What’s behind the superior performance of Japanese stocks this year?

One of the highlights of the stock markets this year has been the performance of Japanese stocks which have held up significantly better than their European and most North American peers. They are set to go from strength to strength as some of the regulatory changes that began over the past few years pick up speed in 2024.

The country’s benchmark index Nikkei has rallied 30% since the start of the year to 33,4311 while the Tokyo Stock Price Index (TOPIX) is trading up 27.5% year-to-date at 2380. Compare this with the 19.5% increase in S&P 500, 8.5% in the DJIA and maybe don’t compare this with the FTSE 100’s 0.74% decline.

Japanese firms have exceptionally strong cash positions, a hangover from Japan’s deflationary era, and they tend to carry little or no debt. Until recently that cash has not been put to good use, but the government has been pushing for changes including tax breaks for stock investments and reforms of the companies’ antiquated governance habits.

This year buybacks, a staple of western stock investment, have caught on in Japan with companies buying back stocks at historically low prices.

One of Japan’s problems is an aging population who will find it difficult to retire comfortably on a government salary. At the same time local households hold more than $14 trillion of financial assets, more than half of it in cash. Consequently, the government has been changing regulation to incentivise retail investors to invest in stocks by providing tax breaks on stock holdings and the scope of those incentives will increase significantly at the start of next year.

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Governance changes to play a big role in Japan

According to Goldman Sachs Research Japanese equities are set to have “a transformational year” in 2024.

The investment bank expects the rally to follow on from a strong performance this year and to be helped by solid global economic growth and domestic stock market reform. The TOPIX, one of the country’s equity indexes, is expected to rise by about 13% to 2650 by the end of next year.

This may seem in contrast with the expected economic growth in the country of 1% and 1.5% but it becomes feasible once you account for the expected governance reform of listed companies.

In March the Tokyo Stock Exchange announced new rules requiring Japanese-listed companies with a price-to-book ratio below 1 to disclose specific initiatives for improvement including addressing their cost of capital. The move was designed to make it difficult for companies to continue with the “lazy management” scenario in which they hoard cash and instead pushed them to start creating value for shareholders either by increasing dividends or through share buybacks.

Bad governance is less and less tolerated, particularly by foreign investors who are becoming more actively involved. Since the new rules have been brought in, the minimum return on equity target was set at 8%.

“The stock exchange has incentivized listed companies to boost valuations and earnings, and companies could potentially be delisted if they’re unable to show they’re using their capital efficiently. Investors see the unwinding of Japanese companies’ cross-shareholdings — shares that firms own in their business partners to maintain those relationships — as an indication of improved governance,” said Goldman Sachs Research strategists Bruce Kirk and Kazunori Tatebe.

There is a cosmic irony that once the government introduced tax breaks on stock holding Japanese investors mostly bought Western stocks because they thought that Western equities would provide stronger growth.

And yes, over the last decade that would have been the case. But in 2023 Western investors looking for safe haven investments ended up flocking into Japanese stocks. Looking at the planned reforms, the strength of the companies’ financial positions and the changes in governance regimes, Japanese investors may end up reconsidering next year.

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