Why Japanese Stocks Now?

Nikkei rallied up to 30% in 2023 outperforming major stock market indices including S&P500. The unexpected rise of the long time loser caught global investor community by surprise, catalyzing a revisit to the third largest economy in the world after three decades of economic stagnation. As the index approaches the all time high far back in 1989, many institutional investors, for example, BlackRock and Fidelity, ramp up their asset management business in Japan, betting on the nation’s long awaited departure from the deflationary regime.

BlackRock’s Fink Sees Echoes of 1980s Miracle in Japan

Mixed Sentiment

As the US treasury trades near 5%, the equity risk premium has never been as tight as today, weighing on valuation not only in the US but globally. As Nikkei also lost part of its YTD gain, the general climate seems rather bearish and worried about the impending rate hike, the impact of which is beyond imagination as Japanese people are unfamiliar with the rate environment which is meaningfully positive.

However, foreign institutional investors and leveraged funds are rather bullish on Japan. Anecdotally, we have seen an increase in job posts looking for Japanese speaking portfolio managers and analysts, partly driven by resources shift away from China at risk of balance sheet recession. We do see signs of more market participants in Japanese stock market with the average daily transaction value in Tokyo Stock Exchange above JPY 3 trillion, versus below JPY 2 trillion till last year.

The optimism among foreign investors looks odd to Japanese people as most feel left behind inflation - our wage by and large remains flattish so far, while prices have soared due to the weakening yen and increasing input prices. At the end of the day, we have not seen the trickle down effect after a decade of the weak yen policy as Japanese companies would not repatriate dollars they earn overseas but continue to invest overseas. However, smart money always looks ahead of the curve. Last night, the country’s largest labor union agreed to seek a 5% wage raise next spring, which is expected to set the stage for healthy and sustainable inflation down the road.

Rengo sets high 5% pay-scale raise goal for spring ‘shunto’

The “g”

Inflation poses tremendous upside risk for Japanese equity. In theory, share price is determined by earnings divided by (r - g) and the industry practice to triangulate the g is to use nominal GDP growth rate give or take a few percentage depending on the subject’s industry profile. Assuming earnings of 100, r of 10% and g of 3%, the intrinsic value would be 1,430. Now we recall once again that Japan has been deflationary for the past three decades and is now entering an inflationary regime, in other words, achieving the 2% target up from 0% - what does this mean in terms of valuation? With the same discount rate, it poses a 25% valuation upside plus additional earnings potential in nominal value.

You may wonder - how far have we come so far? The short answer is that the inflation narrative in Japan began to be heard this spring when Nikkei was still trading at about JPY 29,000, thus leaving another 15% upside in the mid-term. Although the impending rate hike may cause short-term dislocation, it is in my view highly unlikely to affect corporate earnings negatively as Japanese companies are generally cash rich (Don’t mention the public sector debt…) and far less indebted than those in the US or Europe.

Mid-to-Small Cap Opportunities

While it is always good to invest in index products to save time and generate reasonable return at the same time, you may wish to include Japanese single name stocks to differentiate your portfolio. Japanese stocks, particularly mid-cap and small-cap, are significantly undervalued compared with US stocks given the lack of English disclosure discourages foreign investors to invest in such an universe. As more smart money flows into the market, however, we are likely to see ample opportunities with mid-cap and small-caps.

Top Japan Fund Bets English Disclosure to Lift Small-Cap Shares

So here I am to share my select investment ideas in Japanese market. I am a native Japanese used to cover Japanese equity at North American investment bank and asset management company. After retirement, I am actively managing my own money and happy to share my piece of fundamental investment research and perspectives here so that you could make informed decision to invest in Japan. If you do not want to miss out once in three decades opportunities in Japan, do not forget to subscribe! :)