Japan in Demand (Sort Of)

It does not look to us like the long-term demand curve for Japanese equities has shifted that dramatically yet.

By: Verdad Research

Japan is finally in demand. But how much? Net foreign fund flows into Japanese stocks hit $37B YTD through mid-July by our calculation. For context, that is only a few billion more than Elon Musk overpaid for Twitter (in Fidelity’s opinion).
 
Below, we also compare to the net foreign fund flows into Japanese stocks each year over the last decade of data provided by the Tokyo Stock Exchange. We can see that Japan has experienced net outflows pretty persistently for the past decade.

Figure 1: Net Foreign Fund Flows into Japanese Stocks

Source: TSE Prime/TSE1 Constituents. All data through mid-July. USD conversion at average yen dollar rate for each period. Nominal historical values, not adjusted for inflation.

Foreigners have come to own about one-third of Japanese stocks according to the Tokyo Stock Exchange. As a result, foreign fund flows can have quite an impact. 

$37B sounds like a lot, but it comes after almost a decade of outflows totaling 3-4x that amount. The outflows peaked five years ago when the 2018 trade wars kicked off. 

$37B is also dwarfed by the $66.1B in record-setting buybacks performed by Japanese public companies last year. Japanese companies have been buying about twice as much of their own stock as foreigners.

$37B is also dwarfed by the over $152.9B (not inflation adjusted) foreigners poured into Japanese stocks after Abenomics kicked off and the yen had devalued ~60% by the end of 2013, as shown above.

Since 2013, Japan has generally been starved of liquidity from foreign investors, and it still shows in the underweight global investors have in Japanese stocks, as shown below.

Figure 2: Global Equity Investment Funds’ Japan Over/Underweight (%)

Source: Chart by Goldman Sachs Investment Research

And this underweight is arguably much more extreme than the figures shown above based on aggregate global market caps. This is because, today, companies in the S&P 500 trade at 2.6x their revenue while Japanese companies on the TOPIX trade at 0.81x their revenue. Based on global revenue, the underweight would be about 3x the figures shown above and, based on EBITDA, about 2x.

Our point is, it does not look to us like the long-term demand curve for Japanese equities has shifted as dramatically as recent headlines would suggest, nor nearly as much as it possibly could.

But to understand the extent of what’s been going on, the more helpful of the last two comparisons might actually be the original Tesla/Twitter one. You may think that comparing the entire stock market of the third largest economy in the world to just one US stock is not a fair comparison. Or is it?

Famously, before the 1989 bubble burst, with real estate at $139K per square foot in Tokyo, the size of the plot of land on which the imperial palace in Tokyo sat was valued at more than the entire state of California. Ex-post, this was a helpful metric for deciding where relative long-term demand had become stretched and, by contrast, where expected returns were likely higher.

In 2021, we mentioned that it seemed odd to us that Musk’s 20% stake in the ~$1 trillion Tesla could theoretically purchase 100% of the aggregate market cap of the ~2,300 (68%) of all listed Japanese stocks below $400M in market cap. How could one American car company that produced a fraction of the automobiles of Toyota rise to an asset valuation equivalent to 25% of the nation of Japan’s entire GDP?

However, writing this from Tokyo in late June, just a few blocks from that same sacred plot of real estate that 35 years ago markets valued at prices possible only by extrapolating recent trends as “inevitable” and assuming away uncertainty and obsolescence risk, we struggle to understand why the hallowed ground under Palo Alto’s tech giants would be any less subject to unpredictable change. Or why today’s Japan is predestined for the same relative malaise investors assumed for the US in the ’70s and ’80s. 

However, one piece of the puzzle we can report back on is that there may be some very good reasons Japan is now starting to come back in demand: Japan seems to be back in business. 

The contrast from just six months ago is stark. Back then we wrote that Narita airport still looked like a ghost town, nightlife in Tokyo was nearly null, and hardly a foreign tourist could be found among the half-sized crowds of 100% masked Japanese workers who were actually going to an office. Not so today.

In the interim, the Japanese government ordered COVID-19 reclassified to the level of the seasonal flu, and, as several locals told us, the reason for the dramatic shift is that the Japanese people needed that order to feel comfortable getting back to normal.

This summer should be the first since 2019 with decent tourist revenue in Japan, as foreigners who long delayed their visits are enjoying just how far their budgets can go at ~140 yen/dollar now in a country where inflation never went much past 3%. And the Japanese too seem to be quite happy “buying Japan” for now, given just how expensive it has become for them outside these borders.

In fact, we believe the economic rationale of individual consumers “buying Japan” is not all that radically different from what Japanese and foreign businesses are doing. In a world where a dollar now buys ~30% more yen, where the initial input shocks from energy and foreign inflation seem to be stabilizing, and where many Japanese companies have been adjusting their supply chains and investing in onshore capacity, we believe a cheaper yen is now a net positive for most Japanese businesses. 

However, the topic of change that may have grabbed the most attention of late is the latest round of Japanese corporate reform initiatives ordering companies below 1x price-to-book to publish a plan to raise their valuation. We wrote a piece on the topic in the context of recent fund flows in June. And the feedback we got from companies over the last month on the topic was almost universally that it would have some impact. Almost all of them said that this rule simply added some urgency behind something that was already slowly changing. As one company executive recently explained to us: 

“A decade ago, Japanese companies didn’t do buybacks. Dividends were more like trinkets of appreciation for stockholders [they literally are trinkets or gift cards in many cases]. Debt holders and strategic partners’ concerns governed most all management decisions. We never even talked about ‘ROE’ in corporate planning meetings. We focused exclusively on growing income statements. That focus already started to change before this exchange regulation came out. The last two to three years have been different internally, and we have to publish that now.”

In our recent interactions, we also haven’t seen this high of a level of shareholder involvement in deep-value micro-caps over the last decade.

The aggregate statistics seem to agree. The number of Japan activist funds has increasedquite dramatically over the last decade, and a record for shareholder proposals was just set during this year’s annual general meetings. Additionally, many of the largest global active management firms (e.g., Citadel, Point72, and of course Buffett) have been rushing to establish or boost their presence in and exposure to Tokyo this year. Given these developments, we might expect to see a bit more arbitrage and repricing in the developed world’s most passive and passed-over market. 

On the corporate front, buybacks are set to hit a second consecutive record-setting year in Japan, and dividend yields in deep-value Japanese stocks reached parity with the rest of the developed markets for the first time in 20 years this last year. With these developments already in the works, it’s not too surprising to see global asset allocators run out of tangible reasons for the continued dramatic underweight on Japanese equities.