For much of the past 20 years, global investors have generally steered clear of Japanese equities, finding little enticement in a landscape of economic stagnation, elevated debt and political instability. 
Despite intermittent periods of renewed confidence and expectation, the much hoped-for recovery has failed to sustainably take hold. However, encouragingly, we are finally seeing a prolonged period of political stability. Under the government of prime minister Shinzo Abe, much-needed structural change is underway at both an economic and financial market level. This is driving renewed interest in Japan as an investment opportunity.
Talk of Japan’s improvement since the global financial crisis focuses on prime minister Abe and the impact of his Abenomics market and economic reform strategy. However, rarely have we seen the kind of broad-based support for reform initiatives in Japan as has been the case in recent years. The political establishment, bureaucrats, as well as corporate leaders have united behind the Abenomics program, suggesting a clear commitment toward addressing the country’s problems.
Increasing influence of foreign shareholders
One of the most significant achievements of Abenomics is the improvement in Japanese corporate governance. Corporate governance and stewardship codes have been implemented with unexpected speed and determination, visibly changing the corporate atmosphere. Japan’s regulatory reforms are pushing companies to raise return on equity and be more receptive to external directors. This regulatory change is irreversible.
Another important factor here is the increasing influence of foreign shareholders. In recent years, foreign investors have become the largest shareholder class in Japan. This is significant because foreign investors expect a comparable level of shareholder focus and capital allocation discipline from Japanese investments as seen in Europe or the US. With foreign ownership increasing, the influence of offshore shareholders is set to become more prominent.
A striking example of this can be seen in the changing representation on Japanese company boards. In 2004, the majority of Japanese companies had no independent, outside directors. Today, almost all companies have at least one external board director.
A balance between cyclicals and defensives
Perhaps the most understated element of the Japan equity market revival in recent years has been the level of corporate profitability, which has outpaced the US. With the global market cycle now in its latter stages, the question is: Can this high profitability continue?
Japan is still a very cyclical market. As such, any downturn in the global macro environment will see Japanese company profits negatively impacted overall. This could be compounded by a strengthening yen, given the currency’s safe-haven status.
It is, therefore, key to strike a reasonable balance between cyclical sectors and defensive sectors of the market. The stage of the cycle dictates the kind of opportunities available, but it will not determine overall performance.
Domestic sectors becoming more influential
The structure of the market is becoming less reliant on exporters and traditional manufacturers, while domestic sectors, like consumers and services, are becoming more influential. The positive trend is a clear reflection of the evolving Japanese economy, with new and influential areas of domestic demand emerging.
In contrast, the least attractive areas are those secularly challenged by competition from low-cost countries. China is moving up the value chain and is increasingly challenging Japan’s traditional manufacturing base. Areas like steel and cement have been under pressure for some time, and this trend looks set to continue. The banking sector is also problematic, undermined by complex industry structure issues and in need of large-scale reorganisation and consolidation.
The continuity of government in Japan, as well as the broad support for its market and economic reform programme, are crucial factors we believe will continue to underpin Japan’s sustainable growth path. Meanwhile, structural reform of the market is encouraging renewed investment in Japan. This is no ‘false dawn’, in our view, but rather a market undergoing positive change, creating a fertile environment for bottom-up, quality-oriented stockpickers.
Archibald Ciganer is a portfolio manager at T. Rowe Price. The views expressed above are his own and should not be taken as investment advice.