Chief China Strategist
Summary: The recent surge in the Japanese equity market is driven by improved economic prospects, global supply chain shifts, enhanced retail investment incentives, high-profile investments, and significant corporate governance reforms. Share buybacks have increased, reflecting a shift toward more shareholder-friendly practices. Despite the market's rise, numerous undervalued investment opportunities remain, particularly among companies trading below book value and deep-value net-net stocks. These factors make the Japanese market attractive for value-oriented investors who may wish to conduct further research on potential investment opportunities.
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.
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.
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 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.
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.
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.
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.
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:
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.
Among the 2,141 TOPIX constituents, there are 55 deep-value Benjamin Graham-style “net-net” stocks (Figure 2). In its simplest form, without discounting the value of different types of current assets, a net-net stock is a company trading below its net current asset value, which is calculated by subtracting total liabilities, preferred equities, and hybrid capital from current assets. In other words, if the non-current assets are worth nothing, as long as the current assets are worth as much as recorded in the book, investors can acquire and liquidate the company, pay down all liabilities, and end up with some cash proceeds as profits.
While this approach theoretically provides a large margin of safety, in practice, detailed analysis is necessary to assess the achievable liquidation value of the current assets, which may be substantially below their book value. Even more importantly, it is often difficult for investors to acquire these companies and force asset sales or liquidation to return the money to shareholders. Therefore, net-net screening or analysis can only serve as a reference.
This discussion is intended to demonstrate that the Japanese market, despite the broad market advance over the past year, still offers some potentially deep-value stocks that are hard to find in other developed markets. For example, there is not a single net-net stock within the S&P 500 Index. The list of stocks presented is for inspiration and illustration of this unique feature of the Japanese equity market and is not a set of stock recommendations.
The Japanese equity market's recent surge is underpinned by a combination of improved economic prospects, global supply chain shifts, enhanced retail investment incentives, high-profile investments, and significant corporate governance reforms. The increase in share buybacks reflects a broader shift towards more shareholder-friendly practices, further boosting market confidence. Despite the market's rise, numerous undervalued investment opportunities remain, particularly among companies trading below book value and deep-value net-net stocks. Investors with a value investing orientation may find it worthwhile to conduct their further research on stocks in the Japanese market.
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