What explains the recent surge in Japanese stock prices?

Last week, the Nikkei stock index shattered records for the first time in 34 years and was closing in on the 40,000 mark at the time of this writing.

Even considering the boost from the better-than-expected economic and stock market performance in the U.S, the recent market rally in Japan has been remarkable, with the business community celebrating the historic moment as the possible end to the nation’s “lost three decades.”

And yet, the country's macroeconomic reality remains tenuous. It is also a stretch to say that the profitability of Japanese companies' main business activities has significantly improved, too. Although the economic growth rate was relatively good, recording 1.9% in 2023, domestic demand was rather weak. This year's economic growth rate is expected to slow down to below 1%, making the high stock prices a unique phenomenon.

Japan’s stock-market surge began last year when Warren Buffett boosted his holdings in several leading Japanese trading firms. In his April visit to Japan, the chairman and CEO of U.S. Berkshire Hathaway, announced he had increased his ownership in major trading companies Mitsubishi, Mitsui & Co., Itochu, Sumitomo and Marubeni. These companies have benefited from a surge in commodity prices since 2021.

But the main reason for Buffet’s interest in investing in these stocks was that they were undervalued. The "Oracle of Omaha," as he is known, has since announced additional share purchases and continues to show a willingness to invest in trading companies.

Since foreign investors account for nearly 70% of the trading volume of Japanese stocks, they have an outsized influence on share prices.

While Buffett sparked interest among foreign investors in Japanese stocks, another reason for heightened expectations in Japan is the attention to the price-to-book ratio (PBR) boosting measures initiated by the Financial Services Agency (FSA) and the Tokyo Stock Exchange in March last year. Foreign investors’ expectations for improvements in Japan’s corporate governance boosted their confidence.

As part of the government's economic growth strategy, Japan adopted its own version of the U.K. Corporate Governance Code in 2015 to enhance the earning power of companies through management reforms, making the stock market more attractive to foreign investors. Since then, the code has been revised every three years.

To ensure that listed companies can maintain returns exceeding the minimum investment return (namely, cost of capital) for investors, management reforms have been encouraged by changing the structure of the boards and the mindsets of management teams.

As a result, the old practice of cross-shareholding among trading companies, which has long been regarded as an undesirable business tradition in Japan, has decreased substantially as companies are now obligated to provide explanations for their holdings in their annual securities reports. In the latest 2021 revised code, stricter disclosure guidelines were applied to the Prime Market of the Tokyo Stock Exchange, including an increase in the number of independent outside directors, an increase in the number of female directors and executives and English disclosures.

However, even as Japanese businesses gradually became more profitable, their earning power, or the stock evaluation by shareholders, has not improved sufficiently yet. In particular, the disparity in earning power and shareholder evaluation compared to the United States remains significant.

For many listed companies, the PBR, which indicates shareholder evaluation, had been below one. That means that the value of the company is lower than the dissolution value of the company. Such persistent sluggish stock price performance had been pointed out as a long-standing problem for listed companies.

In order to encourage listed companies to further enhance shareholders’ evaluation, therefore, the FSA and the TSE have encouraged listed companies to disclose their future policies and goals, specific measures and implementation schedules to improve PBR, aiming for improvement in March 2023. An overview of the disclosure status of companies was announced in January this year.

So far, 851 listed companies (out of 1,655 firms listed on the Prime Market) have disclosed such plans, and companies with lower PBRs were more likely to issue disclosures. In other words, a greater sense of crisis has been felt by companies with consistently low stock prices. As disclosures are to be made annually, the pressure on listed companies is growing and expectations are rising for increased earnings power and shareholder returns by boosting dividend payout ratios and conducting stock buybacks. Many foreign investors have raised expectations for greater Japanese corporate governance reform in response to these movements.

Over the past years, Japanese companies have been increasing their stock buybacks and have made efforts to increase dividend payout ratios. With the push to increase PBR by the government, further increases in share buybacks and dividends may be more likely.

Two other factors are contributing to Japan’s higher stock prices. One is the decline in investment appetite for China — not only by European and American investors but also by Chinese investors — due to the slowdown in the world’s second-largest economy and increasing geopolitical risks. Thus, many investors have diverted their money to Japanese markets. Another is the cheaper yen having a positive impact on manufacturers’ earning power.

According to the Ministry of Finance’s corporate business statistics, there is little sign that the ratio of companies’ operating profit divided by sales has risen exceptionally over the past year. By contrast, the ratio of nonoperating profit divided by sales has risen recently, which may have resulted from temporary factors rather than profits from their core business. It is therefore still difficult to say that Japanese companies have significantly increased their fundamental earning power.

Outwardly, the stock price surge seems to be supported by improvements in earnings. But that’s on a consolidated basis for many businesses — which could muddle the reality when compared to seeing things on a standalone basis. Earnings on a consolidated basis include profits earned by overseas subsidiaries, which can be inflated by the depreciation of the yen.

Contrary to foreign investors’ optimism, the idea that Japanese companies have undergone significant reforms to enhance their profitability still hasn’t hit home among the public.

While the government has expanded the "NISA (Nippon Individual Savings Account)" system, which provides tax incentives, particularly for younger people, the Japanese appear to be investing more in foreign stocks and foreign investment trusts rather than domestic businesses — indicating that the younger generation may have lower expectations for the earning power of Japanese companies.

So what needs to happen? Japanese companies need to increase domestic capital investment, including investment in equipment renewal, automation, digitalization and de-carbonization initiatives. Active investment actions, exceeding cash flow and significantly enhancing productivity, have not yet been seen. As a result, capital stock has not increased significantly, contributing to a stagnation in the potential growth rate, estimated at around 0.6%.

In order to enhance long-term earning power, companies need to implement forward-looking investment strategies and prioritize technological innovation. In this sense, the hope is that Japanese companies will respond to the expectations of foreign investors, engage in sound risk-taking and strive to enhance competitiveness.