Understanding the Surge in the Japanese Equity Market and Corporate Share Buybacks

Key Points:

• Improvements in corporate governance are crucial to the resurgence of the Japanese equity market.
• Share buybacks are on track to hit a record high for the fourth consecutive year.
• Despite the significant rise in the TOPIX index, 47% of its constituents trade below book value.
• Cash-rich companies trading below book value may be inclined to initiate buybacks.
• The TOPIX index still contains several deep-value net-net stocks.

Key Factors Driving the Surge in the Japanese Equity Market

The recent surge in the Japanese equity market can be attributed to several key factors that collectively paint a picture of a revitalized and increasingly attractive investment landscape. These factors include improvements in Japan's economic prospects, global supply chain reconfigurations, enhancements to the Nippon Individual Savings Account (NISA) program, strategic investments by prominent figures, and significant corporate governance reforms.

Revival of Japan's Economic Prospects

Japan's nominal growth prospects have shown significant improvement, signaling a departure from the prolonged period of slow economic growth and persistent deflationary pressures. Recent economic data highlights a more encouraging prospect and potential the return of pricing power of corporate and growth in earnings.

Global Supply Chain Reconfiguration

The global reconfiguration of manufacturing supply chains, especially within the technology sector, has also played a crucial role in benefiting the Japanese equity market. As companies worldwide seek to diversify their supply chains and reduce reliance on a single country, Japan has emerged as a favorable alternative. Its advanced manufacturing capabilities, skilled workforce, and technological expertise make it an attractive destination for global firms looking to establish or expand their operations. This shift has bolstered Japan’s industrial sector and contributed positively to the equity market outlook.

Warren Buffett's Strategic Investments

Warren Buffett’s high-profile investments in Japan’s five largest trading houses have brought renewed attention to Japanese equities. Berkshire Hathaway’s acquisition of significant stakes in these companies signals strong confidence in their future prospects and the broader Japanese market. This move has attracted global investors, who view Buffett’s investments as a robust endorsement of the market’s potential. Consequently, overseas investment in Japanese equities has increased, adding momentum to the market's rise. 

Enhancements to the Nippon Individual Savings Account (NISA) Program

Significant changes to the Nippon Individual Savings Account (NISA) program in January have profoundly impacted retail investment in the equity market. By increasing the maximum annual tax-exempt investment amount and removing the limit on holding periods, the government has incentivized more retail investors to participate in the stock market. This surge in domestic investment has provided a steady inflow of capital, further propelling the market upwards.

Corporate Governance Improvements

Improvements in corporate governance have been another pivotal factor in the resurgence of the Japanese equity market. Historically, Japanese companies faced criticism for their opaque governance practices and reluctance to return value to shareholders. Recent reforms have aimed to enhance transparency, accountability, and shareholder value. Two years ago, the Tokyo Stock Exchange (TSE) established the Council of Experts Concerning the Follow-Up of Market Restructuring to advise on measures to increase the corporate value of listed firms. These efforts have encouraged companies to adopt more shareholder-friendly practices, including increased share buybacks and dividend payouts. Such reforms have not only boosted investor confidence but also contributed significantly to the market’s upward trajectory.

The Surge in Share Buybacks

Japanese companies significantly increased share buybacks, with ¥9.6 trillion announced and the total number of companies that announced buybacks reached 1,033 in 2023. In 2024, approximately ¥9 trillion has been announced so far, poised to set a new high for the fourth consecutive year. Historically, Japanese management preferred holding large cash reserves as a buffer against economic uncertainty. However, corporate governance reforms and pressure from the Tokyo Stock Exchange (TSE) prompted a shift. The TSE urged management to focus on improving return on equity (ROE) and market valuation, especially for firms persistently trading below book value. Companies must now submit plans to the TSE on enhancing ROE, leading to increased share buybacks and dividend payouts to boost shareholder value. Consequently, Japanese firms actively return capital to shareholders, reflecting a broader trend towards more shareholder-friendly practices.

Prevalence of Below Book Value Stocks

Despite the significant rise in the TOPIX index, a substantial number of Japanese companies still trade below book value. Out of the 2,141 companies in the TOPIX index, 1,016 (47%) have a price-to-book ratio below 1. Notably, 203 of these companies have more cash than current liabilities, and 108 of these have cash exceeding total liabilities. This situation highlights Japanese companies with strong balance sheets and the potential for share buybacks or dividend increases. For comparison, in the S&P 500, only 17 companies or 3% of the index constituent stocks trade below a 1x price-to-book ratio, and none has more cash than current liabilities.

From the initial pool of 1,016 stocks, we can apply additional criteria to uncover further potential. By filtering for companies that meet the following conditions:

Cash Position: Companies where cash accounts for at least 10% of total assets. A strong cash position indicates financial flexibility and the ability to fund share buybacks.

Positive Free Cash Flow: Companies with positive trailing 12-month free cash flow. Positive free cash flow suggests that the company is generating excess cash after meeting its operating expenses and capital expenditures, which can be used for share buybacks or dividend payments.

Manageable Debt Levels:

• Net debt is less than two times the trailing 12-month EBITDA. This ratio measures a company's ability to cover its debt obligations with its earnings.
• Total debt to total capital ratio is less than 0.5. This ratio assesses the company's overall leverage and financial risk. Companies with manageable debt levels are better positioned to allocate funds towards share buybacks without compromising their financial stability.

By applying these criteria, the screening process identifies 53 companies listed on the TOPIX index that exhibit favorable characteristics for potential share buybacks (Figure 1). These companies have strong cash positions, positive cash flow generation, and manageable debt levels, which are advantageous for companies considering share repurchase programs.

The criteria help identify companies with the financial resources and flexibility to engage in share buybacks while maintaining a healthy balance sheet. Share buybacks can be a way for companies to return excess cash to shareholders and potentially enhance shareholder value.This analysis is not intended as stock recommendations, as decisions on buybacks depend on various factors, including the composition of shareholders and the board of directors. Moreover, the merits of a company as an investment depend on many other factors which are not considered or discussed in this short article.