The Awakening of the Sleeping Dragon w/ Made in Japan
Has the Time Finally Come to Invest in Japan?
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Japan is typically touted as “the most inefficient market in the world.” Some claim that the market is not really being inefficient but that the valuation differential really stems from shareholders rights not being at the core of the strategy of publicly-traded Japanese corporations (like it is in the RoW). Many Japanese corporations are family-owned or run by an individual with significant ownership and don’t tend to prioritize shareholders within their stakeholders. This has led to many of these companies being run to survive more than to maximize returns; large cash positions tend to be the norm in Japan and survival historically was prioritized over growth (this is definitely good, but not when taken to the extreme).
While many attributed Japan’s historically lower valuation ratios compared to the RoW to the above, some things seem to be starting to change. The Japanese government and the stock exchange are pushing Japanese corporations to become more shareholder friendly and reinvest into the business, with the objective of reinvigorating the economy. As I consider Japan to be a very interesting geography (based on my belief that these changes are indeed happening, I thought it would be a good idea to bring the conversation (unrecorded) I had with my good friend
about the opportunities in Japanese equities. I’ve been trying to convince him to come to the podcast, but he’s currently unwilling to reveal his identity and therefore I ended up conceding to doing it in written form (I’ll keep trying!). I definitely recommend subscribing to his Substack if you are interested in Japan.I must say I have looked into several Japanese companies and, even though they have their “problems” and investor access is not the best (albeit improving), there seem to be ample opportunities in the geography. There also seems to be no in between: either Japan is a great opportunity or a value trap (something we discuss later on).
I hope you enjoy our conversation.
I thought it would maybe be a good idea to start with your background. Tell us a bit about you and what led you to invest in Japan
Yeah so a little about me: I’m Japanese but my parents were expats so I ended up moving around a lot. Because I was exposed to the such non-Japanese ways of thinking alongside my Japanese way of thinking. It’s made me bilingual and ‘bicultural’ I suppose, but also a complete outsider to anywhere I go. Basically I’m what’s called a third culture kid nowadays.
In university, I discovered the world of ‘value investing’ and decided I wanted to be an investor. I liked the idea of being able to learn about different businesses and profit from that knowledge It’s mainly self-taught because they didn’t really teach you how to be an investor in school. One place I found solace was joining an investment club, where there were some extremely intelligent people who taught me a lot about investing but also just how to think independently as a human and that investing was also an exercise in self-awareness. One of the things I remember learning was to find an ‘edge’ for yourself. It became clear to me that Japan was mine.
I then started my carrier at a buyside firm looking at Japanese companies of all sizes. What was also useful was that I was exposed to companies outside of Japan through my peers. It showed me what great management and companies could look like around the world. Some of these traits I feel are universal.
In terms of how I spend my time today, I’m all in on Japan. I invest with a focus on Japan and write a Substack where my goal is to share differentiated, nuanced insights on Japanese businesses, investment opportunities and culture. There are so many pockets of opportunity, and I really want people to see how interesting Japan is as a market. Based on my conversations with investors the inertia seems to be caused a lot by a cultural barrier. So this is something I hope to break down. Whenever I have bandwidth, I provide consulting services for foreign investors who want to invest in Japan. It’s awesome to be able to lend a hand to others (with way more capital) that are interested in Japan in this way. This also gives me a fresh perspective.
On a longer time horizon I’m thinking bigger. I see a huge opportunity for Japan in the coming years and I want to be able to capture that the best I can. I’m hoping to build something in Japan.
Japan is surely an interesting case study, not only the stock market but also the business environment as a whole. So, the Nikkei (Japanese Index) went through the bubble of the 90s and is today standing close to those highs.
Maybe to provide a bit of context, the Nikkei dropped around 76% from peak to trough from 1989 till 2012, so that’s basically more than 20 years of dead money and a painful decline. Maybe a bit of context about this bubble would be interesting…was there more than hefty valuations to the 1990s bubble?
From an investor perspective, the Japanese asset price bubble of the late 1980s was indeed more than just a story of excessive valuations. I mean, our economy was booming! We had insane P/E ratios and speculative fervor played a significant role across various asset classes. We also had structural factors amplified the bubble’s rise and fall.
This was the peak of Japan’s economic miracle post-World War II, fueled by export-led growth in things like automotives and with loose monetary policy, created a sense of invincibility/mania. Japan in some regards was seen as a country that was set to ‘dominate’ the world back then. Japanese companies acquired major US companies for example. A funny anecdote is that I have a few Aussie friends that learnt Japanese in school because they believed it will be an important language! The Plaza Accord of 1985, which strengthened the yen also pushed the Bank of Japan to slash interest rates. This flooded the system with cheap credit. As you can imagine this liquidity surged into real estate and equities, driving valuations to unsustainable levels. This could be apocryphal but the story was that the land where the imperial palace stands today was estimated to be worth more than the entire state of California! In any case Real Estate prices also went pretty bonkers. The bubble bursting was also an unfortunate series of events that all came into place. I wasn’t just a market correction but a systemic unwind of overleveraged banks, zombie companies, and a demographic shift toward an aging population, all of which trapped Japan in stagnation and this is something that still plagues Japan today, to some extent.
Many investors fear that Japan might not be a secular shareholder value creator, what would be your counter argument here?
I don’t have a counter argument for this actually, this has been true for the last 3 decades – a lot of the profits and consequent cash generated by companies never really re-circulated in the economy as a far as shareholder value goes, and ended up piling up in the balance sheet.
My view though is that things are really changing this time and that represents the opportunity set. I’d point to the transformative shifts in its corporate landscape and market dynamics since the ‘lost decades’. Historically, Japan’s markets underperformed due to deflation, weak governance, and a focus on stakeholders over shareholders which meant capital wasn’t returned adequately to shareholders - evidenced by the Nikkei/TOPIX’s stagnation while the S&P 500 marched higher. But today, structural reforms like Abenomics and the Tokyo Stock Exchange’s push for better capital efficiency are driving change. To me it’s starting to happen at a jarring pace. Companies are unwinding cross-shareholdings, boosting dividends, and doing buybacks and we’ve seen a step change in pace in recent years. But I think this clearly signals that these companies are starting to prioritize shareholder returns.
Traditional Japanese culture has recurringly been touted by many skeptics as the main reason for not investing in the country.
Many management teams in Japan are seen as too conservative, conservatism which translates into cash-rich balance sheets and low reinvestment rates. To what extent do you think this has changed?
This is changing albeit slowly. I think the reality is that it has changed but I think more change is to come – and that’s why the opportunity in Japan is so exciting. Really since the time of Abenomics, businesses have actually been improving steadily. I’d point out that the media portray it as this change being ‘new’ but it’s been happening gradually for over a decade. I do think the recent developments pushing for improved governance and shareholder friendliness means things are accelerating. We’re now starting to see companies target higher ROEs, and shareholder returns via dividend and buybacks. Last year as of July we saw 78% of Prime market companies disclosed initiatives to improve cost of capital and stock price. For the standard market 31%. So on one hand, great initial progress but also shows there’s room for further improvement.
In absolute amounts you can see statistically the aggregate amount returned to shareholders by public Japanese companies has seen a step change over the last 24 months. If you pull up the total amount of dividends and buybacks done by year, it’s pretty clear.
What is your opinion on the sophistication of Japanese investors vs. foreign investors? From our prior conversations, I have always been surprised with your view on the sophistication of the Japanese investor. Who moves markets in Japan (institutions, individuals…) and why?
So over time I’ve really tried to be more nuanced in terms of the sophistication of Japanese investors. I give a lot more credit than I used to but I’ll share a few observations.
For one the market has been uninteresting to locals for decades, this has meant that there’s been limited incentives to learn about the equity markets for many Japanese people. Even today many still see this as a ‘risky gamble’. So by global standards on average I think stock market sophistication might be lagging. Anecdotally until recently I’ve barely seen talks of ROIC for example. When they look at PE ratios, it was only after the Kiyohara book (one of Japan’s most successful Hedge Fund Managers) that people started thinking of PE ex-cash which can make some businesses look A LOT cheaper. For both actual corporates and investors alike, there hasn’t been as much consideration for other valuation metrics until recently, things like EV/EBIT or EV/EBITDA or EV/FCF. That’s something I’m starting to see slightly more of but I think there’s some room to improve. It’s weird because sometimes it almost feels like individuals focus heavily on J-GAAP earnings and not the cash flow that gets generated. Although in fairness, I don’t think this is necessarily a Japanese phenomenon per se.
The other feature and the impression I get is that the investment horizon is more short term focused versus RoW. So I think trading is the more popular method in Japan. Another interesting perspective I got from a friend though is that because there are so many stocks and there’s limited capital that can be allocated relative to it, it’s like walking into a candy shop full of interesting things but you only have $5 with you. So with an abundance of opportunities among Japanese Stocks compared to the dollar amount you can invest, which is so limited, that the deciding factor has been ‘whats most interesting in the short term?’. I think that some of the short termism comes from the market trying to optimize their allocation based on catalysts.
In terms of who moves markets I think it’s relatively bifurcated, broadly speaking between large caps and small caps. In large caps the participants can be a mix of individuals as well as institutions which include both domestic and international. On the other hand, in smaller companies, the participants are mainly individuals with just a handful of funds. This happens because the market cap of these smaller companies are usually already quite small and the liquidity is not there for institutions to participate. This on the other hand provides a huge opportunity for smaller companies where there is a relatively large disconnect in valuation. Conversely large caps, especially growth companies aren’t all that ‘cheap’ by several measures.
Do you think that the fact that individuals are so prominent and unsophisticated in Japan is an opportunity (through more price dislocations) or a risk (because the real value might take longer to show up)?
I think it’s a massive opportunity because it’s not going to continue like this – Japanese Investor literacy was behind because the market was not interesting and they were right in that the index has been flat. We’re starting to see more interest from individuals and I think the literacy is improving extremely quickly. I mean I’ve been fortunate enough to meet some of the best individual investors in Japan who’s CAGR-ed at insane rates and I’d put them up there against anyone out there globally. These guys were early, and I think there’ll be more coming out of the woodwork.
So I think that ‘discovery’ phase of undervalued companies will happen faster and faster as the cohort of investors knowledge base improves. Japanese individuals are studious and hard working, if the opportunity is right I think individual investors as a cohort will start to improve quickly. The question is “can the Japanese equity market remain interesting long enough for them to want to study it?” My answer is yes, because of so many of the changes we’re seeing but we’ll have to see. And I think interest is increasing for stocks in general thanks to the new NISA (Nippon Individuals Savings Account) a Tax Exempt Investment Scheme for individuals. Which means that there is an added incentive for consumers to be investing their savings in Stocks.
The risk you mention is real in the sense that good companies may stay cheap for longer than you hope but I think the reality is that you just have to adapt your investment process somewhat to the local rules, lets say. If your incremental buyers are individual investors, then instead of complaining they’re wrong I think it’s best to understand how they think and think about what is going to make them want to buy the stock and therefore uncover the value? I had to learn this the painful way but I think for me I spend a lot of my time on figuring out what the catalyst is and if that event would be interesting enough for the market to realize. The opportunity for me is finding the areas in which my investment strategy overlaps with what the market wants to buy. Admittedly this does invite some short-term thinking but ultimately I want to buy businesses that are long term opportunities, just that I want the value realized sooner rather than later.
Another opportunity of course is the participation of international investors, which may have more sophistication arguably. I think these participants will value companies more appropriately which almost usually mean at higher valuations. With Japan becoming more interesting to many foreign investors I think this is going to have a positive impact as money flows into the country.
What seems clear is that there are certain changes in Corporate Governance being implemented in the country to try to close the valuation gap with other countries. Which of those corporate changes would you highlight?
They are all inter-related so it’s hard to isolate them but I think the ones most directly related to increasing shareholder value is the most interesting. Namely this is the companies focus on improving ROE as well as making sure they’re not valued at below 1 times book.
I think the focus on ROE and releasing the pent up cash balance is a powerful one that could create a positive feedback loop to then attract more investors into these companies which conversely improves liquidity and valuation for these businesses. The more they see the results in terms of improved valuation, the more they may be compelled to keep doing it.
My hot take is that the improving board independence narrative is kinda BS. I mean the spirit of this is absolutely positive but the reason why is because by the numbers representation from independent directors are improving. But by sophistication, I think these independent directors don’t know enough to have the shareholders best interest in mind. They’re not ‘colluding’ with management or anything like that but you have to remember Investor sophistication for Japan as a whole has been behind and this includes the directors too! So directors are only starting to learn what ‘shareholder capitalism’ is.
I’m fortunate enough to be in a place where I get to hear some of these stories and … seems like focus on things like ROIC or cashflow is absent. It’s also been a bit of a box ticking exercise where today we’re seeing pro-athletes or TV announcers being nominated on the board as independents. Now I think this is on one hand is symptomatic of the shortage in board talent in Japan. With all due respect, if this is what having an ‘independent’ board means, we’ve got some work to do.
Something that I believe is interesting regarding the ongoing changes in Japanese corporate governance is that the Japanese Government is very incentivized to close the valuation gap with the rest of the world. Can you explain why?
The Japanese government is likely driven to close the valuation gap because it impacts economic growth and investor trust. Undervalued stocks can make it harder for companies to raise capital, invest, and compete globally, which hurts the economy. To address this, the government has pushed for corporate governance reforms, like urging companies to improve profitability, and created policies to attract both domestic and foreign investment. The stuff we talked about earlier.
One key effort is making Japan a hub for asset management, with tax breaks and special zones for financial businesses, aiming to draw global investors. They’ve also encouraged Japanese households to invest in stocks through programs like the Nippon Individual Savings Account (NISA) as I mentioned earlier. These steps suggest the government sees closing the valuation gap as crucial for economic recovery and global competitiveness.
Something that’s also embedded in Japanese culture is gifting. I know this is something you’ve talked about before, but it still remains pretty astonishing for non-Japanese investors. Can you explain what gifting is in the context of the stock market and why it’s so popular in Japan?
Shareholder gifting is a unique quirk of the Japanese Stock market. Today if you have a registered address in Japan, you are eligible to receive a gift. Unfortunately this means most foreign investors don’t have access to this.
The exact policy depends on the company but basically companies hand out gifts if you own a particular amount of stock in the company and/or if you’ve held for longer than the required period (sometimes they don’t have this). This gift can be anything from retail discounts, to packages of food to cash vouchers. These cash vouchers are called QUO Card and can be used pretty much anywhere – so it’s almost like handing out cash.
One of the main reasons why this started is because to be listed on the TSE, there was a requirement to have a certain number of shareholders to remain listed. In the past with many showing almost no interest in investing in stocks, which is/was seen as a risky thing, the companies had to find a way to entice people. The result of that was the shareholder gift to make sure they had enough shareholders. It’s been decades now and this has become a core part of Japanese investment culture – to the point that one of the most well known figures in the Japanese Investment industry is Kiritani-san who became famous for living off shareholder gifts from various companies.
I don’t know if this is a consensus view anymore but I think shareholder gifts are here to stay unless the TSE restricts this completely but its not that easy because some investors buy stock because of this and participates in the market whether right or wrong. Furthermore, I don’t have numbers for this but for a small, microcap starting a shareholder gifting policy in the short term can really raise your valuation and liquidity. Again this is not the right way to do it, but I’m pretty sure there’ll be more companies that will.
I imagine that there are lots of companies that screen pretty cheap in the country. What do you do to separate the value traps from the real opportunities? I imagine there would be quite a bit of both.
Absolutely, when you have a ‘cash rich’ company, and with close to 0 Enterprise Value, you have to remember that the market discounted this correctly by ascribing limited value to it. Why? Because that cash wasn’t really for the shareholders.
Now because of the efforts on the part of the TSE cracking down on companies with P/B lower than 1, some companies will change. It’s almost binary right? All of a sudden there is real value to the cash these companies hold on to. Theres also the ‘peer pressure’ and seeing your neighbors will push peers (in an industry) to do it too. One component you want to be careful of, and this was also mentioned in Tatsuro Kiyohara’s book, is that many of these manufacturers have facilities that are getting too old which means for some of these companies the cash could end up being used for massive cash programs and not shareholder returns investors are hoping for.
Ultimately, there’s no real great answer for this because some will improve shareholder returns to a limited extent for lip service and others will take it more seriously. But I think talking to management and seeing how they think about this is one way to figure it out. You’d be surprised how many do it without really understanding why it’s value accretive. So I prefer trying to find the ones that are likely to do it sustainably and signals that they’ve taken the issue seriously. These are increasingly improving disclosure and also more openly share their capital allocation framework.
Furthermore if you had a fund, you could actively work to ‘unlock’ these issues yourself by actively engaging with the companies and/or starting an activist campaign. Contrary to the impression many have, Japan’s shareholder rights are very supportive – you need surprisingly little ownership to make a shareholder proposal.
As an individual investor, you can conversely think of these activists in terms of ‘catalysts’ you can either a) Find the ones where activists are invested or b) figure out the one’s activists are likely to invest where – there’s an open register, severely undervalued, decent business fundamentally.
Do you believe you have an edge being Japanese and knowing the language and the culture?
So because I’m Japanese I’m pretty biased here but I would say so. Perhaps AI can level the playing field somewhat.
There’s several ways I think this has been an advantage.
1. I’ve noticed quite a bit can get lost in translation through an interpreter. Also It’s way more costly from a time perspective versus the information you get too. You need English to Japanese and Japanese to English interpretation so it takes twice as long.
2. I can look for resources in Japanese which can be really helpful and may not be readily available in English. This may not be obvious nor easy to find at times.
3. Sometimes when I sit in a company meeting with a non-Japanese native, they’re surprised how quickly I build rapport with companies and I think that relationship (at least in my experience) has been pretty helpful in terms of openness and getting faster responses.
4. It’s also not just a language barrier but a cultural barrier – there may be structural differences in a particular industry you have to grasp and this may not be clear. I’ve had conversations with other foreign investors where they react “Why does this business even exist???” Once you familiarize yourself with Japan this no longer becomes an issue, but combined with all the other factors I think it can be quite cumbersome.
5. This is slightly contradictory to my previous point but I also believe my advantage is that I’ve also had experience in global markets – this I’d say is my advantage against other local investors. Especially because some industries are more developed abroad, so you can extrapolate useful insights in terms of risk and opportunities. In my experience most local investors only look at Japan and often don’t know where to start to look for insights abroad.
Any interesting opportunities you are seeing that you’d like to discuss briefly?
I mean I’ve written about this on my substack already a few times, but I like SaaS businesses in Japan. I think some of them are ridiculously cheap at the moment. You have recurring revenue streams that are profitable at 1-2 times sales! Many actually also trade at pretty attractive earnings multiples. Though unfortunately not below book value. However, I think some of these businesses have been able to build a significant foothold in the market, are generating tons of cash and can continue to grow at a decent rate (by that I mean at least mid-teens). In my mind we’ve only started embracing the public cloud like… 5-6 years ago so there’s a significant runway in my opinion. I also think there’s simply just a huge opportunity for Japanese corporates to ‘DX’ this means “Digital transformation”. It’s pretty amazing even at large companies how much paper is still being used. There’s a lot of low hanging fruits that I think will be solved over time.
There’s an index called the One Capital Cloud Index which is an index that constitutes of SaaS businesses in Japan. The Median P/S is 3.7 times. But the median growth is 18.6% and operating margin is 17.7%.. so the median Japanese SaaS is almost a Rule of 40 company and trades significantly below global benchmarks – I think this is too cheap. Like I said earlier given that I think there’s significant room for digitalization in Japan, I think we’re still early in terms of the growth curve.
The risk people talk about is AI disrupting software – but will this really happen? I’m skeptical because selling software to companies in Japan has ironically required significant man power – sales people going to offices and engineers helping customers implement the systems. Are these same customers really going to all of a sudden figure out which AI agents to use for their business? This, I seriously doubt. My belief is that System Integrators (Japanese System Developers) and SaaS companies will be the gatekeeper for AI in Japan.
Probably this last question is a bit open-ended, but what is the market missing here? Why does Japan remain a country where there are ample opportunities?
I think we’ve discussed the main topics already but I think people are starting to understand how Japan works and the opportunity set. A lot of this governance change is not new but has been playing out gradually over a decade – in recent years this has accelerated and the market got excited about it. I think one thing is not to underestimate how long this can go on for. Funnily the index has been flat pretty much from summer last year after a solid 1.5 year run. This makes me more bullish about the Japanese market because I think there’s way more to come – it’s not about how it is today but how it could be 5 , 10 years down the road and I think it can be very bright.
One nuance that I may be different to the rest of the market is how long the changes will take – the impression I get is that these improvements will happen in the next few years but with the context of long decision making processes, the learning curve, lack of related talent in Japan – I think the improvements are going to take longer than what many might be expecting.
Finally, I think they’re ample opportunities because it’s not just the cash rich value stuff that’s cheap in my opinion– but also the growth companies which are mid caps or smaller. These look less cheap than the value names by valuation metrics, but still trading at incredibly low earnings multiples. These have gotten sold off quite heavily post Covid despite many (like the SaaS companies) having ample room to grow domestically. I’ve been more focused on writing about these growth names on my substack as it feels relatively less talked about in the context of Japan. So there’s an opportunity for multiple investment styles in my opinion and the more vibrant the capital market gets through participation of more local investors, foreign investors and the like I think we’ll start to see some incredible outcomes.