On 22 February 2024, Japan’s Nikkei 225 closed at ¥39,098.68, eclipsing the previous record high set in December 1989–a staggering 34 years ago. As we highlighted in a prior article, Japan went through a truly extraordinary boom in asset prices through the 1980s that caused a bubble to form in the value of both shares and real estate that would take more than 3 decades to overcome–a period that surpassed even the 25 years it took for the Dow Jones Industrial Average to fully recover following the Great Depression in the United States from 1929 to 1954.

One key concern for investors considering allocating funds to Japan is the country’s ageing demographic. Japanese lifespans are among the longest in the world, something that would have once been an enviable statistic. Yet an ageing workforce combined with low birth rates and low levels of immigration has meant that Japan’s workforce peaked in 1995. Japan is a country steeped in tradition and has long been leery of opening its workforce to immigration to offset this trend. However, the late Prime Minister Shinzō Abe considerably softened Japan’s labour migration policies, including reforms in 2017 and 2018 that made it easier for skilled workers to obtain permanent residency permits and increased the number of visas available to blue-collar workers (this was part of a series of widespread economic reforms most commonly referred to as “Abenomics”).

Today, approximately two million out of the 69 million employed in Japan are foreigners according to the Ministry of Health, Labour and Welfare. The majority of these are employed in manufacturing and service roles (which account for 43% of Japan’s total foreign workforce) and originate from eastern or southeastern Asia (predominantly Vietnam, China and the Philippines). Unfortunately, this influx of workers has done little to ease Japan’s labour shortages, with unemployment hovering at an extremely low 2.4%–similar to levels prior to the pandemic and a key driver behind the recent surge in inflation. Unlike many other nations around the world, however, this inflation is actually welcome (to some degree) given the country’s persistent deflation and high debt levels.

 

Another quirk of the Japanese market (as well as other Asian markets) is the number and extent of cross-shareholdings. Large Japanese companies, such as the Sogo shosha that Buffett has invested in, often hold significant stakes in other public and private companies–which can in turn, hold stakes in the parent company itself or other companies. This creates substantially greater complexity for prospective investors, and can often become the sole reason they choose not to allocate funds to a particular company. The purported benefit is to cement long-term relationships between companies but they can also dissuade takeovers, reduce the influence of minority shareholders, limit competition and obfuscate the financial strength of a company.

Fortunately, the Tokyo Stock Exchange has introduced a number of mandates that should improve transparency and returns for investors. Two of the most significant of these concern company valuations and cross-holdings. Specifically, the Japanese market operator has directed companies with a price-to-book value of less than 1.0 to disclose specific initiatives that they have in place to increase this ratio above 1.0. This is significant given that it impacts an incredible 39% of the TOPIX 500, as compared to just 5% of the S&P 500.

As a very broad guideline, a company that consistently generates a return on equity above 10% will usually have a book value at or above 1.0, while those generating an ROE below 10% will most commonly trade at a P/B multiple of less than 1.0. The denominator in the ROE equation (equity) is a key factor in determining this outcome, and can be heavily influenced by the amount of cash held on the corporation’s balance sheet. In essence, reducing the amount of cash by returning it to shareholders through dividends or share repurchases can immediately lift a company’s ROE and therefore its valuation.

The second major reform is designed to reduce the prolific level of cross shareholdings by requiring firms to annually assess whether there is an appropriate purpose for having this relationship (if not, the cross-shareholding should be disposed of). The pressure appears to be having an impact, with cross-shareholdings dropping to a record low level in 2023. In total, cross-shareholdings have reduced from approximately one-half of Japan’s stock market to approximately one-third today, according to Nomura Institute of Capital Markets Research (one-third of a $6.6 trillion share market is still an incredibly large number, implying that this proposal has significant room to run).

 

Japan’s economy surprisingly slipped into recession in 2023, it was reported last month, falling an estimated 0.4% in the October-December period following a 3.3% decline in the prior quarter (by comparison, market forecasts had called for a 1.4% increase in the December quarter). This might seem confounding that the share market is notching all-time highs at the same time that the economy is sluggish. Yet it’s important to remember that the share market is not the economy. It accounts for just a small portion of the overall economy that is usually concentrated in certain sectors (such as financials) and omits large portions of the economy (such as services). Therefore, while the Japanese economy may not be performing at optimum levels, its publicly-listed corporations can still be (and are) experiencing high levels of profits.

Additionally, Japan is undergoing a true transformation of its corporate governance, which may take some time but is likely to lead to substantial value creation for shareholders. The pressure to reduce cross-shareholdings should simplify the analysis of Japanese corporations and lead to greater efficiency, M&A activity, and capital return to shareholders. Dividends and share buybacks should also get a boost from less hoarding of cash, increasing the appeal of share ownership among both Japanese and international investors. These are all good reasons why the Japanese share market has performed strongly in recent times, and the low valuation suggests there might be more to come–particularly given the increasingly elevated valuations in the U.S.