Japanese Equities Remain Compelling Despite Record Crushing RiseAnimal spirits are palpable in the Land of Rising Sun. Nikkei-225 smashed through it previous all-time-high set more than 40 years ago. Japanese equity markets have turned steaming hot over the past year after stagnation through lost decades.
Strong foreign investment inflows, positive impact from the corporate governance reforms, portfolio rebalancing away from China, and low valuations, are collectively serving as robust tailwinds for the Japan equity market.
Yet risks remain from an early BoJ policy pivot, high inflation eroding spending power, and limited domestic capital investment.
This paper delves into factors driving record rally of Nikkei-225 index, its outlook, and posits a hypothetical trade to benefit from its continued ascent.
WIDE RANGING REFORMS IN PLAY TO BOOST MARKETS. IS IT WORKING?
In 2022, the Tokyo Stock Exchange (“TSE”) embarked on market restructuring plan with the creation of new market segments.
Source: Tokyo Stock Exchange
TSE rolled out a raft of corporate governance reforms in March 2023. It summarized key initiatives that investors aspire to see into fruition, namely (a) Weigh the cost of capital from investors perspective, (b), Report profitability and valuation metrics from multiple perspectives, and (c) Allocate resources to improve corporate value.
Reforms aim to boost capital efficiency by utilizing excess cash reserves held by Japanese firms. Price-to-book ratio (“PBR”) is a key metric in TSE’s cross hairs. As of 31/Dec , more than half the firms that have submitted disclosures have a PBR of less than one. PBR less than one suggests that a firm’s dissolution value is greater than its market cap.
Data Source: TSE
Even among some of the largest firms in the country, PBR is less than 1.
Data Source: TV Stock Screener
A TSE Review shows that firms are allocating additional resources towards growth initiatives. It suggested share buybacks and dividends were effective means for improving profitability.
Impact of the reforms are visible in many ways. Higher shareholder returns (through dividends and buybacks) are already manifest across many firms.
Still, there is a long way to go. Disclosures and reforms are not widespread yet. As smaller firms join, capital investment could spread wider.
Data Source: TV Stock Screener
Also, while dividend growth is high, capex growth remains low. A focus on investor returns improves stock valuations in the near term. However, a larger push towards long-term capital investments will be required for long-term sustained growth.
Capital spending by firms surged 16.4% YoY in Q4.
Japan’s Prime Minister Fumio Kishida is pushing for its citizens to invest in domestic firms rather than save. He has re-launched the NISA tax-free investment programme. It provides extended tax-exemption periods and higher annual investment limits. The scheme, if successful, could channel large chunks of new capital into Japanese equities.
Domestic participation remains low for now. Japanese investors prefer foreign stocks over domestic ones as per a Morningstar study .
VIBRANT FOREIGN INFLOWS IN JAPANESE EQUITIES
While domestic investors are yet to embrace its domestic markets, foreigners are leading the charge. US investors have poured USD 8.3B into Japan focused ETFs ( AMEX:EWJ , AMEX:BBJP , and AMEX:DXJ ) since 2023.
JAPANESE EQUITIES REMAIN UNDERVALUED
Japanese equities remain under-valued. Warren Buffet famously invested USD 6 billion during the pandemic in Japanese trading giants citing that he was offered a “ridiculous price”.
Despite the recent market surge, P/E for stocks in the Nikkei-225 stands at mere 20.8x. Comparatively, stocks in the S&P 500 have an average P/E of 34.9x.
Data Source: TV Stock Screener
Nikkei-225 valuations are even more attractive when adjusted for growth. Average (excl. outliers) TTM PEG ratio for Nikkei-225 firms is 1.3x while for the S&P 500 its 2.5x.
Data Source: TV Stock Screener
Low profit growth remains a concern for Japanese firms. According to the Japan Ministry of Finance figures , ordinary profits rose by 13% YoY in Q4 2023, while high, that’s slower than 21% during Q3 2023.
JAPAN IS ALSO AN AI BENEFICIARY
Tokyo Electron, Renesas, and Advantest, constituents within the Nikkei-225 index have emerged as AI rush beneficiaries. Specifically, Tokyo Electron has surged more than 58% YTD. Softbank is another top performer thanks to its investment in $ARM.
Heatmap of Nikkei-225 with key firms that comprise a large weightage in the index highlighted in blue.
Nikkei-225 is a price-weighted index. Tokyo Electron commands the second largest weight in the index at 9.4% due to its high price. Advantest is third with 4.7%. Softbank ranks fourth with 4.45%. Therefore, a sustained AI fuelled market rally is likely to positively impacting the index.
Not just the chip stocks, the Nikkei rally has been top-heavy due to outperformance of other large stocks too. Fast Retailing (the top weight in the index) is also supported by strong tailwinds and solid financial performance which has clocked a 26% rise YTD (versus 19% jump in the index).
If outperformance among the large Japanese firms continue, the Nikkei will continue to race at a fast pace.
NIKKEI IS STARTING TO FACE HEADWINDS
Despite impressive performance and bright outlook, cause for concerns exist in the near term. Rising concerns that the BoJ may exit its loose monetary policy sooner than previously expected could snap the rally.
Inflation has started to rebound. Wage growth estimates are solid. Revised figures for capital spending are expected to show that the economy avoided a technical recession in Q4.
The benchmark index is starting to face resistance. An earlier than expected BoJ pivot could put brakes on this rally.
Some market participants expect the BoJ policy pivot as soon as the 19/March policy meeting. Most expect the pivot to occur at the 26/April meeting. A consensus on the exact meeting has not been reached among BoJ officials according to Bloomberg .
HYPOTHETICAL TRADE SETUP
Nikkei is benefiting from strong tailwinds. It also faces the risk of a near-term correction, particularly from anticipated strengthening of the Yen.
A hypothetical long position in the Yen denominated CME Nikkei-225 index futures with an entry upon near term correction is posited for a superior reward-to-risk ratio.
The following hypothetical trade setup comprising of a long position in the Nikkei-225 Yen Denominated futures expiring in June (NIYM2024) benefits in case the Nikkei-225 rises.
As the payout from the position is denominated in Yen, a strengthening of the Yen will serve as an additional boost to the dollar P&L.
• Entry: 37,900
• Target: 41,690
• Stop Loss: 35,000
• Profit at Target: ¥1,895,000 ( (41690 – 37900) x 500 Yen/index point)
• Loss at Stop: -¥1,450,000 ( (35000 – 37900) x 500 Yen/index point)
• Reward-to-Risk Ratio: 1.3x
MARKET DATA
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