The fund manager of our Japanese equity fund Taiko Japan, Rupert Kimber, recently came back from a trip to Japan. Here are his notes.
After 30 years of deflation, corporate Japan has widely embraced inflation and product/service prices will continue to rise for another couple of years especially as internal cost pressures, such as wages, need to be offset. Recent regulatory changes have further raised wages. These higher selling prices will be implemented even at the expense of sales volumes. Minor yen appreciation and correspondingly lower imported costs will not alter this strategy.
We have seen a very mixed 2 speed picture on domestic consumption, with cost of living expenses rising well in excess of wages and overall spending flattered by the inbound tourism component. Low to mid income earners are squeezed whilst high earners’ consumption remains robust and price agnostic reflecting a decline in overseas consumption and the result of surging asset prices.
The BOJ remains in a quandary on interest rates. Despite modest yen appreciation, the headline CPI inflation should easily remain above their 2% target, hence the comments by Ueda on further likely rate hikes. However, we continue to believe that the BOJ will be constrained by the underlying weakness in the SME sector and the threat of higher credit costs in the banking sector. Key economic indicators, such as capex, remain very mixed despite the reshoring initiatives. In our opinion, a gentle upturn in rates is the most plausible scenario, a view which is echoed by many corporates including financial institutions, unless the BOJ simply prioritises inflation data in preference to the impact it may have on the economy.
Given our view on Japanese interest rates, any further yen appreciation will be determined by the degree of US interest rate cuts. Taken the current market pricing for future FED rate declines, there is no basis to expect further material yen appreciation.
Consolidation in the corporate sector continues to accelerate in multiple sectors. This reflects a decision by companies to exit non-core strategies as well as the succession issues at SMEs. Our meetings with CEOs in many sectors confirmed not only a rising number of potential transactions but, interestingly, also a more recent trend of larger sized businesses now being offered for sale. Many companies are currently involved in transaction negotiations.
The upcoming election of a new prime minister to replace Kishida will only influence the stock market if there is official intervention to protect Seven & I holdings from the potential takeover by Touche-Card. The recent corporate code amendments suggest a greater free market approach and this proposed transaction will prove a litmus test. Our discussions and meetings suggest the government will struggle to make a valid case to oppose the transaction. Given the imminent LDP leadership election, the timing of the bid looks very well designed. Recent political pressures on the BOJ to raise rates following a consumer backlash are likely to fade.
The corporate sector continues to downsize exposure to China, and this appears to be a long-term trend. Companies with local production are facing an ever-rising trend towards a preference for local Chinese brands. The Mitsubishi Motors withdrawal will be replicated by many other companies. Supply chains will continue to be redirected towards SE Asia and Japan. This will also be reflected in the expected rise in overseas acquisitions over the next couple of years which will include the US and SE Asia. We found recent examples of such overseas deals at some of our visits.
The stock market is clearly rotating away from the significant weak yen liquidity inflows and the resulting index focus of the last 18 months towards a broader focus that includes both small caps and growth stocks. This will continue given the unlikely return to significant yen depreciation. With most corporate earnings forecasts based on the current $/¥ 145 exchange rate, there is no immediate earnings risk from the recent yen appreciation. Activists remain highly visible especially at vulnerable small/mid-sized companies but the larger corporates appear less concerned as they are already undertaking clear strategies to improve both operational and shareholders’ returns. Further MBOs do appear likely and global PE companies have considerable further capital to invest.
Economy
Many commentators had expected faster economic growth given rising wages, strong inbound tourism consumption and a revival in capital expenditure given the reshoring and government subsidies for foreign companies to relocate new plants into Japan.
With the domestic consumer facing higher cost of living expenses despite wage rises, the argument that Japan is shortly to enter real wage growth, whilst optically correct, looks very misleading. Retailers are experiencing a clear consumer trend towards lower priced products and the large supermarkets and convenience stores are reporting smaller basket sizes per visit. The government have been forced into a rapid U-turn and reintroduced fuel subsidy payments. A recent rise in credit costs and delinquencies, albeit from very low levels, reflects the pressure on the consumer. The soft drinks industry has further planned price rises in October of 20-25% at Suntory Beverage, the industry leader. Our meeting suggested that they are quite prepared to sacrifice sales volumes and furthermore remain confident that the retailing channels will not undermine this strategy through price discounting. Looking into 2025, the P&C insurance companies will further raise premiums, c4-5 % in the auto sector, to reflect higher repair costs. High end consumption remains visibly buoyant, and property prices remain very firm and largely unresponsive to mild interest rate hikes. This is also partly due to the introduction of new jumbo family mortgages that have enabled affordability of the high absolute property price levels.
Perhaps the largest discrepancy relates to capex. Conversations with machine tool companies suggest that the benign overall capex numbers reflect very low investment levels by the auto sector, a material component. The issue here is that the large OEM manufacturers are no longer investing in ICE and have not meaningfully embraced the EV market. Hence, the only current investment is concentrated in hybrid products which are generating significant profits. There are expectations that in 2025 overall capex levels will rise as the semiconductor industry will increase production and there are multiple new plant construction orders from Japanese companies. The recent April 2024 regulatory changes, relating to overtime payments in both the construction and logistics sector are contributing to higher cost pressures. For the construction industry, this represents a shift from a 6 to 5 day working week and hence new project quotes have risen by over 30% and we found certain examples of customers both deferring and cancelling new investment plans. Our visit to the largest importer of high-end construction materials confirmed this development. This does not affect the current boom in areas such as data centre construction though again, the higher construction and operating costs seem likely to exert further upward pricing pressure on customers.
Corporate sector
In recent years, the management focus on improving operating returns has been well documented. From our meetings, the current focus surrounds the need to raise labour productivity. In this sense, we found more examples of corporates employing outside consultants, both foreign and domestic, to conduct analysis and provide implementation advice. This strategy is partly designed to persuade reluctant employees that change is required after internal efforts to implement change have failed. The domestic consulting industry remains very buoyant with many firms likely to expand headcount. Higher consulting revenues also reflect the historic lack of investment related to inhouse technology which has left many companies, and some surprisingly large ones, ill-equipped for the new digital era. The recent AI interest seems likely to improve productivity but very few companies, including software companies that we visited, have a precise view on the actual cost/benefit analysis and there are many instances of Japanese companies making investments in overseas startup technology VCs as a hedge on future developments.
The ongoing consolidation process has accelerated markedly in 2024. Yoshimura Food, an aggregator of small food companies, has seen potential acquisition pipelines expand significantly and has been offered companies with almost double the sales revenues with unchanged valuations. From another perspective, our visits to the leading M&A advisory companies confirm this trend, both in deal flow transaction numbers and the higher value of the transaction. This trend appears likely to be a multi-year development but potential regulatory changes have lowered share prices sharply at these advisory companies. However, without material changes to the fee structures, which are currently not being considered, then we see an interesting investment opportunity emerging, given the multi-year deal flow prospects.
Management response to the activism and increased corporate governance pressure is determined by the size and valuations of each company. Whilst clearly small/mid cap companies are more vulnerable, especially those with discounts to book value, our meetings in both London and Tokyo suggest that the larger companies are more focussed on longer term ROIC improvements to lift valuations and there is a certain cynicism over ROE improvements generated by buybacks alone.
The potential acquisition of Seven & I holdings is a further illustration that recent changes to the corporate code are making it more difficult for boards to summarily dismiss bid approaches. The recent changes now force the outside directors to make the first judgement on any bid proposals.
Investment conclusions
The recent stock market flash crash in early August should be viewed as a turning point. With peak yen depreciation now behind us and possibly another 1-2 rate hikes over time, the leadership within the market will become more balanced and will broaden out to include some smaller companies and certain beleaguered growth stocks. The mid/small cap universe has many companies with a bright future at cheap valuations whilst some of the higher quality growth companies have seen extreme multiple compression. Foreigners certainly are well underrepresented on these shareholder registers. We have seen peak flow momentum into index names and into popular trades such as the trading companies bought by many who have simply followed Warren Buffett. A surprising and most welcome feature of the flash crash related to individual investors, who have historically had long margin positions that would have been closed out at losses, but this time were cashed up and therefore eager buyers on the Monday where overall daily trading volumes reached a 2024 high. Given the ongoing acceleration of the consolidation process, the industry leaders should have considerable long-term appeal which is not priced into valuations today. A more nuanced portfolio approach should work well.
One final word on the implications for foreign takeovers in Japan… In the event of a successful acquisition of Seven & I Holdings by Touche-Card, there will be speculation on potential other candidates. In reality, the national security law provisions will prohibit many of the best manufacturing companies from foreigners. The most logical impact will be further pressure on managements to raise returns to avoid aggressive shareholder engagement which in some cases such as Fuji Soft had ended in a transaction for the entire company. The subtle end game here is that domestic institutions are quietly withdrawing support for managements that serially underperform whilst the cross-shareholding feature of the corporate sector is unwinding very quickly. Managements find themselves vulnerable to shareholder discontent today more than at any time previously in my 37 year career in Japan.