Last year was an economically and politically turbulent one for most markets and Japan was no exception. In what was otherwise another bumper year for Japanese equity indices, the upward trajectory was marred by an Avengers: Infinity War-esque ‘blip’ in late July. Rather than a purple Titan, however, it was a septuagenarian academic in the shape of Bank of Japan Governor Kazuo Ueda who clicked his fingers, as he raised the benchmark interest rate by 15 basis points to 0.25%.
Markets were taken by surprise at the timing and rate of increase, leading to a sharp unwind in the yen carry trade and ensuing volatility across cash equity markets. The first three trading days of August saw benchmark indices (Nikkei, Topix, MSCI Japan) falling by over 20% as the yen jumped against the US dollar.
Although the moves were dramatic, we were encouraged to see that the market recovered in relatively short order as investors continued to show increasing conviction in the Japanese market. It was, however, a timely reminder that the decades of loose monetary policy and negative interest rates in Japan are (very) slowly but surely coming to an end, and that will likely result in upward pressure on the yen.
We believe both foreign and domestic investor interest will move away from the large-cap exporters that have benefitted so strongly from this environment over the past two years and shift towards smaller, domestic companies who can reap the benefits of a stronger yen.
Meanwhile, corporate governance reform continues apace, led by the Tokyo Stock Exchange (TSE). Early last year, the TSE began publishing the now infamous ‘name and shame’ list of corporates who are taking measures to improve their share prices, and crucially, those who are not, on its website. Later in the year, the list was refined to enhance accountability for companies that pledge to implement measures, and it began to include examples of companies’ “bad practices”. The TSE has promised further measures in 2025 and we eagerly anticipate the unveiling of their plans.
In late September 2024, the revolving door of Japanese leadership swung once again and it was reported that Shigeru Ishiba would be the new prime minister and leader of the Liberal Democratic Party (LDP).
Since the election, Ishiba has shown a clear commitment to fiscal stimulus and emphasized the need for greater investment compared to savings. We anticipate that the Ishiba administration will follow a path similar to that of former prime minister Fumio Kishida and we do not foresee this leadership transition disrupting Japan’s ongoing corporate governance reforms or our engagement strategies with portfolio companies.
Against this backdrop, private equity interest in Japan continues to grow, with global funds further expanding their Japanese presence and levels of activity. The over-looked, asset-backed, quality small-cap companies that AVI typically invests in have proven to be an attractive universe for private equity to deploy their bourgeoning keg of dry powder and four portfolio companies received takeover bids in 2024.
An additional tailwind for small-cap names could be reforms brought into the NISA (Japanese ISA) program. The original NISA program was introduced in 2014 to encourage a shift from Japanese households’ cash assets into securities. The Government has proposed plans to double NISA purchases over five years, by more than doubling the amount of tax-free investment that can be made by individuals and extending their period of use. NISA purchases enjoyed a strong start in 2024, but with Japanese households still holding cash assets of over a quadrillion yen ($7trn), this trend is likely to unfold over the coming years.
At the individual company level, engagement efforts continue to progress and bear fruit. The small and mid-cap sector presents compelling investment opportunities in high-quality companies, many of which are asset-rich and trading at significant discounts to their true corporate value. Shareholder proposals in Japan have increased more than tenfold over 10 years and the amount of buybacks has hit a record high, as has the percentage of outside directors at companies.
Direct, constructive and active engagement has proven to be an ever more effective catalyst for change for these companies and with such a supportive landscape in place, the number of attractive opportunities is only increasing. We believe that it is within these smaller companies that we will see the most change and the greatest prospects for catalysing and generating corporate value. Although 2023 and 2024 were strong years for Japan as a whole and for our strategy in particular, we think we are only at the beginning of a once-in-a-generation investment opportunity in Japan.
Joe Bauernfreund is chief executive officer of Asset Value Investors and manager of the AVI Japan Opportunity Trust. The views expressed above should not be taken as investment advice.