Disclaimer: The content on this website is for informational and educational purposes only and is not created to meet your personal financial situation. Nothing should be considered as investment advice or as a guarantee of profit. You are advised to consult with your financial advisors to discuss your investment options and whether it would be a suitable investment for your personal needs. The information used in this publication is from sources that are believed to be reliable but the accuracy cannot be guaranteed. It may include some errors, please make sure to do your due diligence. The opinions expressed are those of the author and the author only. These opinions are subject to change without prior notice.
Hey everyone! I was fortunate enough to be invited by
to have a discussion on the Japanese capital markets and the opportunity set.We discussed a wide range of topics, including the brief history of the Japanese markets, the participants of said market, some unique quirks, and why I’m excited for Japan over the long term.
He’s kindly allowed me to share an excerpt (below). If it interests you, be sure to check out the whole thing on his page!
Thank you for your support!
MIJ
Many investors fear that Japan might not be a secular shareholder value creator, what would be your counterargument here?
I don’t have a counterargument for this actually, this has been true for the last 3 decades – a lot of the profits and consequent cash generated by companies never really re-circulated in the economy as a far as shareholder value goes, and ended up piling up in the balance sheet.
My view though is that things are really changing this time and that represents the opportunity set. I’d point to the transformative shifts in its corporate landscape and market dynamics since the ‘lost decades’. Historically, Japan’s markets underperformed due to deflation, weak governance, and a focus on stakeholders over shareholders which meant capital wasn’t returned adequately to shareholders - evidenced by the Nikkei/TOPIX’s stagnation while the S&P 500 marched higher. But today, structural reforms like Abenomics and the Tokyo Stock Exchange’s push for better capital efficiency are driving change. To me it’s starting to happen at a jarring pace. Companies are unwinding cross-shareholdings, boosting dividends, and doing buybacks and we’ve seen a step change in pace in recent years. But I think this clearly signals that these companies are starting to prioritize shareholder returns.
What is your opinion on the sophistication of Japanese investors vs. foreign investors? From our prior conversations, I have always been surprised with your view on the sophistication of the Japanese investor. Who moves markets in Japan (institutions, individuals…) and why?
So over time I’ve really tried to be more nuanced in terms of the sophistication of Japanese investors. I give a lot more credit than I used to but I’ll share a few observations.
For one the market has been uninteresting to locals for decades, this has meant that there’s been limited incentives to learn about the equity markets for many Japanese people. Even today many still see this as a ‘risky gamble’. So by global standards on average I think stock market sophistication might be lagging. Anecdotally until recently I’ve barely seen talks of ROIC for example. When they look at PE ratios, it was only after the Kiyohara book (one of Japan’s most successful Hedge Fund Managers) that people started thinking of PE ex-cash which can make some businesses look A LOT cheaper. For both actual corporates and investors alike, there hasn’t been as much consideration for other valuation metrics until recently, things like EV/EBIT or EV/EBITDA or EV/FCF. That’s something I’m starting to see slightly more of but I think there’s some room to improve. It’s weird because sometimes it almost feels like individuals focus heavily on J-GAAP earnings and not the cash flow that gets generated. Although in fairness, I don’t think this is necessarily a Japanese phenomenon per se.
The other feature and the impression I get is that the investment horizon is more short term focused versus RoW. So I think trading is the more popular method in Japan. Another interesting perspective I got from a friend though is that because there are so many stocks and there’s limited capital that can be allocated relative to it, it’s like walking into a candy shop full of interesting things but you only have $5 with you. So with an abundance of opportunities among Japanese Stocks compared to the dollar amount you can invest, which is so limited, that the deciding factor has been ‘whats most interesting in the short term?’. I think that some of the short termism comes from the market trying to optimize their allocation based on catalysts.
In terms of who moves markets I think it’s relatively bifurcated, broadly speaking between large caps and small caps. In large caps the participants can be a mix of individuals as well as institutions which include both domestic and international. On the other hand, in smaller companies, the participants are mainly individuals with just a handful of funds. This happens because the market cap of these smaller companies are usually already quite small and the liquidity is not there for institutions to participate. This on the other hand provides a huge opportunity for smaller companies where there is a relatively large disconnect in valuation. Conversely large caps, especially growth companies aren’t all that ‘cheap’ by several measures.
Do you think that the fact that individuals are so prominent and unsophisticated in Japan is an opportunity (through more price dislocations) or a risk (because the real value might take longer to show up)?
I think it’s a massive opportunity because it’s not going to continue like this – Japanese Investor literacy was behind because the market was not interesting and they were right in that the index has been flat. We’re starting to see more interest from individuals and I think the literacy is improving extremely quickly. I mean I’ve been fortunate enough to meet some of the best individual investors in Japan who’s CAGR-ed at insane rates and I’d put them up there against anyone out there globally. These guys were early, and I think there’ll be more coming out of the woodwork.
So I think that ‘discovery’ phase of undervalued companies will happen faster and faster as the cohort of investors knowledge base improves. Japanese individuals are studious and hard working, if the opportunity is right I think individual investors as a cohort will start to improve quickly. The question is “can the Japanese equity market remain interesting long enough for them to want to study it?” My answer is yes, because of so many of the changes we’re seeing but we’ll have to see. And I think interest is increasing for stocks in general thanks to the new NISA (Nippon Individuals Savings Account) a Tax Exempt Investment Scheme for individuals. Which means that there is an added incentive for consumers to be investing their savings in Stocks.
The risk you mention is real in the sense that good companies may stay cheap for longer than you hope but I think the reality is that you just have to adapt your investment process somewhat to the local rules, lets say. If your incremental buyers are individual investors, then instead of complaining they’re wrong I think it’s best to understand how they think and think about what is going to make them want to buy the stock and therefore uncover the value? I had to learn this the painful way but I think for me I spend a lot of my time on figuring out what the catalyst is and if that event would be interesting enough for the market to realize. The opportunity for me is finding the areas in which my investment strategy overlaps with what the market wants to buy. Admittedly this does invite some short-term thinking but ultimately I want to buy businesses that are long term opportunities, just that I want the value realized sooner rather than later.
Another opportunity of course is the participation of international investors, which may have more sophistication arguably. I think these participants will value companies more appropriately which almost usually mean at higher valuations. With Japan becoming more interesting to many foreign investors I think this is going to have a positive impact as money flows into the country.
What seems clear is that there are certain changes in Corporate Governance being implemented in the country to try to close the valuation gap with other countries. Which of those corporate changes would you highlight?
They are all interrelated so it’s hard to isolate them but I think the ones most directly related to increasing shareholder value is the most interesting. Namely this is the companies focus on improving ROE as well as making sure they’re not valued at below 1 times book.
I think the focus on ROE and releasing the pent up cash balance is a powerful one that could create a positive feedback loop to then attract more investors into these companies which conversely improves liquidity and valuation for these businesses. The more they see the results in terms of improved valuation, the more they may be compelled to keep doing it.
My hot take is that the improving board independence narrative is kinda BS. I mean the spirit of this is absolutely positive but the reason why is because by the numbers representation from independent directors are improving. But by sophistication, I think these independent directors don’t know enough to have the shareholders best interest in mind. They’re not ‘colluding’ with management or anything like that but you have to remember Investor sophistication for Japan as a whole has been behind and this includes the directors too! So directors are only starting to learn what ‘shareholder capitalism’ is.
I’m fortunate enough to be in a place where I get to hear some of these stories and … seems like focus on things like ROIC or cashflow is absent. It’s also been a bit of a box ticking exercise where today we’re seeing pro-athletes or TV announcers being nominated on the board as independents. Now I think this is on one hand is symptomatic of the shortage in board talent in Japan. With all due respect, if this is what having an ‘independent’ board means, we’ve got some work to do.
Any interesting opportunities you are seeing that you’d like to discuss briefly?
I mean I’ve written about this on my substack already a few times, but I like SaaS businesses in Japan. I think some of them are ridiculously cheap at the moment. You have recurring revenue streams that are profitable at 1-2 times sales! Many actually also trade at pretty attractive earnings multiples. Though unfortunately not below book value. However, I think some of these businesses have been able to build a significant foothold in the market, are generating tons of cash and can continue to grow at a decent rate (by that I mean at least mid-teens). In my mind we’ve only started embracing the public cloud like… 5-6 years ago so there’s a significant runway in my opinion. I also think there’s simply just a huge opportunity for Japanese corporates to ‘DX’ this means “Digital transformation”. It’s pretty amazing even at large companies how much paper is still being used. There’s a lot of low hanging fruits that I think will be solved over time.
There’s an index called the One Capital Cloud Index which is an index that constitutes of SaaS businesses in Japan. The Median P/S is 3.7 times. But the median growth is 18.6% and operating margin is 17.7%.. so the median Japanese SaaS is almost a Rule of 40 company and trades significantly below global benchmarks – I think this is too cheap. Like I said earlier given that I think there’s significant room for digitalization in Japan, I think we’re still early in terms of the growth curve.
The risk people talk about is AI disrupting software – but will this really happen? I’m skeptical because selling software to companies in Japan has ironically required significant man power – sales people going to offices and engineers helping customers implement the systems. Are these same customers really going to all of a sudden figure out which AI agents to use for their business? This, I seriously doubt. My belief is that System Integrators (Japanese System Developers) and SaaS companies will be the gatekeeper for AI in Japan.
Probably this last question is a bit open-ended, but what is the market missing here? Why does Japan remain a country where there are ample opportunities?
I think we’ve discussed the main topics already but I think people are starting to understand how Japan works and the opportunity set. A lot of this governance change is not new but has been playing out gradually over a decade – in recent years this has accelerated and the market got excited about it. I think one thing is not to underestimate how long this can go on for. Funnily the index has been flat pretty much from summer last year after a solid 1.5 year run. This makes me more bullish about the Japanese market because I think there’s way more to come – it’s not about how it is today but how it could be 5 , 10 years down the road and I think it can be very bright.
One nuance that I may be different to the rest of the market is how long the changes will take – the impression I get is that these improvements will happen in the next few years but with the context of long decision making processes, the learning curve, lack of related talent in Japan – I think the improvements are going to take longer than what many might be expecting.
Finally, I think they’re ample opportunities because it’s not just the cash rich value stuff that’s cheap in my opinion– but also the growth companies which are mid caps or smaller. These look less cheap than the value names by valuation metrics, but still trading at incredibly low earnings multiples. These have gotten sold off quite heavily post Covid despite many (like the SaaS companies) having ample room to grow domestically. I’ve been more focused on writing about these growth names on my substack as it feels relatively less talked about in the context of Japan. So there’s an opportunity for multiple investment styles in my opinion and the more vibrant the capital market gets through participation of more local investors, foreign investors and the like I think we’ll start to see some incredible outcomes.
Disclaimer: The content on this website is for informational and educational purposes only and is not created to meet your personal financial situation. Nothing should be considered as investment advice or as a guarantee of profit. You are advised to consult with your financial advisors to discuss your investment options and whether it would be a suitable investment for your personal needs. The information used in this publication is from sources that are believed to be reliable but the accuracy cannot be guaranteed. It may include some errors, please make sure to do your due diligence. The opinions expressed are those of the author and the author only. These opinions are subject to change without prior notice.