Japanese equities: From re-rating to earnings growth

• Ben Leyland
  Senior Fund Manager
  J O Hambro

The rehabilitation of corporate Japan has been under way for more than a decade. Returns on equity have improved materially because Japanese companies have focused on both profitability and capital efficiency. But now, a lot of that potential has been realised, at least among large caps. The emphasis therefore shifts towards assessing the sustainability of margins and returns, as well as the potential to compound through reinvestment. Investors increasingly need to identify businesses with structural growth drivers, strong competitive positions, disciplined management teams and the ability to reinvest capital effectively.

For us, valuation is therefore a starting point rather than an investment thesis in isolation. An investment initially identified as undervalued can remain attractive even after valuations normalise if these other characteristics remain underappreciated. For such companies, total returns have the potential to remain strong, although their drivers will evolve away from multiple expansion and towards earnings growth and dividends. 

Structural tailwinds from the capital cycle

Since 2022, we have seen a shift towards capital investment and infrastructure renewal. We have started to move away from a globalised, ‘just-in-time’ world operating with long supply chains and very high utilisation, towards a ‘just-in-case’ landscape of greater regional self-sufficiency and spare capacity, supported by fiscal stimulus. This is a significant shift in the demand outlook for ‘real-world’ sectors like industrials, which has always been a large and growing proportion of the Japanese equity market, even as it has shrunk considerably in the US and Emerging Markets. If you want exposure to the capital cycle thematic, the best place to look is Japan.

China increases the need for selectivity

It is important to acknowledge that Japan’s industrial exporters have benefited in recent years from an extremely weak currency, which may now be starting to strengthen, and in some cases face a serious new challenge from Chinese companies that are becoming increasingly formidable competitors across industries such as capital equipment, heavy industry and electric vehicles.

Again, though, we do not believe this means that the opportunity in Japan is over, simply that investors need to dig deeper and take a more selective approach. They need to look for companies with genuinely sustainable competitive advantages, built on deep customer relationships, sustained investment in R&D (research and development), long product-development cycles and high switching costs. Domestically oriented businesses should also benefit from being less directly exposed to Chinese competition and currency movements.

Selectivity is becoming increasingly important

Japan is no longer the overlooked market it was 15 years ago. Corporate reform, improved capital allocation and the return of inflation have helped create the foundations for structurally higher corporate returns. The global shift towards capital investment and infrastructure renewal is a tailwind for many Japanese companies. Meanwhile, the appeal of Japanese equities is starting to be recognised by both foreign and domestic investors, supported by initiatives such as the NISA (Nippon Individual Savings Account). The opportunity for deep value investing may have diminished, but the potential rewards from active management and stock selection remain compelling.