A New Growth Plane for Japanese Equities

Anu Rajakumar: Over the past few years, Japanese equities have gone through one of the most significant re-ratings in the developed world. The first phase was about the denominator: leaner balance sheets, more efficient capital management. Now, under Prime Minister Sanae Takaichi’s administration, the focus has shifted to the numerator, earnings growth itself, with the government designating 17 priority sub-sectors, from autos to semiconductors to shipping, for both public and private investment. So far, the response from investors has been positive.

Earlier this year, the benchmark Nikkei’s forward price-to-earnings ratio approached 20 times, even as the broader market remained far cheaper. Is this re-rating built on a sustainable earnings story, or is it running ahead of the fundamentals? What does the next leg of Japan’s transformation mean for investors, both those already in the market and the majority still on the sidelines? My name is Anu Rajakumar. Today, I’m joined by Kei Okamura, portfolio manager on Neuberger’s Japan equity team. Kei, welcome back to the show.

Kei Okamura: Thanks for having me, Anu.

Anu: Kei, let’s start from the top. Last time we had you on the show, back in May 2024, we talked about the Bank of Japan’s first rate hike in 17 years and a market that had just rallied more than 30%. Now, let’s fast forward to 2026. More recently, you wrote a white paper titled Japan for the Long Haul, in which you described Japan’s re-rating like a flight. There’s a runway, a takeoff, and now cruising altitude. Kei, walk us through that arc. How did we get from Japan’s corporate governance reforms a decade ago to a market approaching 20 times forward earnings on the Nikkei, and how does that history and that journey shape how you and your team are positioned today?

Kei: Sure. The illustration that you put through earlier in terms of the taxi runway and then, of course, the takeoff and the cruising altitude is really showing the evolution of Japan from a corporate governance reform standpoint, and then more recently to a capital management, and now earnings growth standpoint. What’s interesting is that, especially in the last five to six years, we have seen quite a substantial re-rating of the Japanese equity market.

This was initialized in 2020, 2021, and we saw the market shoot up. What’s been interesting, though, is that much of that was driven by companies and their capital management improvements, primarily through streamlining of balance sheets. As equity investors in this market, I think it was always clear that there needed to be an equity story. Essentially, how do companies grow over the mid- to long-term? This is where, as you’d alluded to earlier, the part of the numerator story needed to come through.

Here comes Ms. Sanae Takaichi, Japan’s first-ever female prime minister, in October of last year. She put out a number of very exciting economic growth policies. One of which is, of course, the strategic investments of public and private capital into these 17 sub-sectors. It is our view that Japan is now going from the taxing on the runway, getting ready to take off, have taken off in 2024, and is now trying to get into cruising altitude through this very good long-term investment for the future.

This is where we stand today. In anticipation of that, I think over the last one year or so, we’ve seen a very strong re-rating of the Japanese equity market. The TOPIX has returned 32% in US dollar terms, the Nikkei higher at 56%. That’s because they’re focused more on a concentrated bucket of exporters and AI-related names. That compares to, say, the S&P 500 at 24%.

Anu: Excellent. It’s a great foundation. Maybe building on that, you talked about the capital management improvements. The story really does seem to be shifting from how companies return cash to how they deploy it. To your point, CapEx, R&D, M&A, et cetera. As we talked about, the government is naming these 17 priority sub-sectors for investment. Tell us a little bit more about what’s driving that push, and how does it change how you underwrite a company’s quality?

Kei: Yes, it’s very important. Essentially, the way Ms. Takaichi sees the funding of this project is, of course, there’s going to be public assets deployed into this initiative. More importantly, she thinks that the sustainability of this whole entire project is dependent on the private sector coming in. I think this is the part where she sees a lot of opportunities for the underutilized assets, the very bloated balance sheets of many of these companies, to be deployed into these sub-sectors that she thinks is crucial from a national growth and defense standpoint.

To do so, this year, she’s actually done quite a few very important initiatives. For instance, the revision of the Corporate Governance Code for the first time in five years. There are specific references made within the code that strongly encourages corporate management to think more constructively about using their cash and their real assets to essentially boost growth of the mid- to long-term.

Another instance is the Fair M&A Guideline, where the Ministry of Trade has these guiding principles on what constitutes good practices for M&A. Again, there’s a strong reference to making growth investments over the mid- to long-term, whilst also keeping in mind about the protection of minority shareholder rights. I think all in all, this is very, very constructive. That being said, I think it is important, like, Anu, what you alluded to, in terms of quality. We, as Quality-at-Reasonable-Price investors, one of the ways that we define that is not just the strong business fundamentals and the good growth outlook, but also good corporate governance.

This, we think, is going to become increasingly more important because as companies decide on what constitutes a good investment, the very people that are making that decision need to have a good diversified skillset in terms of corporate finance, capital management, international business experience. All of these skillsets are something of a scarcity in Japan. If companies don’t have that, it is quite possible they might make a decision that could potentially be destructive for shareholder value down the line.

Anu: That’s a great point. Thank you. Now, no growth story comes for free. Japan’s debt load sits above 200% of GDP, and yen weakness is often described as the flip side of ‘Sanaenomics’. Should investors be worried about fiscal slippage, currency risk, or even currency intervention?

Kei: Yes, absolutely. Ms. Takaichi is both the opportunity and the risk in the situation. The opportunity is what I alluded to earlier. The risk is, of course, the implications this may have on Japan’s fiscal situation. You just did a great job of outlining the key statistics there. I think it is important, though, that prior to Ms. Takaichi being appointed to the position, Japan has actually been doing quite a good job streamlining the government budget, trying to get the fiscal health back.

The other point that I think is worth noting and what often gets overlooked in the press is that a lot of the key advisors surrounding Ms. Takaichi and, of course, some of the key leadership parliamentarians in the ruling party are individuals who think about the fiscal health quite highly. They also view the importance of having a good fiscal balance down the line. We are of the view that this is the key subject.

That being said, for Ms. Takaichi, she believes that economic growth is a must for Japan to have sustainable growth down the line. For the time being, she is betting on that to essentially get Japan back on its feet. One point I would just keep in mind, though, is that a lot of the debt that the Japanese government issues is actually internalized within domestic institutional investors and, of course, the asset owners domiciled here. That is a very key differentiating factor versus other governments like, say, the UK, which had the “Truss moment,” et cetera. That, I think, is something that also gets overlooked.

Anu: Absolutely. That leads me to my next question. There is a widening gap between the well-governed capital allocators and companies that are really sitting on quite a lot of cash. Why is that bifurcation showing up now as Japan exits deflation?

Kei: Yes. Over the last five to six years, we have seen a very pivotal moment for Japan where the “lost decades” of deflation is coming to an end. We are starting to see positive interest rates. We are starting to see wages take up higher on a 4% to 5% growth rate per annum. We are, for the first time in a very long time, seeing animal spirits come back to life. Companies are starting to see growth.

One, because of the fact that this economy is now seeing structurally higher costs, so they need to look for new ways to improve the top line to secure margins. Also, there is a ton of activist shareholders in this market and also very engaged long-term investors such as ourselves that are encouraging management to make better use of the capital. For that reason, I think we are seeing more and more companies really look to what their opportunities are in this market to generate growth.

Part of that has to do with, of course, making these very, very important investment decisions. This is exactly why we are also seeing a bifurcation in the market in terms of the performance of good-quality companies that have the solid fundamentals and the pricing power so that they could essentially pass on rising input costs and secure the margins at the expense of lower-quality companies that are essentially getting their market share eaten and are not able to pass on costs.

The other important part is what I alluded to earlier in terms of good corporate governance. If you don’t have well-qualified management and board directors who can actually think for the benefit of shareholders, then, essentially, they’re going to make some very poor decisions in terms of their capital allocation. This is exactly why we think that this is a market that pays to be actively invested. This is something that comes really centered to many of our conversations that we have with clients.

Anu: Actually, that’s a great segue into a discussion I wanted to have about active versus passive. We’ve seen the broader TOPIX at roughly 16 times 2027 earnings versus the S&P 500 near 19 times. Seems like a better gauge of opportunity than the narrower Nikkei index. Tell us about why that valuation gap really matters, and why a passive index isn’t the right way to get that exposure. Just go into that in a little bit more detail.

Kei: The valuation gap continues to exist in this market, albeit it has somewhat narrowed over the last several years. One of it has to do with the fact that the return-on-equity profile for Japan continues to remain around 9% or so. Whereas for the US market, it’s actually a mid to high teens. Clearly, there is that delta in terms of capital efficiency that has resulted in this valuation gap. Interestingly, I alluded to this earlier in our conversation.

As a result of the macroeconomic changes that we’re seeing at the moment, we’re starting to see interesting sectors of this economy beginning to emerge as investible parts of the economy. A good example is regional banks. 10 years ago, while the Bank of Japan was undertaking monetary policy that was very accommodative, and this is the QQE, essentially, that made it almost impossible for banks to make money from their core lending business. Today, the Bank of Japan has normalized its monetary policy or is on their way to doing so. As a result, many of these regional banks are able to make money on their core lending business.

Because many banks are starting to consolidate, they’re starting to see top-line growth for the first time in a very long time. It is our view that as the Bank of Japan normalizes its monetary policy, and we could potentially see the terminal rate go to around 1.5% to possibly closer to 2%, a lot of these banks will likely see return on equity reach mid-teens. Yet, a lot of the valuations of these banks are trading at half to one-third of what US and European banks are trading at. This is part of the interesting opportunity sets that you see in Japan that you probably won’t get much exposure to in a passive vehicle.

Anu: That’s a great point. Thank you. Now, let’s talk about the theme that everyone asks about, which is, of course, AI. Robotics and automation seem to be emerging as Japan’s next wave within the AI trend rather than chip makers directly. How does that supercycle actually show up in your portfolio? Is there a valuation gap that’s still attractive for you?

Kei: Yes, absolutely. Japan is well-positioned in the supercycle we’re seeing in the AI theme. The most obvious places that investors look for is, say, in the wafer fab equipment, or the chip testers, or the specialty chemicals companies where Japan actually has very high market share globally. We continue to find interesting opportunities on that front. As Quality-at-Reasonable-Price investors, where we look for reasonable price opportunities, we look for companies that are, say, maybe in a different part of that value chain but are mispriced.

For example, we own a couple of construction companies that have a very specialized focus in electrical engineering. They have high market share in Japan. Essentially, if any company wants to make a data center or a semiconductor brushing equipment type factory, they have to go to these construction companies. For the last 30 to 40 years, most of these companies were actually not making much money on this front. Therefore, their valuations continue to trade at low teens. This makes it a very interesting opportunity because they’re continuing to basically ride the same AI theme.

Another interesting opportunity is actually transformative technologies. As you know, Japan is home to automakers and auto suppliers and the parts that go with it. many data servers across the world are currently contending with electricity and energy management. Actually, a lot of Japanese component makers for the automotive industry contended with that decades ago when they had to try to build the most energy-efficient engines.

As a result, they have a lot of great technologies that can be applied. We have invested in a number of companies that, for instance, built the batteries that go into Teslas. Well, now, they’re taking additional capacity from that manufacturing line and building the battery backup units that are being used in the data servers. Again, the valuations are still trading at very attractive multiples, and yet they are producing the very components that will really make or break this technology down the line.

Anu: Yes, that’s excellent. Zooming out, Kei, the foreign inflows since last spring are still really below the Abenomics era peak, which suggests there’s plenty of room left to run. I know that here in the US, institutional investors remain underweight in Japan. What’s the rationale there, and what do you think it will take to shift that behavior?

Kei: The US institutional market has a very strong home bias. Therefore, it is a higher hurdle for many asset owners and institutional managers in the US to allocate capital in dedicated fashion to Japan. Also, historically speaking, in the last 15 years or so, we have seen fits and starts for the Japanese equity market. There were signs that Japan is looking interesting, but then the momentum fizzled. People that got into the market faced a value-trap situation.

However, in the last five to six years, one thing has been absolutely clear is that the reforms are here to stay and the transformation is ongoing and the valuations continue to remain attractive. In addition to that, I think what has caught the attention of many institutional investors is that the US dollar returns have actually become increasingly more attractive in favor of Japanese equities.

For, I’d say, the last two years or so, we have seen the TOPIX return around 74%, the Nikkei 100%, versus the S&P 500 at 53%, the MSCI EAFE at 56%. Increasingly, I think one thing is clear is that this is a very interesting market, not just from a balance sheet improvement side of things, but also from an earnings growth standpoint because of a lot of the themes that we discussed today. For the last 12 to 24 months, I think we have seen more and more interested institutional clients and owners in the US market knocking on our doors. I think we will continue to have some very, very constructive conversations down the line.

Anu: Thank you very much, Kei, for sharing some great knowledge on the Japanese equity market. I can’t let you go without a quick bonus question. What’s a small ritual or habit that helps you switch off after a long day of watching the markets?

Kei: Okay. For me, it’s actually not the end of the day. It’s actually the start of the day. I have two girls aged seven and four, and they need a bento box to take to school. As an early-morning person, I’m in charge of their bento boxes and their breakfast. While I’m creating these bento boxes in my PJs and a very sleepy-eyed face, I’m also thinking about the day ahead and also hearing up on the markets, listening to your podcast. I think that has been an excellent way to detach first, but also to begin to have this laser-focused mind. It has also helped me have a much better relationship with my girls as well.

Anu: Oh, that is lovely that you get to do that. Like I say, good way to start the day. If you get to put on a podcast like Disruptive Forces, then even better. Thank you very much for sharing that. Kei, we talked a lot about the Japanese market today. A few of the comments that you shared, just some highlights. You really talked about how Japan’s reform story has moved from balance sheet efficiencies to an earnings growth story with the opportunities in both AI-adjacent and overlooked non-AI names.

You also highlighted that fiscal risks do remain an area to watch. We talked a lot about Prime Minister Takaichi, some of her focus areas. You talked about how she has said that earnings growth is a must. Sustainability really also needs partnership with the private sector. We also talked about how active management matters because governance and capital allocation quality increasingly can separate the winners from the laggards.

I’ll just highlight some of your last few comments. The reforms are here to stay. Valuations are attractive. You reiterated that this is a compelling market. Not just from a balance sheet perspective, but again, importantly, that earnings growth perspective. Hopefully, I summarized some of your comments appropriately. Thank you, as always, for being on this show. We look forward to having you again soon.

Kei: Thank you very much, Anu.

Anu: To our listeners, if you’ve enjoyed what you’ve heard today on Disruptive Forces, you can subscribe to the show from wherever you listen to your podcasts, or you can visit our website at nb.com/disruptiveforces, where you can find previous episodes as well as more information about our firm and offerings.