Is now the time to consider Japanese shares?

Stock market investing 101 says that diversifying the sectors and regions you invest your money in is a good strategy. However, there’s one region that’s been overlooked for decades when it comes to investing – Japan. But could that be about to change?

Why has Japan been shunned?

The Japanese stock market peaked in 1989, and in the years since the Nikkei and the Topix indices have been unable to break higher ground.

Unsurprisingly, the global investment community have shunned a regional market that’s not managed to regain its peak for nearly 34 years.

Four in five active fund managers are underweight in Japanese shares. Of the 225 actively managed strategies in the eVestment database that list the MSCI EAFE as their preferred investment benchmark, 85% are underweight Japanese stocks by an average of 7.5%.

Japan is a G7 economy and has an important role on the world stage. However, a stock market bubble that burst nearly 35 years ago still haunts investors and fund managers when it comes to investing in Japanese stocks.

Is the tide turning for Japanese shares?

The Japanese stock market has had a resurgence in the past year, and there are reasons to be optimistic about the future.

Big changes are afoot in the Japanese economy. First, the country is emerging from decades of deflation to inflation. Second, the government has put its weight behind efforts to persuade Japanese companies to become more profitable for shareholders and to incite more Japanese individuals into investing in financial markets.

These fundamental changes are welcome to us. In April 2023, the Tokyo Stock Exchange (TSE) took the unusual step of urging companies listed in Japan to promote management strategies that place greater focus on stock prices and capital efficiency.

This move was seen as a way to boost the attractiveness of Japanese companies for investors at home and abroad, and also to revitalise the Japanese stock market.

Back in March, the TSE asked listed companies with a price-to-book value of less than one, to announce measures and map out how they would shore up their figures.

A price-to-book value of one means that a company’s trading in line with the value of the assets on its balance sheet. A company with a price-to-book value of less than one, means the stock’s trading at a price that’s less than the value of the assets on its balance sheet – so it could be undervalued.

The TSE noted that in Japan there’s a higher number of companies that trade with a price-to-book value of less than one compared with Europe and the US. For example, on the Topix, one of the main benchmark stock indices in Japan, over a third of its listed companies had price-to-book values of less than one. In the US, 6.6% of companies have a price-to-book value of less than one, and in Europe it's just under a quarter.

It's possible to boost the price-to-book value of a company. But it requires the company executives persuading shareholders that the company’s worth investing in.

There are lots of ways to do this, like buying back shares, boosting dividends, investing in the business, and spending money on research and development.

Japanese companies are well-placed to do this.

Half of companies listed on the Topix index have net cash on their balance sheets. This compares to less than one fifth of net cash for US and European companies.

There are also signs that Japanese companies are taking the TSE’s call to boost profitability seriously. As of mid-July, just under a third of the biggest companies listed on the Topix with a book value of less than one had disclosed initiatives to boost shareholder value.

Is Japan’s stock market due for an investment injection?

Another structural shift that could boost the attractiveness of Japanese shares, are the changes to the Nippon Individual Savings Account (NISA) programme.

Japan’s NISA is a tax-free savings scheme, and shares some similarities to the UK’s ISA. The Japanese government recently announced changes to this scheme to promote investment in shares.

The annual investment limit for the NISA is doubling in January 2024, and the tax-exempt lifetime limit will be raised.

These changes are exciting because of the huge amount of cash and deposits held by Japanese households. The Bank of Japan reported that Japanese households have 2 quadrillion yen in wealth.

Just over half of this wealth is kept in currency and deposits, with only 11% held in shares. This compares with the US, where households have 12.6% of their $114.3tn of wealth in currency and deposits and nearly 40% held in shares.

Even a small shift of Japanese household wealth into shares could have an impact on stock markets at home and abroad.

Will economics play a part too?

Macro-economic change could also boost the attractiveness of Japanese shares.

Japan’s spent long periods in deflation, but inflation’s finally reached Japanese shores. The consumer price index (CPI) is currently 2.5%, which is the highest level since 2014, and one of the highest levels since the 1990s.

The return to inflation is one of the drivers of enthusiasm for Japanese shares this year, and there are signs that inflation could persist.

The third quarter Tankan survey measured the inflation outlook for large Japanese companies, and they’re expecting inflation to remain elevated on a one-year, three-year and five-year horizon.

This is an important economic development. If companies believe that inflation will continue to stay high, it could feed into upside wage pressure and boost purchasing power for the Japanese consumer. It could also make investing more attractive for Japanese companies, who could deploy some of their large cash reserves if inflation continues to eat away at the value of their cash deposits.  

The currency issue

While we’ve mentioned the upside potential for Japanese stocks, there is one hindrance to investing in Japan – the yen.

The Japanese yen has fallen nearly 13% so far this year and is down 33% in the last five years versus the US dollar (as of 30/11/2023, Bloomberg).

On a broad basis, the Japanese yen index, which measures the performance of the yen against a basket of G10 currencies, is lower by 12% so far in 2023 – it’s nearly 21% lower in the last five years.

A rising domestic currency means that foreign investments will have lower returns when they’re converted back to their local currency.

For example, the Nikkei 225 is higher by 28% so far in 2023. This is more than the US blue-chip index, which is up by nearly 19% so far this year.

However, when you measure the performance of the Nikkei with the US blue-chip stock market index in US dollar terms over five years, the Nikkei is still an underperformer.

This suggests that recent weakness in the yen is taking its toll on the Nikkei’s performance for foreign investors. When you trade Japanese shares, you need to keep in mind the performance of the yen.

Performance of the Nikkei and the US blue chip index in USD, normalised to show how they move together.

Scroll across to see the full chart.

Past performance isn’t a guide to the future. Source: Bloomberg, 30/11/2023.

What should investors consider?

Investors shouldn’t ditch their investments in other global markets in favour of Japanese investments. Instead, this article argues that Japan’s stock markets should once again be part of the conversation when investors are creating regionally diversified portfolios.

After many years, Japan is becoming an interesting investment opportunity again, and it’s certainly worth watching what its stock markets do next.

This article isn’t personal advice. If you’re not sure whether a course of action is right for you, ask for financial advice. All investments can fall as well as rise in value, so you could get back less than you invest. Past performance is not a guide to the future. Figures shouldn’t be looked at isolation.

Kathleen Brooks is Founder of Minerva Analysis, a market analysis company. Hargreaves Lansdown may not share the views of the author.

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