a number of very low price-to-book stocks. Most Japanese companies that previously traded below book value have disclosed strategies to become better capital allocators, usually by adopting share buyback programs or raising dividends. That said, the aggregate price-to-earnings ratio represented by the MSCI Japan Index stood at about 15.1x as of early December 2024 and remains slightly lower than the 10-year average. Thus, I believe there is still plenty of room for further valuation improvement.

Japan’s corporate sector has the ability to drive further value creation through better capital allocation. Many Japanese corporations simply hold too much cash on their balance sheets. Companies that are naturally asset light and cash flow generative often “punch below their weight” when it comes to producing a return on equity. As a result, they must be content to generate a return-on-equity in the mid-teens. By deploying capital more productively and reducing cash levels in the process, I believe many companies could deliver ROE upwards of 30%—and would thus merit a corresponding increase in stock valuation.

Corporate Earnings Benefit From Productivity Growth

Japanese companies have been able to accumulate large cash positions because they are masters at increasing productivity. Even though Japan’s economy remains slow-growing—with the IMF projecting a growth rate of just 0.3% in 2025—corporations have become proficient at managing those factors that are under their control, especially in terms of cost savings and investments in greater operating efficiency, albeit from a low starting base.

One key contributor to the strong performance of Japan’s corporations is the fact that they are not heavily dependent on the domestic economy to fuel their growth engines. Approximately half of the aggregate revenues of the largest Japanese companies is generated outside of Japan. Additionally, even in a stagnant domestic market, Japan is still the third-largest economy in the world, providing ample opportunity for emerging growth companies to take market share from the incumbents.

As a result of productivity enhancements and exposure to faster-growing markets, “Japan Inc.” has enjoyed healthy earnings growth, which has translated into a robust return on equity asset class even without expansion of P/E multiples. Over the 10-year period that ended November 27, 2024, the MSCI Japan Index returned 160.65% excluding dividends, of which the majority has come from earnings.

Excess Capital for Buybacks and Dividends

Thanks to years of productivity improvements and conservative (some might say miserly) cash management practices, the balance sheets of Japanese companies are awash in cash. While some companies have tapped these cash hoards to fund share repurchases and strong dividend growth, the levels of both buybacks and dividend payouts at present still lag behind their U.S. and European peers.

To help persuade global investors that Japanese corporations are deeply committed to increasing shareholder value, the companies, especially those with good fundamentals and robust cash flow generation capability, will need to show the will to go beyond their fundamentals and have a more dynamic capital allocation strategy.

Investors also need to understand that, despite the recent market volatility, Japan’s corporate profit fundamentals remain resilient and companies still have considerable room to increase shareholder returns independent of the macro economy or interest rate cycle. Earnings growth is in the high single digits, while dividends and buybacks are growing by double digits year-over-year. Yet the market’s valuation is currently at or slightly below historical highs, as noted earlier, which we see as a positive sign for investors.

It is likely that many longtime observers of the Japanese economy are still put off by the memory of the post-1990s “lost decades” or simply find it easier to invest in companies that have results buoyed by faster-growing economies like that of the U.S. However, I believe Japan’s corporations are well- positioned to overcome these obstacles—if they continue to unleash the power of their capital to drive shareholder returns.

Shuntaro Takeuchi is a portfolio manager at Matthews Asia.

This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of ISS STOXX or its affiliates.

 

 

 

Tags: Japan, Japanese Equities