The Tokyo Stock Exchange’s Nikkei index has been on a rising trend since the last decade. The index closed January at 36,286, the highest since the early days of 1990, approaching its all time high of 38,915 registered on the final trading day of 1989. In the 35th year that followed the high that once looked like a distant mirage, it is finally within sight. Though investing in Japan has been an unpleasant experience for a very long time, it has become rewarding in recent years. It was beyond anyone’s patience to be waiting for a fresh new high for well over three decades.
Once the 39,915 mark is reached, there are little reasons to think that the market has run its course. Wall Street kept moving up on two such occasions in the past, having conquered the once-dizzying peak after a prolonged period of adjustments that followed a spectacular bubble.
25 years were required for the Dow Jones Industrial Average to conquer the high of 381 that stood since 1929, the height of the spectacular 1920s bubble. The Dow lost almost 90% of its peak value in an epic collapse. It was not until 1954 when the two and a half decade old high was rewritten. Then, the Dow essentially kept climbing until the 1,000 mark was cleared in 1972, until it was stopped by rising inflation.
15 years were spent by the Nasdaq to move over the dizzying 5,000 mark that was reached in the late 20th century tech bubble. On the burst of the bubble, the tech-heavy index fell almost 80% from its peak, and then came back. Once the 5,000 mark was reclaimed in 2015, it kept rising and everyone knows where it is today.
35 years had passed since the Nikkei Index hit its all time high at the end of 1989, full ten years longer than the time it took for the Dow to rise to a new high. The NikkeI fell almost 80% from that peak, but this was not unusual as what follows a massive bubble. What was unusual about the Nikkei was that it took 20 years to reach the bottom ultimately after many false dawns, and it still crawled at the bottom level for three years. It was not until 2013 when the index got onto a genuine recovery mode, nearly a quarter century after the peak. On Wall Street, bottoms were found in three years after hitting the peak.
“History does not repeat itself but it rhymes” Mark Twain famously said. This time around, history doesn’t have to be unkind to Japan, and may choose to allow the Tokyo market similar behavior. In a long period of 35 years, lots of energy must have been stored in the market that enables it to leave the once dizzying 38,915 mark behind. The market is going to attach whatever fundamentals reasons that suit a rally beyond the old peak, but the following are likely excuses that validate a new rally.
One: The market is inexpensive
Valuation of the Tokyo market in terms of price/ earnings ratio has been a problem for decades, due to different accounting practices though the majority of multi-national corporations have been reporting on either GAAP or IFRS recently. The Tokyo Stock Exchange issued their dissatisfaction on its listed companies’ low valuation in terms of price/ book ratio, which is probably a better valuation metric than P/E ratio. The TSE is demanding the companies in its prime section to improve their valuation or face demotion to the standard section. The exchange’s wrath is a testament to low valuation of Corporate Japan. It is not the job of a stock exchange to pressure companies to do something about their valuation. However, they chose to do this in order to raise the exchange’s attractiveness. A collection of perennially undervalued and unexciting companies does not bode well for the exchange’s future.
At the end of 2023, the median price/ book ratio in the TSE was a touch above 1.0 and roughly 40% of the companies traded below book value. This was less than a third of the median price/ book ratio of 3.3 for the S&P500. The huge difference is essentially attributed to premiums given to U.S. tech and tech-enabled companies that dominate the world. In addition to tech, American drug makers and financial institutions command premiums over their counterparts elsewhere due to their competitiveness.
That being said, however, the median price/ book ratio at 1.0 for Corporate Japan is lamentable. Since the last decade, management of Corporate Japan has been frequently talking about raising return-on-equity as one of their management goals in the face of greater presence of foreign shareholders. They are yet to prove that higher ROE is more than a lip service. Nonetheless, it is fair to expect steady improvement on this front in the coming years even if a sudden rise in ROE is highly unlikely.
Corporate Japan is probably more undervalued than the median P/B ratio of 1.0. In a land of relatively infrequent mergers and acquisitions, much less frequent than in the U.S., book value of the companies are marked to market less frequently. Completion of M&As updates asset prices to ongoing market prices, to be reflected on balance sheets. Corporate Japan does this much less often, carrying decades old price of real estate on their book. Japanese companies could be even more inexpensive than they look on the surface.
2. Earnings can rise steadily
With greater focus on ROE and shareholders’ value, earnings can improve in a relatively steady fashion. Though there may be a global recession in the coming years, it is not a stretch to expect doubling of earnings per shares in the next ten years. It would take ‘only’ an annualized 7% increase for ten years. Doubling of EPS doubles share prices, assuming valuation stays constant. And doubling of EPS usually brings valuation upgrades.
3. Different interest rate regime brings different valuation
Japan is at last out of mild deflation in which it has been mired since the mid-1990s, thanks largely to ultra low interest rates and economic policy to stimulate demand. The pandemic’s outbreak raised prices around the world and Japan was no exception. A very weak yen exacerbated inflation. Amid much higher inflation that was unthinkable before the pandemic, the Bank of Japan has not made a move to lift its super accommodative monetary policy. The BOJ governor Kazuo Ueda remains cautious, saying the Japanese economy remains vulnerable to higher interest rates. Small and medium companies are still heavily indebted and addicted to low interest rates while large ones are financially healthy after having shed their debts that crucified them in the 1990s. An environment that makes Dr. Ueda hesitant on rate hikes still is considered deflationary despite rising prices. Deflation has been hurting valuation on Corporate Japan, together with management’s lukewarm focus on shareholders, which has caused the TSE’s wrath. A new and healthier economic environment that would allow the BOJ to hike rates on the other hand lifts valuation. Sooner or later, the Japanese economy will get to where Governor Ueda would feel more comfortable.
About the author: Mr. Suzuki is a retired investment banker based in Tokyo, Japan.