Sam Perry, senior investment manager at Pictet Asset Management, discusses why corporate Japan’s governance overhaul is about to enter a new phase, boosting the long-term appeal of Japanese stocks.

Japanese Prime Minister Fumio Kishida pledged 18 months ago to deliver a new form of capitalism, aimed at boosting economic growth and addressing social challenges, Sam Perry at Pictet Asset Management said this week. 

The initiative appears to be based on a simple strategy: persuading Japanese citizens to buy domestic stocks. 

Kishida is urging the country’s traditionally risk-averse, cash-rich investors to manage and invest their assets proactively. “His administration is introducing a new tax exemption scheme for investment that, combined with other private-sector measures, is designed to accelerate a switch from savings to investment, enhance the long-term value of Japan Inc, and redistribute wealth,” Perry said.

“The return of inflation and mounting concerns over the cost of retirement have prompted a growing portion of Japan’s population to take action to safeguard their financial future,” he continued. Such efforts could also boost Japan’s appeal among foreign equity investors as they could turn previously conservatively-managed businesses into the dynamic, lean, shareholder-friendly companies that are investment staples for global investors. 

“New NISA Japanese retail investors have traditionally placed nearly half of their wealth in cash and bank deposits. Only 15 per cent of their assets are held in stocks and investment trust funds, compared with around 30 per cent in the US and Europe,” Perry said. Kishida is working to unlock this huge cash pile. In order to lift the share of equities, he is overhauling the tax-exemption scheme for investment, also known as the Nippon Individual Savings Account, or NISA.

“Japanese investors have in recent years sought higher returns abroad, but the allure of foreign assets is fading. One of the risks that always concerns the Japanese investor – whether institutional or retail – is currency volatility,” Perry continued. 

Typically, Japanese investors have been happy to take higher foreign yields but have always hedged away the currency risk. However, now the cost of hedging has shot up to a level which outweighs the positive yield differential. The three-month hedging cost from the dollar to the yen, for example, stands at 5.2 per cent, compared with the yield differential of 3.4 per cent between 10-year US Treasuries and 10-year Japanese Government Bonds. This means that the 3.5 per cent on US Treasuries becomes a negative 1.8 per cent after hedging, comparing unfavourably with Japanese stocks which offer a 2.6 per cent dividend yield.

“If Japan is to become a nation of shareholders, this also augurs well for foreign investors. Not least because the emergence of a large domestic shareholder base should accelerate efforts to raise Japanese corporate governance standards,” he said. 

Traditionally, Japanese companies have had to cater to the needs of a very broad group of stakeholders, including employees, customers and business groups. The lack of focus has led to an inefficient use of capital. It is not for nothing that half of the companies listed on the Tokyo Stock Exchange have persistently commanded a price-to-book ratio of below 1 and return on equity below 8 per cent. This compares poorly against a return on equity of 19.4 per cent for the S&P 500 – albeit at a price-to-book ratio of 3.9. 

But the expectation now is that Kishida’s renewed drive to establish a culture of share ownership across Japan will add greater momentum to the Tokyo Stock Exchange’s own efforts to improve corporate governance and shareholder returns. By Perrys calculations, the country’s economy is expected to register the fastest rate of growth in the developed world this year, fuelled by a rise in investment and spending by cash-rich companies and households. 

According to the OECD, Japan’s real GDP growth is expected to reach 1.8 per cent in 2023, followed by Canada with a growth rate of 1 per cent and France at 0.6 per cent.

Japanese equities
Looking further ahead, Perry expects Japanese equities to deliver an annual return of over 10 per cent in the next five years, outperforming US equities and almost matching returns from emerging equities in dollar terms yet with far lower volatility. 

“The returns could be even higher if reforms have their desired effect. This means Japanese equity should be a more prominent feature of international portfolios,” he said. 

Overseas investors have in aggregate underweighted Japan for much of the past two decades. Currently, foreign equity portfolios’ allocation to Japan is at its lowest level since 2012. Yet as corporate Japan’s priorities change, and domestic investors are starting to favour their own market again, the incentives to lift those allocations are building. “Japan’s stocks should be a bigger component of every investor’s portfolio,” he concluded.