Japan’s market rally lacks solid backing

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Proclamations of a new dawn for Japanese equities have been a regular occurrence over the past decade — destined, repeatedly, to prove premature. Now, a burgeoning bull run appears to be under way. The optimism still needs more fundamental backing.

True, some domestic policy changes have had a positive effect. The government has long pushed for independence on company boards to encourage more attention to shareholder needs. Between 2014 and 2022, the number of Tokyo Stock Exchange constituents with a board boasting a third or more independent directors climbed above 90 per cent from a tiny percentage, notes US fund manager GMO. Corporate poison pills have dropped by half.

This means hostile takeovers are more likely. Tokyo now also encourages targeted company boards to show how they could create as much value as any acquirer’s takeover premium, says Peter Tasker at Arcus Investment. Nidec, an acquisitive electric motor maker, had not attempted an unsolicited deal in more than 15 years. But last year, Takasiwa Machine Tool found it could not beat Nidec’s roughly 80 per cent premium.

Whether these changes have made a meaningful difference is not clear. Japanese equities have persistently traded cheaper than world markets for many years, compared with the huge premium they commanded in the heady days of the 1980s.

One reason is that returns on equity remain low. On Lex’s calculations, forward ROE for Topix constituents (at 8.5 per cent) has crawled sideways for a decade. It is currently only just above the 10-year average, while the S&P 500 offers well over double that. The government’s push for companies to buy back their excess equity is welcome.

A weak yen makes Japan more of an export play than ever. Relative to GDP, exports have climbed to a fifth. But the currency’s weakness saps returns for overseas shareholders. Japan indices have only kept up with world benchmarks over two years in dollar terms. Local investors could well pile in, given a new US-style pension policy to encourage equity investment. But that will need time to come to fruition.

Japan’s market reform efforts are encouraging but will need time. Declarations of victory should, for now, be treated cautiously.