Rising sun, rising market: Japan’s overlooked potential

Economic renaissance, governance reforms and steadily growing profits have lifted the Nikkei 225 to new highs, yet we believe valuations remain undemanding and the market is under owned. Nicholas Price, Portfolio Manager of Fidelity Japan Trust PLC, explains why the outlook for Japanese equities remains positive, with many investors still underexposed to the market.

There’s a major shift underway in Japan. After 34 years, the country’s stock market has climbed past its previous record high, making history as it does so. This reflects signs of a blossoming in the economy as deflation appears defeated and companies embrace the interests of shareholders.

Following a powerful rally in the first few weeks of 2024, the Nikkei 225, a key market index, has climbed back to the levels last reached in 1989 before the country’s asset price bubble burst. There’s real optimism that the ingredients are in place for stocks to continue to rise.

Breaching the previous high marks a watershed for Japan. Yet what’s hardly noticed is that the Japanese stock market has quietly been one of the world’s best performing over the last 10-15 years – fuelled by steady growth in company profits and corporate governance reforms that started in 2015 under Prime Minister Shinzo Abe, known as ‘Abenomics’, rather than the fickle rises in stock valuations seen in other countries.

Indeed, over the past 10 years to the end of February 2024, Japan’s broad-based Topix Index has generated an annualised return of 9.6% (in UK pounds), outstripping the MSCI Asia (ex-Japan) Index’s 7.3% What’s more, it has also exceeded the UK FTSE 100 Index’s 5.1%. 

A new era of opportunity

In a sign of springtime for corporate Japan, a fresh era of governance improvements is underway. In 2023, the Tokyo Stock Exchange (TSE) started to push companies to unlock their market value through better use of capital. Broadly speaking, it encouraged them to think about their capital efficiency, reduce cross shareholdings and restructure businesses that are not performing.

Since January, the TSE has been publishing lists of companies making positive changes every month, and in Japan this kind of pressure works. As momentum for improving shareholder returns spreads across TSE companies, the valuations of Japanese stocks may rise. Indeed, Japan’s price-to-book ratio (measured on the Topix Index) remains at a steep discount and the price-to-earnings ratio of around 14 times 2025’s earnings forecasts does not look expensive relative to history other markets, especially considering current interest rates. Both price-to-book and price-to-earnings ratios are key measures for judging a stock market’s value – the former comparing stock prices with book value and the latter against earnings per share.

But a major driver of the country’s corporate revival is also the return to moderate inflation after years of flat and falling prices. In its most recent Outlook for Economic Activity and Prices report, the Bank of Japan forecast that core inflation will exceed its 2% target through fiscal 2024. This shift towards moderate inflation and its impact on the spending and investment decisions made by households and corporates is a very positive trend. It’s also creating new opportunities for domestic industries that can increasingly raise prices and boost profit margins for the first time in many years.

True, the economy slipped into a technical recession in the second half of 2023, but Japan still saw the strongest rate of annual growth in nominal gross domestic product since 1991. What’s more, this is unlikely to derail the country’s long-term return to moderate inflation and economic normality.

Will growth stocks recover their premium rating?

So far, Japan’s stock market revival has been led by its large companies, partly influenced by the US interest rate cycle and the weakness of the yen, as well as renewed buying by overseas investors. As US rates peak, though, and investor interest broadens further down the market-cap scale, medium-sized and smaller companies with faster earnings growth should be back in vogue.

Fidelity Japan Trust invests in just such stocks. Yet in an unprecedented anomaly, the average price-to-earnings valuation ratio for stocks in the fund is broadly in line with the stock market, despite their forecast profit growth being almost twice as high over the next 18 months or so. In fact, the Japanese market is forecast to deliver just over 10% average profit growth over 2024 and 2025 – by contrast, the average for the fund is approximately 20%.

This is very unusual: given the higher growth and better returns on capital among the fund’s holdings, it normally trades at a premium valuation to the overall market.

Past performance is not a reliable indicator of future returns.

Source: Morningstar as at 31.01.2024, bid-bid, net income reinvested. ©2024 Morningstar Inc. All rights reserved. RIMES as at 31.01.2024

Looking forward

As Japan’s stock market celebrates, it looks to have a fair wind. Corporates are generating steady earnings growth and the market trades on a reasonable forward valuation. Further, the TSE’s corporate governance push is bearing fruit, while a return to inflation is bolstering profit margins.

Will the land of the rising sun continue to quietly deliver returns? There can be no guarantees, but no other country has such a robust combination of economic renaissance, governance reforms and positive corporate fundamentals. Despite 2024’s new high, we believe Japan’s potential is yet to be recognised in stock prices.

Important information

Past performance is not a guide to future returns. The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Fidelity Japan Trust PLC invests more heavily than others in smaller companies, which can carry a higher risk because their share prices may be more volatile than those of larger companies and the securities are often less liquid. Changes in currency exchange rates may affect the value of investments in overseas markets. The shares in the investment trust are listed on the London Stock Exchange and their price is affected by supply and demand. This investment trust can gain additional exposure to the market, known as gearing, potentially increasing volatility. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser. Investors should note that the views expressed may no longer be current and may have already been acted upon.