How Japanese stocks got back on track

On March 14 2017, amid the hustle and bustle of Tokyo’s Minami-Nagareyama railway station, a Tsukuba Express train pulled away from the platform at 9.44am. On the face it, there appeared to be nothing unusual about its departure.

In fact, something had gone wrong. The driver had moved off 20 seconds early – at 9.44.20 rather than the scheduled 9.44.40. The operator of the service, Metropolitan Intercity, duly issued a public apology for the “severe inconvenience” suffered by its customers.

The incident was reported worldwide. It was offered as amusing proof of Japanese firms’ fierce commitment to honing their craft and striving for perfection.

That Japanese businesses have extremely high standards and are quick to apologise for and correct errors is beyond dispute. Yet that commitment to perfection has not always extended to the balance sheet.

Many Japanese companies have made a habit of holding too much cash and not returning sufficient profits to their shareholders. This often conceals the impressive returns on invested capital generated by building world-leading products that dominate a specific niche and by cultivating employee bases that accumulate inimitable expertise through years of dedication.

Now, at last, this problem is being addressed through the adoption of tougher governance and stewardship codes. As I discovered during a recent fact-finding trip to the Land of the Rising Sun, this is likely to be good news for investors.

Transformation in action

Needless to say, the focus here is not so much on making trains run on time. The culture of many Japanese companies remains centred on continuous improvement – kaizen – and creating value over decades rather than quarters. The recent impetus is about ensuring more firms return a greater proportion of that value to shareholders.

The principal architect of this transition is the Tokyo Stock Exchange (TSE), which last year finalised its new market restructuring rules. Central to these is a requirement for listed businesses to “comply and explain” if they trade at a price-to-book ratio of less than one – likely a sign of inefficient use of capital.

In March 2023 the TSE reported that around half of its “prime” listings and approximately 60% of its “standard” listings fell into this category. Under the new regime, these firms would need to demonstrate how they intend to enhance their capital efficiency.

Crucially, they would also need to show they have engaged with investors in seeking to improve. This in itself represents a significant shift for many companies.

In theory, a business that fails to satisfy these demands could have its securities placed under supervision. Eventually, it could even be delisted.

In truth, neither of these outcomes is especially likely. But that is not necessarily a concern. Instead of relying on strict regulation, the TSE is betting on the power of peer pressure to drive sweeping transformation.

Leaders and laggards

I attended a keynote speech by Hiromi Yamaji, the TSE’s CEO, during my trip. He was appointed in 2021, having previously held roles including Head of Global Investment Banking at Nomura Securities. He worked overseas for many years, developing a deep understanding of how foreign investors think.

Mr Yamaji entered office acutely aware that many Japanese companies had a concept of shareholder returns at odds with that of shareholders themselves. He also recognised the TSE’s limited scope for enforcing change.

His solution: set out robust guidance and let the market do the rest. He reasoned that if sufficient firms proved willing to embrace a new approach to corporate governance – even on a largely voluntary basis – others would inevitably follow suit.

He was right. The culture of mutual respect that has always run through the Japanese business world is compelling more and more companies to follow the lead of those that were quick to respond to the new codes.

The ripple effects are considerable. The controversial practice of cross-shareholding, which involves firms holding shares in their business partners, is falling out of favour. Buy-backs, board independence and female board membership are all on the rise. Investor disclosure is now routinely published in both Japanese and English. Maybe above all, many companies are reducing high cash levels held on the balance sheet – a tendency born out of Japanese management teams’ lived experience through the debt-fuelled boom-and-bust cycle in the ’80s and ’90s.

The TSE has even started producing best-in-class case studies. They highlight businesses that have reduced their cash balances, raised their dividends, restructured their boards and upped investor engagement. Again, the laggards are taking note and making efforts of their own.

There is no disputing... that the direction of travel is positive

Proof of positive change

The Artemis Global Select Fund had increased its exposure to Japanese stocks in the third quarter of 2022. Market momentum has since led us to rotate out of some of the more well-known companies and instead focus on smaller firms that are leaders in their respective niches yet often fly under the radar.

This inspired my March 2024 research trip, during which I met with nearly 40 companies. Most were able to show me a solid plan for delivering returns and generally aligning their policies and practices with shareholder interests.

Similarly, I was frequently invited to give my own thoughts on a business’s strategy. This underscores that Japanese firms are open to broad perspectives as they optimise shareholder return policies.

Mr Yamaji regards such dialogue as essential. He also sees “activist” investors as sources of necessary disruption – welcome catalysts for revealing latent and unappreciated value in companies.

Of course, whether the TSE is ultimately able to bring every business in line with this thinking is a moot point. The exchange is home to almost 4,000 listings, which means a market-wide conversion remains a sizeable task.

There is no disputing, though, that the direction of travel is positive, which is why the arguments for Japanese stocks appear stronger today than they have for many years. Even if a train might occasionally set off 20 seconds early, the Land of the Rising Sun finally seems back on track.