A Bullish View on Japanese Companies

Japanese stocks are experiencing a historic rally and the Bank of Japan has raised interest rates for the first time since 2007. With this backdrop, the Portfolio Management team discusses the market rally, interest rates, ongoing inflation, expectations for tourism, and current valuations.

April 2024
  • Masakazu Takeda
    Masakazu Takeda, CFA, CMA
    Portfolio Manager
  • Angus Lee
    Angus Lee, CFA
    Portfolio Manager
  • Kohei Matsui
    Kohei Matsui
    Portfolio Manager

With the Nikkei climbing above 40,000 for the first time, what could keep stocks climbing?

We believe Japanese stocks could continue rising based on the following: 

•    The Bank of Japan (BoJ) interest rate hikes this year. An increase in rates should pave the way for Japanese banks to improve yield on assets after many years of ultralow interest rates.
•    Tokyo Stock Exchange’s (TSE) continued effort to drive market reforms. Importantly, the TSE has encouraged listed companies trading at a price-to-book (P/B) of less than 1x to focus on stock prices and capital efficiency.
•    Potential wage increases at the upcoming nationwide spring wage negotiation season, which should solidify Japan’s much-needed sustainable inflation with positive real wage growth. 
•    A benign currency environment. With a depreciated Japanese yen versus the U.S. dollar, exporters have enjoyed solid earnings growth accompanied by improving capital efficiency.
•    Japan’s geopolitically neutral destination for global equity investors. Japan is attracting foreign direct investment at an accelerated pace particularly in the semiconductor manufacturing area, which should bode well for local economics across Japan.
•    The Nippon Individual Savings Account (NISA) program, a tax-free investment savings account for individuals that began in January 2024. The overhauled program offers a higher maximum investment amount, which should encourage Japanese retail investors to put more money into the stock market. The impact could be significant as Japanese households hold approximately $15 trillion of financial assets in aggregate.

The BoJ increased interest rates for the first time since 2007 in March 2024. What’s next?

We believe that raising interest rates too quickly might stifle the economic recovery and could cause deflation. In other scenarios, if the BoJ’s rate hike coincides with the U.S. rate cut, the yen could reverse sharply hurting the export industry, which in turn dampens the domestic economy. Exiting from unprecedented quantitative easing measures is another tricky path for the BoJ Governor Ueda. The BoJ would likely want to err on the side of higher inflation owing to its mistake in the early 2000s under then-BoJ governor Hayami, who prematurely lifted the quantitative easing measure entailing a faltering of the economy and worsening deflation. 

That said, we believe the Japanese economy has the ability to absorb an increase of at least 50-100 basis points. Particularly, if the BoJ pushes through the normalization of interest rates with a “short-term pain for long-term gain” approach such that many “zombie” companies can be weeded out along the way, then it will make a more compelling argument that Japan is finally changing. 

Would you please provide an update on inflation in Japan? 

We believe domestic inflation will remain “higher for longer” than currently predicted by the stock market and the BoJ. There are signs pointing to higher inflation in the future. For example, the high import prices have been adding to inflationary pressure, and the yen’s depreciation seems to be causing inflation through other avenues as well. In addition, the Tokyo Stock Exchange’s efforts to improve the share prices of listed companies with a P/B of less than 1x could also bring about inflation indirectly. Raising return on equity (ROE) is one effective way to increase share prices, but to do that, Japanese companies need to price their goods and services more adequately, which have been kept too low compared to global standards, and secure better profit margins. Put differently, this stock market reform could not be achieved without inducing inflation.

Other notable factors include the following:  1) An influx of international tourists, an area of focus by the Japanese government for its growth strategy, is helping to increase prices in the services sector; 2) a rapid increase in semiconductor-related foreign direct investments by TSMC and Micron as well as the government-led project to build Japan’s first-ever chip foundry company Rapidus are projected to amount to more than $100 billion collectively, creating favorable inflationary trends in many parts of Japan; and 3) this year’s spring wage negotiation season, which could be another year of strong year-over-year growth (higher than last year). Combined with softening of raw materials prices, the real wage growth could move into positive territory this year.

What are the expectations for tourism in 2024? 

Japan has experienced a strong recovery in tourism despite the absence of many Chinese tourists, which accounted for 30% of a total 30 million visitors in 2019. If Chinese people resumed their travel to Japan, the upside could be significant. Furthermore, equally important is per tourist spend, which was around $1,450 at the previous peak in 2019, representing roughly 1% of GDP. We are optimistic of a comeback of overseas tourists. 

We believe inbound tourist numbers could exceed the previous peak given that:

•    With the yen’s decline against the U.S. dollar over the last three years, the same dollar amount gives a visitor 30% more purchasing power today.
•    Smaller popular tourist destination countries such as Spain and France attract far more visitors (80-90mn) than Japan.
•    Within Asia, Thailand, also a smaller country than Japan, has been successful in drawing in 45 million tourists annually.

With the market rally, how do valuations in Japan compare to the U.S. and Europe? What is the price to book (P/B) and price to earnings (P/B) of the portfolio?  

When comparing the long-term cumulative returns among the three developed markets, Japanese equities lags the U.S. and European indices. Since the end of 1989, Europe’s FTSE All Shares index has grown eight-fold, and the S&P 500 Index has risen 26x. Although Japan is a significant laggard, it may bode well for performance in the coming decade. 

Valuations appear reasonable. In 1989, the stock market was much frothier and corporate earnings did not support the elevated valuation multiples. Today, a P/E of 15-16x forward earnings feel a lot more “down to earth” thanks to strong corporate profitability across major large-cap names. 

The market cap leaderboard looks very different today than 34 years ago too. At the end of 1989, over half of the top 20 market cap names were commercial banks, most of which ceased to exist during the consolidation that ensued. For example, the Fund’s holding Mitsubishi UFJ Financial Group was created through the merger of Mitsubishi Bank, Bank of Tokyo, Sanwa Bank, Tokai Bank as the major components. 

Today, the market is more dominated by Japanese global enterprises such as Toyota, Sony Group, Keyence, Fast Retailing and Tokyo Electron, most of which are held in the Hennessy Japan Fund. 

As for the Fund’s valuation as of the end of February 2024, the P/B was 2.17x compared to the Tokyo Stock Index Price’s (TOPIX) 1.49x. The weighted average P/E is nearly 19x, which is only slightly higher than TOPIX’s 16.8. Considering that our portfolio is made up of high-quality companies with above-average growth profiles and returns on capital, we believe the Fund’s valuation is attractive.