Japanese firms trade at EV/EBIT multiples less than half of their US peers. Even Japanese investors don't like investing in Japan – they've slashed their domestic equity exposure by tens of trillions of yen over the past three decades, and now hold over half of their assets in cash. Why?
We believe that the languishing of Japan's stock market has become a self-fulfilling prophecy, an example of anchoring bias writ large. Over the past 30 years, Japanese equities as a whole have performed so poorly that investors have become deeply disillusioned with the prospect of ever receiving an adequate return. Some of this is deserved. Management in Japan has traditionally been heavily entrenched and has prioritized stakeholders over shareholders and stability over capital efficiency. However, we believe qualitative signals suggest corporate governance norms are changing, and quantitative data supports it.
In our Fundamental Value strategy, we seek to identify and exploit investor biases to find misvalued opportunities in public equities. Sometimes these biases are idiosyncratic, pertaining to only a particular security, while others are endemic to a group of securities. The pervasive discounting of Japanese stocks is the largest size and scope of any bias we have yet uncovered.
The Largest Bubble of All Time
In the 1990s, Japan was fifty years into its post-WW2 economic miracle, and its economy was the envy of the world. Japan had grown GDP by over 10% annually for decades, and economists argued over just how soon Japan would eclipse the US to become the world's largest economy.
Japan's exporters were the epitome of excellence. Companies like Sony, Nintendo, Panasonic, and Canon dominated the global consumer electronics industry, developing trendy, innovative and industry-leading products like the Sony Walkman, VHS players, and the Nintendo Entertainment System. Toyota's cars were exploding in popularity, and its manufacturing process was already legendary and widely emulated. Japanese semiconductor manufacturers dominated the burgeoning market for computer memory so thoroughly that Intel was forced out of the memory business to try its hand at logic.
This economic boom produced arguably the largest asset price bubble of all time. The value of the land under Tokyo's Imperial Palace – less than a square mile – was on paper more valuable than the whole of California. Japanese equities comprised nearly 50% of the total global market cap versus less than 30% for the US. Western businesses brought in Japanese businessmen to give their US counterparts lessons on capitalism and manufacturing. Debt exploded as capital was cheap and accessed liberally.
These halcyon days were not to last. In Japan, the 1990s – later to be termed "The Lost Decade" – saw a precipitous slowdown as annual GDP growth fell to only about 1%. Business investment declined sharply, and asset prices collapsed spectacularly. In 2004, prime commercial real estate in Tokyo traded at less than 1% of their peak value. Residential real estate was down over 90%. The Nikkei 225 stock market index (Japan's equivalent of the Dow Jones Industrial Average) plunged 80% from its 1989 high.
Japan fell victim to a version of the middle income trap. Japan's economic engine was low-cost manufacturing, but there is only so far that manufacturing prowess can take a country up the income ladder. As Japan became wealthier, labor became increasingly expensive, undermining competitiveness. Japanese exporters could not follow the same old formula and continue to grow revenue and profit. Japan needed to transition to knowledge work and high-value-add manufacturing.
Japan needed to deleverage and reinvent its economy. Unfortunately, this does not come naturally to Japanese-style capitalism.
Retooling the economy
In the US, misallocation of capital is cured by creative destruction: bankruptcies, mass layoffs, and write-offs. Capital is quickly reallocated to more productive uses and workers retrain. Most recently and spectacularly, the United States saw this during the Great Financial Crisis due to overinvestment in housing. In the aftermath, the unemployment rate spiked to 10%, corporate bankruptcies tripled and non-financial corporates paid down debt. This period was extremely painful, but short-lived – GDP recovered to its 2008 high within about two years.
Japan does not have a social contract that permits such a painful episode. In Japan, companies practice a form of stakeholder capitalism, where the interests of shareholders are often subordinated to the interests of vendors, customers, society, and, especially, employees. Employment was traditionally considered more of a familial, lifetime arrangement: companies hired fresh graduates and implicitly guaranteed a job until retirement and a pension afterwards. In return, the Japanese salaryman was expected to work long hours with unwavering loyalty.
Because the relationship with firms has historically been a pseudo-familial one, there have been other obstacles to corporate dynamism and responsiveness. Management is often appointed based on seniority rather than strictly on merit. Since employment is traditionally for life, acquiring fresh talent and perspectives through lateral moves is rare.
Moreover, management teams tend to be heavily entrenched. As late as 2004, a third of listed companies had no independent directors. A common practice in Japan is cross-shareholding, where two corporations own substantial chunks of each other as a reciprocal passive investment. At the peak, these friendly cross-shareholders controlled 70% of the public market in Japan, and served to insulate management from takeovers and shareholder activism. In fact, shareholder activism is very rare, and there are strong social norms against unsolicited bids and hostile takeovers. Banks have not been willing to fund unsolicited offers, and corporate boards replete with insiders will often discard or even ignore them. In the US, we'd call this weak corporate governance; in Japan, this has just been the accepted corporate compact. Regardless, these practices have meant that the market for corporate control has historically been extremely limited.
It is beyond the scope of this paper to make any relative value judgments about stakeholder capitalism versus shareholder capitalism. However, it is clear that they can lead to starkly different outcomes.
In Japan, after the bubble burst, financial institutions and the government were unwilling to let companies fail, and corporations were unwilling to undergo layoffs. Despite its economic struggles, Japan has never experienced an unemployment rate above 5.4% – a level so low it would be consistent with many boom years in the US. Instead, heavily indebted firms were kept afloat by their bankers, who used extend-and-pretend practices to avert bankruptcy. In turn, the government practiced generous fiscal policy, unprecedented monetary easing, and made direct capital injections to spur demand and keep financial institutions solvent. This resulted in a de facto nationalization of private sector debt – gross public debt as a percentage of GDP rose from less than 40% in the '90s to over 250% today, one of the highest ratios in the world.
This led to the rise of so-called “zombie firms:” companies who were functionally insolvent yet allowed to remain afloat by Japanese banks that were unwilling to write off the bad debt. This undoubtedly saved jobs and reduced economic distress in the short term, but it came at great cost. A reallocation of human and financial capital into more productive uses that might've been accomplished in the US via a short and sharp recession was instead drawn out into an economic stagnation that lasted decades.
Chastened by their experience with the enormous debt loads of the bubble years, Japanese firms have collectively sought stability through fiscal conservatism. They have spent the last 30 years hoarding capital and building fortress balance sheets rather than investing in growth or returning capital to shareholders. In aggregate, public companies now run a net cash position. Many companies hold cash and securities representing well over half their market capitalization.
As a result, the Lost Decade that started in the 1990s is arguably still ongoing. Economic growth has stagnated, with Japan's nominal GDP falling from $5.6t in 1995 to a mere $4.2t in 2023. In 1995, GDP per capita in Japan was 50% greater than in the US; today, GDP per capita in Japan is nearly 60% lower than in the US.
In 2024, the Nikkei 225 set a new high – its first since 1989. Some investment professionals undoubtedly worked their whole career in finance without seeing a new high in the Nikkei. In contrast, over the past 50 years the S&P 500 has hit a new high in more than a quarter of all months. For US investors, conditioned on constant new highs, the idea of 34 years of negative nominal returns is nearly unfathomable. The last time the Nikkei set a record, the USSR still existed – and five of the eight largest US companies didn't.
Promoting capital efficiency
This is of course a stylized version of the economic history of Japan. But this narrative is consistent with market perception, and the perception of Japan as a deflationary capital sinkhole has driven valuations down to unreasonable levels. We believe this narrative is misleading at best. While Japan has its problems, the country is getting serious about generating higher returns on capital through economic and corporate governance reform, creating a phenomenal tailwind for discerning investors.
First, we believe Japan's seemingly unending economic transformation is largely complete. We suspect that many people still have an outdated idea of Japan as predominantly a consumer goods exporter. However, Japanese companies today have become global leaders in advanced materials, components and inputs that are critical to many industries and supply chains, as Ulrike Schaede documents in his excellent book The Business Reinvention of Japan. Schaede calls this an "aggregate niche strategy." For example, in our portfolio, we hold companies that manufacture ultraprecise grinding machines, top-of-the-line human machine interfaces, and high-precision Swiss type lathes, respectively, all of which have only a few global competitors. These companies are not well known – no consumer knows who built the machine tool that polished the silicon wafer that eventually becomes a chip in their iPhone – but they are indispensable, high-tech inputs to secular growth industries. Japan now dominates global market share in many such niches, providing a strong foundation for long-term economic growth.
Second, we believe Japan is escaping from its debt-induced deflationary trap. After decades of unprecedented monetary policy, Japan has finally seen inflation – inflation has been above the Bank of Japan's 2% target for 28 straight months. Benchmark interest rates were raised for the first time since 2007 and are now positive for the first time since 2016. Wage growth is strong, indicating healthy corporate demand for labor. Japan's "shunto" – the annual wage negotiation between labor and large employers – resulted in a 5.3% wage increase in 2024, the largest in 33 years. Real wage growth is finally turning positive.
Third, reforms are starting to bear fruit. On the economic front, the government has enacted growth-oriented reforms like deregulation and tax cuts. They've promoted public-private investment partnerships to increase competitiveness in key industries. They've entered into new free trade agreements. This year Japan also instituted new rules for NISA, their IRA-equivalent program, increasing investment limits and making the tax benefits permanent, to attempt to boost domestic investment.
Governance reforms, which began over a decade ago under Shinzo Abe, have been slow to take hold. This is unsurprising, as Japan has a "tight culture", with strong norms of behavior and low tolerance for deviance. Thus, decision making in Japanese organizations emphasizes stability and consensus building over dynamism and individuality. While this makes Japanese corporations resistant to change, there is a bright side: once sufficient momentum has been built in a new direction, a trend will become powerful and self-fulfilling.
Under the leadership of the Japan Exchange Group (JPX) and the Ministry of Economy, Trade and Industry (METI), we believe Japan has reached such a tipping point for corporate governance reforms.
The JPX has arguably made the most impact. Over the past decade they have pushed for companies to appoint independent directors, mandated English-language financial disclosures, and encouraged open dialogues with investors. They have also recognized that persistent undervaluation (nearly 40% of the top 500 companies in Japan trade below book value versus only 5% of the S&P 500) serves no one. Thus, the exchange requested in March 2023 that all companies on the “Prime” and “Standard” markets analyze their implied cost of equity capital, disclose an improvement plan if necessary, and be conscious of their stock’s valuation when managing the business going forward.
As a result of this pressure, corporate governance and capital allocation practices have improved across many different metrics. Buybacks are up 60% year-over-year in 2024 and as of July had already surpassed the 2023 total. Cross-shareholding is down, with insiders comprising only 20% of shareholders, down from a peak of 70%. Independent directors representing the interest of shareholders have also increased dramatically. In 2015, only 12% of corporations had a board that was more than one-third independent; in 2023, 95% of boards cleared this hurdle.
In 2023, METI published new M&A guidelines for the first time in nearly 20 years. The old guidelines were focused on actions corporations might take to defend themselves from unsolicited offers, such as poison pills. The new guidelines promote and encourage M&A, and force companies to seriously consider unsolicited offers.
The 2023 guidelines are already having an effect. Last year, Nidec Corp, a Japanese company that is one of the world's largest manufacturers of electric motors, successfully acquired a smaller competitor via an unsolicited takeover bid at roughly double the unaffected share price. Nidec’s CEO hailed the new guidelines. In August, a Canadian convenience store giant made a $38b offer for Seven & i Holdings, the parent company of 7-Eleven, a cornerstone of Japanese life. This would be the largest-ever foreign acquisition of a Japanese firm. The company has rejected the proposal, stating that it grossly undervalues the shares and citing potential regulatory issues. However, Seven & i have stated they are open to considering another offer if their concerns are addressed. The mere fact that Seven & i is engaging with a hostile foreign bid represents a pivotal moment in the country’s corporate-governance revolution. Even if this particular deal is not consummated, we think it portends an unprecedented wave of M&A to come. Global private equity firms have noticed the opportunity as well and are ramping up activity in Japan, including Blackstone, which raised its first-ever fund focused on the country. Shareholder activism is still infrequent, but there were 103 campaigns last year, up from a measly 14 in 2013.
This wave of mergers may unlock tremendous value. Many industries in Japan are fragmented relative to Western counterparts, having been starved for decades of synergistic M&A. As GMO put it, “Does Japan really need 10 automakers and 13 printer manufacturers?” Furthermore, an active M&A scene will put a floor under share prices. Stocks will tend to trade at prices closer to their intrinsic value as investors begin to expect unsolicited bids for companies whose management teams fail to maximize shareholder value. And once management knows that running an inefficient balance sheet or bloated payroll risks their company becoming an acquisition target, they will be much more amenable to shareholder friendly policies in the first place.
Investors are noticing these changes. Domestic investors are pouring into the new NISA accounts. The first five months of 2024 saw 2.6x as many accounts opened as in 2023, and 4.2x the purchase amount. Foreign investors are also entering the market. Warren Buffett made high-profile investments in five major Japanese trading firms in 2020 totaling $6b. Overseas investors owned a record 31.8% of the Japanese stock market in 2024, up from less than 5% in 1990. We think this trickle could become a flood.
Unquestionably, we are early in the game, and this thesis will take time to play out. The blessing and the curse of being a good investor is to see nascent trends before they gather steam. We have been too early on other investment theses before, like when we railed against the excesses of the 2021 growth stock bubble. While we looked foolish in the interim, eventually these bets have paid off. We believe the tailwinds behind the Japanese stock market may well prove to be one of the largest trends we have yet identified.
Crucially, there's a price for everything. Even if we're wrong and Japanese business practices aren't changing at the pace we think they are, our investments have an enormous margin of safety. If you buy a growing company at five times earnings, even under the pessimistic (and unrealistic) assumption that the company will perpetually pay out only 50% of earnings as dividends, amass an indefinitely growing cash pile on the balance sheet, and the valuation never rerates, you will still collect a 10% dividend. It is difficult to swing and miss in such an environment.
Risks
In addition to the corporate governance issues, Japan has a host of challenges, like any other country.
First and foremost are Japan's severe demographic issues. We've talked before about the baby bust that's soon to cause economic and societal ructions around the world; Japan is unfortunately on the leading edge of that phenomenon and is already suffering a labor shortage. Japan's population is rapidly aging (Japan has the highest old-age dependency ratio among developed countries) and quickly shrinking (projected to decline from 125 million people to 88 million by 2065).
There are no easy solutions to this problem. In contrast to the US, where declines in the native-born population can be addressed through net immigration, Japan has traditionally been resistant to accepting outsiders. There are signs this may be changing. In March 2024, Japan announced a doubling of skilled worker visas. The number of foreign nationals living in Japan reached a peak of 3.4m at year-end 2023, up more than 300,000 from the year before. While we think immigration is unlikely to fully offset declining birth rates among native Japanese, we do expect increasingly liberal immigration policies to slow down Japan’s overall population decline relative to the most pessimistic projections.
But despite higher immigration levels, Japan’s real GDP may shrink even if per capita GDP grows. This will make it that much harder to support Japan's enormous public debt. In addition, the increase in the elderly population relative to the labor force will tend to increase inflation and the burden of social services like healthcare and pensions. These trends are slow-moving, and the reckoning may be decades away, but long-term investors like us are best served by being thoughtful about it today.
The second big risk for investors in Japanese equities is macroeconomic: the intertwined issues of monetary policy, public debt and the yen exchange rate.
In an attempt to counter the post-bubble deflationary forces, Japan has conducted an unprecedented experiment in accommodative monetary policy over the past 30 years. The Bank of Japan, Japan's central bank, has held interest rates at or near zero since 1999 – including a negative rate for most of the last decade. They also conducted the world's biggest quantitative easing program: the BoJ now owns about half of all outstanding JGBs. The BoJ is still purchasing trillions of yen per month, though at a reduced rate that will lead to a small balance sheet runoff over time.1
Exactly what effect this QE has had is hotly debated. With interest rates so low, essentially exchanging zero-interest bonds that would've been held by the public for zero-interest base money is, we think, unlikely to have substantially altered macroeconomic conditions. However, what is clear is that Japan now has a public debt problem. As interest rates normalize, servicing this debt will become a severe burden on taxpayers.
When combined with the possibility of shrinking real GDP due to demographic trends, Japan has a real problem – that is, the debt will be nearly impossible to pay off in real terms. Some very rough back-of-the-envelope math illustrates the scale of the problem. Let’s assume a long-term 3% interest rate. At that level, interest payments alone would consume 7.5% of GDP. The government tends to collect around 34% of GDP in tax revenues and has recently run a budget deficit of roughly 6% of GDP. To merely keep the debt flat in this scenario, the government would need to cut more than 30% of public spending. To pay debt down would necessitate even more cuts.
Of course, given the BoJ owns more than half of outstanding government debt, half of all interest payments go straight back to the government. However, swapping one type of government obligation (currency) for another (debt) does not solve anything, but merely transmutes the problem from one of debt service to one of inflation: this huge pile of zero-interest base money will soon be searching for a home.
With interest rates at zero, there is little disincentive to holding zero-interest base money. However, if interest rates are positive, a "hot potato" effect occurs. This will stimulate economic activity, but will also be inflationary as yen holders chase consumer goods and financial assets rather than endure a loss in real value.
While this inflationary pressure might be painful for the Japanese consumer, it could be good news for holders of Japanese equities. During Japan’s long deflationary era, it has been more attractive to hold cash, which has kept its purchasing power, rather than equities, whose real value has decreased. In an inflationary environment, the reverse is true. Stocks, which are real assets, should hold their value, while cash will lose purchasing power. This change in the relative attractiveness of cash relative to stocks could drive a meaningful increase in valuation. In any case, the Japanese government can change the mix between inflationary base money and painful debt service, but one way or another, it will eventually pay the bill for its debt load.
Suppressed interest rates have also led to the prevalence of the yen carry trade, where traders borrow yen at low rates and reinvest in assets in higher-yielding countries, earning a "carry" on the difference between the two yields. Estimates of the size of the yen carry trade vary, but it has become popular, contributing to a decline in the yen exchange rate. The yen hit an all-time low of more than 160 to the dollar in July. Despite bouncing back to about 145 to the dollar today, the yen still looks extremely cheap – according to PPP estimates, the yen’s long-term value is roughly 90 to the dollar.
The yen carry trade also contributes to volatility. In early August, expectations for a change in the trajectory of global rates (the BoJ raising yen rates and the Fed cutting dollar rates) made the carry trade less attractive. The sharp rise in the yen due to the unwind of carry trades was widely blamed for causing a 12% plunge in Japan's Topix index on August 5th, its worst daily performance since 1987. Though the Topix snapped back on August 6th to eliminate most of the previous day's forced selling, it is a strong reminder that macroeconomic distortions can create volatility that investors in Japan must be prepared to endure.
We think the yen is likely to appreciate further over time. As real interest rates rise and the yen strengthens, this will be a double-edged sword for holders of Japanese equities. The earnings of export-oriented firms are mechanically reduced by a rising yen. However, we suspect that many Japanese companies have latent pricing power. Because of the stakeholder capitalism model, management are satisficers, not maximizers, when it comes to earnings and margins. There's no reason to push price when your constituents are split between your vendors, employees, and customers. Pressure on margins from a rising yen will encourage companies to raise prices, and the end of free money will encourage capital efficiency.
For dollar-denominated investors like ourselves, yen strength will result in better US dollar returns. We also believe yen strength will put positive pressure on valuations. The Japanese are the largest creditors in the world, owning $10.6t in foreign assets as of the end of 2023. More attractive domestic interest rates and investment opportunities will encourage repatriation of foreign assets and discourage cash hoarding. We think Japanese savers will rediscover the domestic equity market.
Japan has other risks as well. Japan is reliant on imports for energy, food, and raw materials, leaving it vulnerable to external shocks. Japan is prone to natural disasters such as earthquakes and tsunamis. Any global economic weakness could be a headwind for Japan's economy which is weighted towards industrial production. Geopolitical risks in the Asia Pacific are growing due to Western tensions with China.
The above risks highlight the complex landscape for investors in Japan, balancing its advantaged position as a major developed economy firmly allied with the West against its significant challenges. With careful security selection, we at Bireme hope to maximally benefit from the plethora of positives working in Japan's favor while minimizing exposure to some of its most glaring issues.
Our portfolio
In October of last year, we traveled to Japan for the first time to learn more about the country, companies, and management teams. The Japanese were overwhelmingly kind, considerate and humble. Economic inequality is low and social stability is high. The cities were clean, orderly and technologically advanced. Public transportation is excellent. Management took great pride in their work and were eager to meet potential investors.
While not an investment case in and of itself, these positive attributes should not be overlooked. Unlike in the US, retailers do not suffer from petty theft. Companies do not struggle to find and retain reliable, hard-working, low-wage labor. Employees take pride in, and feel loyalty to, their employer. There is low risk of strikes and disruptive societal upheaval.
Our time in Japan has helped make us more comfortable taking a large position in Japanese equities. We currently have roughly 50% of NAV (~40% of our gross long exposure) invested across a selection of nine Japanese securities, up from zero a year ago.
We believe we are one of a very small subset of investment managers with the flexibility and mandate to make a shift in allocation like this. Most asset managers have mandates requiring them to invest in a certain geography, sector, and/or market cap range, or have layers of bureaucracy that would never allow for such a change. Our small size, both in number of employees and AUM, allowed us to focus our efforts on quickly building up a portfolio of undervalued Japanese stocks once we gained conviction on the corporate governance story.
Prospective clients sometimes ask us how we can be generalists in a world of specialists. They are used to talking to managers who are experts in one particular field. They wonder how we can compete with, say, a US large cap growth telecom fund replete with analysts who have been studying the industry for 30 years. What is our edge?
Our flexibility is our edge. The ability to go anywhere and do anything allows us to swing at only the fattest pitches. If you are a US large cap growth telecom fund, you need to have a full book even if the opportunity set isn’t particularly attractive. At any given time, there may or may not be misvalued securities in any particular vertical. In fact, we believe the market is usually reasonably efficient, and thus a small segment of the market usually does not present an investor with any great opportunities. Finding the rare truly misunderstood and grossly undervalued situation requires a wide ambit.
We are extremely excited about the prospects for each of our positions and for our Japan bet as a whole. We invested in a range of industries and company sizes, each with different business risks, valuations, currency exposures, and correlation to the Japanese economy. We discuss a few examples below. Other holdings are smaller cap and illiquid, and as such we will refrain from discussing them here.
TBS Holdings is a conglomerate whose core business is TV broadcasting (hence the original name, Tokyo Broadcasting System). Today they also operate retail and ecommerce businesses, own valuable real estate, and manage a substantial portfolio of publicly traded securities. When we began buying, the securities portfolio was worth around 700b yen, nearly double the 450b yen market cap of the company. As of 3/31, their fiscal year end, that same portfolio was worth over 1 trillion Yen versus a market cap of 690b yen.
Outside Japan, negative corporate values are reserved for money-losing businesses. But between 2019 and 2023, TBS’s operating income never fell below 10b yen, and the company forecasts 16.5b yen this year. While the stock has appreciated, we think it is still too cheap, with a value of 6,800 yen and a price of around 4,000.
