While the world remains captivated by U.S. stocks, I’ve also had my eye on another market. One that appears to steadily be making a comeback—Japan.
After decades of economic stagnation (AKA “the lost decades”), Japan is seeing renewed interest from global investors. In fact, earlier this year, for the first time in 34 years, the Nikkei 225 Index topped its peak.
Source: https://privatebank.jpmorgan.com/nam/en/insights/markets-and-investing/japan-is-this-time-different
Can Japanese stocks maintain their momentum? Three catalysts have me feeling optimistic.
Monetary Policy Normalization
For nearly two decades, monetary policy in Japan has been unconventional — a “bold experiment” that included negative interest rates and bond buybacks aimed at pumping liquidity into the system and combating deflationary pressures. In March, that changed.
For the first time in 17 years, as signs of healthy inflation emerged, the Bank of Japan raised rates, becoming the last major central bank in the G-20 to reverse negative borrowing costs. For many investors, us included, the BoJ’s move to align its policies more closely with global economic norms is considered a step toward broader macroeconomic normalization.
Source: https://www.statista.com/chart/31930/japan-interest-rate-and-inflation/
Improving Corporate Governance
Historically resistant to shifts in corporate governance and minority investor interests, Japanese companies are making changes to enhance shareholder value. They’re moving closer to global standards, fostering a more investor-friendly environment through share buybacks and dividends, and implementing strategies to improve capital efficiency.
At a macro level and in the one-on-one meetings we’re having with management teams, we’re seeing that corporate governance is improving and profits are growing. It’s a slow but positive trend that’s instilling confidence in investors and unlocking shareholder value.
Attractive Valuations
The third catalyst, and possibly the most compelling, revolves around valuation. Japan’s equity market has been cheap for a long time – and for good reason given its zero-interest-rate policy and resistance to corporate reforms. However, the improving environment for Japanese equities and recent rally have me feeling optimistic. I think valuations will climb further, which makes Japan fertile ground for stock pickers like us.
Heavier Tilt Toward Japan
Not surprisingly, the revival in investor interest in Japan has led to a shift in our portfolio. Today, thanks largely to developments in Japan, our exposure in developed Asia stands at roughly twice what it was a year ago (~30%).
Those who are less familiar with our investment process might assume the market’s momentum drove this expansion. It certainly played a role, but our proprietary quantitative model and systematic ranking of stocks also was pivotal, informing our stock selection and, in turn, shaping our regional and sectoral allocation decisions.
Our model ranks the stocks within our investible universe according to their free cash flow, return on equity, earnings growth, earnings revisions, valuation, and momentum—characteristic consistent with our investment philosophy and objectives. But even then, we’re just getting started.
Marrying Art With Science
We supplement our quantitative research with qualitative research, engaging in continuous dialogue with companies to assess each investment opportunity's merit. We have a local advantage in Asia, where our Director of Fundamental Research, Othon Ruiz, is based (Hong Kong). On-the-ground due diligence and in-person meetings allow Othon to gain firsthand insights into a company’s operations, strategies, and growth prospects. Moreover, his fluency in Japanese eliminates the need for translators and facilitates direct communication with management teams, ensuring clarity and accuracy in our interactions.
It’s this combination of qualitative and quantitative research that enables us to ensure our capital is deployed judiciously across competitive investment ideas and regions. In Japan, it’s led us to exciting small- and mid-cap opportunities across multiple sectors.
For instance, Mitsubishi Heavy Industries is an industrials company with some interesting business segments we believe can drive secular growth. Many investors see Mitsubishi merely as a maker of heavy machinery and equipment, but we’re excited by its foray into sustainable energy and by the proprietary technology it’s developing for green hydrogen. We think it’s building a leadership position within the segment globally.
We also own the stocks of several technology companies, all of which are in the semiconductor manufacturing and artificial intelligence (AI) ecosystems. They check all the boxes in terms of the fundamentals we look for in businesses, and relative to their U.S. counterparts, they’re inexpensive. On top of that, they’re benefiting from favorable currency dynamics (depreciation of the yen), which has enhanced their competitiveness in global markets.
A consumer discretionary holding we’re excited about is JVC Kenwood, renowned for its audio manufacturing expertise. Despite its traditional manufacturing roots, JVC Kenwood boasts a global brand presence, efficient operations, and an attractive valuation. It, too, is an exporter benefiting from currency devaluation.
While these companies are representative of the interesting stories and businesses we believe offer opportunities for future growth, we’re also focused on the present. All our holdings currently exhibit strong cash flow, return on equity, price momentum, and other key criteria assessed through our modeling.
Cautious are the Wise
Will the outlook for Japan continue to brighten? Time will tell, but several factors come into play, not the least of which are macroeconomic dynamics. Although we’re not a macro-focused firm, we incorporate a macro overlay into our investment approach and therefore are closely monitoring Japan’s economy after consecutive quarters of GDP contraction. Though not severe, this downturn hints at potential challenges that could impact investment outcomes. We’re also keeping an eye on currency volatility spurred by the yen’s devaluation.
We believe Japan’s equity market offers promising opportunities but are taking measured approach to investing there. We’re confident our approach to portfolio construction —rooted in a blend of quantitative analysis and qualitative research — along with our stock picking expertise will enable us to capitalize on the country's evolving economic landscape.
Webinar Replay
An Unconventional Approach to International Investing
To learn more about where and how we uncover small- and mid-cap international equities watch this interview with Alejandro Garza.
