Japan: the second leg of the bull market takes shape in 2023

First leg of the stealth bull market in Japanese equities is now firmly established and now there are indications of the catalyst for the second leg of the bull market for 2023 and onwards.

The simple thesis behind the first leg of the bull market centres on the once in a generation transfer of wealth from corporate balance sheets to investors. The origins can be traced to 2009 and the post Lehman crash. Japanese banks forced highly indebted large Japanese conglomerates into restructuring to improve cashflow. The government from 2011 encouraged industry consolidation which then improved the market shares and profitability of the domestic market leaders. Today in 2022 both factors are still very much apparent with the post covid restructuring focussed on technology led internal productivity improvements and further portfolio product downsizing whilst the consolidation accelerates due to financial problems amongst SMEs. For investors this has led to the perfect environment whereby rising FCF is returned to investors through higher dividends and share buybacks. Individual companies are returning over 10% annually to shareholders and individual share buybacks have reached 40% of the issued share capital in extreme cases. The dividend yield on the market remains higher than the inflation rate. Corporate managements cannot afford complacency with a new breed of activists on the warpath whilst the global PE companies are active buyers of whole companies and specific divisions, which allows management to improve ROIC and ROE. The only missing ingredient has been significant foreign investor participation, partly explained by the weaker yen and also a lack of appreciation over a decade of the scale of the changes in the corporate sector.

The second leg of the bull market in 2023 will start to become visible for multiple reasons. An accelerated reopening of the Japanese economy will bring a return of the foreign tourist who in 2019 spent USD 19bn. A reshoring by corporates is leading to buoyant domestic capex as multiple new factories will be constructed. However, the most significant factor surrounds a likely change in monetary policy driven by genuine signs of sustained domestic inflation that will improve consumption levels and most critically bring around yen appreciation, thereby enabling foreign investors to make money from the yen. The origins of the genuine sustained inflation are very poorly understood and will cause macro strategists, today almost universal bears on Japan, to radically and positively reassess Japan. We are confident that our research into the cause of this sustained inflation is robust.

Japan still offers the most compelling equity valuations of most developed markets. Valuations are very cheap. Where else can you buy companies with net cash, positive FCF on EBITDA multiples of 1x? Dividends will continue to rise as will share buybacks. Issued share capital is shrinking in front of your eyes given the buybacks and cancellation. The BOJ will not be equity sellers. No material energy shortages to worry about.

A period of yen appreciation will cause foreigners to return, and they will be confronted by an ever-diminishing supply of equity.