Over the past 30 years, the Japanese equity market has gained an unfortunate reputation and has come to be thought of as a source of perpetual disappointment among many investors. Contrary to popular belief, however, micro and macroeconomic indicators across the market suggest that Japanese equities present vibrant and compelling valuation opportunities. 
Investors’ long-held scepticism has been borne from several beguiling theories about the Japanese equity market. The nation’s government bonds have been dubbed the ‘world’s greatest widow-making trade’, referring to the short-selling of bonds after the Bank of Japan implemented its zero-interest-rate policy in 1999 - inevitably causing their price to fall. While a seemingly unusual policy, parallels can in fact be drawn with economies closer to home.
Since the financial crash, Western markets have positioned themselves in preparation for a ‘normalisation’ of monetary policy which is yet to materialise. This failure to launch has been illustrated most clearly by the Fed’s recent reversal of its own policy, but the only true difference between these two scenarios is that short sellers of Japanese government bonds seriously underestimated the fierce sense of loyalty among local investors, who have maintained long positions in Japanese Government bonds despite anaemic yields. These investors have only been emboldened by the Bank of Japan, which has remained supportive of the government’s reflation efforts, particularly under the stewardship of governor of the Bank of Japan, Haruhiko Kuroda.
The notion that the Japanese equity market has never recovered from its catastrophic crash in the late 1980s is another persuasive theory often championed by investors, but this assertion can also be challenged. Despite the market direction, equities have become progressively cheaper and the occasional market sell-offs can be attributed to nervous sentiment that is at odds with improving fundamentals.
The market is currently trading at price to earnings ratio that is multiples lower than those witnessed during the great financial crisis and the time at which Shinzo Abe swept to power. As positive developments continue to unfold at micro and macroeconomic levels, justifying the notion that Japanese equities have failed to recover on a fundamental basis is proving an increasingly difficult task.
Reasons to be cheerful
Empirically, we know that Japanese corporations continue to generate historically high profits and margins - and that trend shows no signs of slowing. Supported by Japan’s tight labour market, which encourages income growth, we can expect to see further boosts to consumption, all of which bodes well for Japanese equities.
The knock-on effect of healthy profit margins and cash flow also provides Japanese corporate executives with more room to manoeuvre their capital expenditure plans, fostering future business growth. Corporates are also better placed to drive adjustments to capital deployment policies in favour of returning cash to their shareholders.
Finally, we know that dividend yields, which are an important component of total equity returns in Japan, continue to rise.
Japan: then & now
We have been encouraged by the evolution of the Japanese corporate landscape since the boom years of the 1980s. Since then, Japan has remained at the forefront of innovation in robotics technology – a development which could help the nation overcome its challenging demographics – and its reliance on technology exports has significantly declined. In the context of extraordinary FAANG (Facebook, Amazon, Apple, Netflix and Google-parent Alphabet) stocks inflation, the Japanese equity market is in fact substantially ‘underweight’ in relation to its global benchmarks.
Today, the Japanese stock market enjoys far more balance skewed towards manufacturing and consumer-related sectors, such as industrial goods, autos, household goods and telecoms. We continue to find conviction in our technology related holdings, though the broader market in Japan is less exposed to the technology and services sectors. This can only be interpreted as a positive as these industries may soon be subject to global regulation.
For the time being, the investment case for Japan is firmly rooted at the micro level, where skilled investors can uncover the niche players which offer sustainable earnings growth at a reasonable price. But from a valuation perspective, investors should note that Japanese corporates are currently enjoying high profitability in the face of anaemic share price performance, bringing the equity risk premium to its highest level in over 40 years - all the more reason to seize the prevailing opportunity embedded in Japanese equities.
Ernst Glanzmann is head of Japan equities at GAM Investments. The views expressed above are his own and should not be taken as investment advice.