In today’s Finshots, we explain why Japan’s stock market is on everyone’s radar right now
The Story
On 29 December 1989, the sun set on the Japanese stock market. The Nikkei index hit a high of 38,916. And then came crashing down.
Anyone who had invested at the peak, believing in the advice “stocks go up in the long run”, would still be cursing themselves. Because even after 30 years, the stock market hasn’t breached that record.
But maybe, just maybe, the sun is finally rising again on the Japanese stock market.
The Nikkei has risen by 20% this year. It’s still below the peak but it has hit a 33-year high. And when Warren Buffett visited the country in April, he said he was quite ‘proud’ of the recent investments he’d made in Japanese stocks.
So what’s going on now?
Well, most people think there are a few key reasons why investors are finally warming up to Japan.
For starters, the US and Europe are facing a recession and the Japanese economy is growing pretty solidly. And while the US is hiking interest rates, the Bank of Japan is still sticking to its ultra-loose policy to push growth. Not to forget the Japanese Yen has weakened against the US dollar. And this will help Japanese companies that rely on exports. Their earnings will improve.
On the face of it, these are all valid arguments as to why people are gung-ho about the Japanese stock market.
But…
Maybe there’s something else that most people are missing. We’re talking about corporate governance! And we have to go back in time quickly to understand this.
When the asset bubble burst in 1990, people had a rude shock. There was a lot of hanky panky going around in the Japanese corporate space back then.
You see, when the Bank of Japan cut interest rates significantly to spur domestic growth, the idea worked too well. Banks opened up the credit tap with reckless abandon. And businesses threw caution to the winds and latched on to this easy credit. They invested massively in factories, equipment, and office construction. A residential real estate boom also began.
And when prices of land shot up, stock prices rose alongside it. Simply because companies had bought large tracts of land on their books too. And with rising share prices, they used that excuse to borrow even more money from banks.
Banks obliged.
And when finally in late 1989, the Bank of Japan started to raise interest rates to prevent the economy from overheating, everything collapsed — land prices, stock markets, and private company investments.
That’s when people saw the unholy nexus in the corporate world.
Banks and big companies were in cahoots and that’s why the money tap flowed freely. There was a lot of cross-holding in shares. For instance, a massive 70% of companies in the Nikkei had also invested in their direct competitors. It was a blatant conflict of interest. And no one cared about the minority shareholders. Companies with political connections also apparently struck secret deals to get cash. Undeserving people were sitting on the boards of companies. Also, Japan’s top companies were ploughing money into the stock markets. Apparently, top brokers like Nomura and Daiwa promised to protect them against a stock market crash and helped to conceal losses too.
And when news of all this broke, so did the trust in the Japanese corporate system. Investors turned super cautious.
So what’s changing now, you ask?
Well, it’s not really an overnight change if we’re being honest.
You know how people always talk about former Prime Minister Shinzo Abe’s three arrow approach in 2012 to saving the economy?
One arrow was about monetary policy — slashing interest rates to negative territory in a bid to push borrowing. The second arrow was fiscal — unloading money on infrastructure and stuff. But the third arrow was about structural reforms aka corporate governance. Abe introduced the Corporate Governance and Stewardship Codes.
And it’s the third arrow that has slowly been firing.
See, Japan has never liked foreign investment funds interfering in how they should run their companies. So when foreign activist funds tried a US-type of approach at Japanese companies in the 2000s, they were shooed away.
But once the corporate governance codes came about, the Japanese felt maybe they had to take matters into their own hands. Do it before the foreigners try to interfere again. And these Japanese investors started to get more involved in decision making at companies. While they submitted just 5 shareholder proposals in 2015, it has now risen to over 60. And these activist funds in the country ballooned — from under 10 in 2014 to nearly 70 this year. They’re trying to help Japanese companies make better decisions to benefit shareholders.
For instance, companies have been hoarding cash for the past couple of decades. They didn’t spend it on new projects. Not did they bother returning idle money to shareholders. In fact, over 50% of companies on the Tokyo Stock Exchange, have a net cash balance today.
But because of the noise around good corporate governance, they’re finally caving in and paying record dividends back to shareholders.
Companies are also being prodded by the Tokyo Stock Exchange to change their behaviour. In fact, it made a public statement saying that over half of the companies are undervalued. And it singled out the Price to Book metric to make its displeasure evident.
If you’re wondering what this P/B thing is, well, think of the book value as the net assets that a company owns. So if the company goes bankrupt and has to sell assets, that value is what is leftover to be distributed to shareholders. And good companies don’t generally trade at a discount to their book value. But in Japan, nearly 50% of the companies fall into this bucket. Simply because the executives aren’t doing enough to convince investors of their plans and all the future value they could reap.
So just to avoid being shamed by the stock exchange, companies have started using their cash balances to buy back their own shares. At a higher price. This returns money to shareholders and boosts the value of the shares as well. And these buybacks have hit an all-time in the previous financial year.
All this is what’s rebuilding trust in the Japanese system. Investors like the intent to rebuild solid corporate governance. And they like that shareholders are finally being given the attention they deserve.
But will it be enough to finally give the Japanese stock market its moment in the sun? Investors who’ve practiced the ‘buy and hold’ strategy since 1989 will be hoping.
Until then…
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