Japan optimism has been fueled by 'game-changing' reforms and Warren Buffett: Here's what you need to know

For the first time in decades, Japan stocks are back in vogue.

In the last few weeks, the benchmark Nikkei 225 and Topix indexes touched their highest levels in more than 30 years as foreign investors pour into Japanese equities with a consistency rarely seen in at least a decade.

After what turned out to be a false dawn a decade ago, when “Abenomics” first raised hopes of corporate governance reform in Japan, many seem to think better of the latest measures by the Tokyo exchange.

“The recent Tokyo Stock Exchange initiative is a game-changing moment, because it’s going to challenge a lot of companies that are trading on less than one-time price-to-book to improve profitability and support their share price,” said Oliver Lee, a Singapore-based client portfolio manager.

The Tokyo Exchange Group recently finalized its market restructuring rules. Among the latest measures was one that directed listed companies to “comply or explain” if they are trading below a price-to-book ratio of one — an indication a company may not be using its capital efficiently.

The exchange warned such companies could face the prospect of delisting as soon as 2026.

Part of the optimism in Japanese stocks stems from how specific and tangible the Tokyo exchange’s requirements are this time round. Warren Buffett’s bullish calls on Japanese equities has also helped boost confidence among foreign investors.

There is hope this would press Japanese companies’ notoriously resistant management — which typically view shareholders as enemies — for greater capital efficiency and profitability. It could in turn lead to a domino effect among other Japanese companies once the big players start to make changes.

“Until very recently, the problem was although there has been a rise in healthy corporate activism, companies and managers were still not so proactive listening to shareholder proposals,” Yunosuke Ikeda, Nomura’s chief equity strategist, told CNBC last week.

The scale for change — or disappointment — is tremendous.

The exchange said in March that half the number of its “prime” listings — the most liquid stocks with the largest market capitalization — and about 60% of those in the “standard” listings have a return on equity of less than 8% and are trading at price-to-book value of less than one.

Price-to-book value is the ratio of the total market value of a company’s share price over its book value — a company’s net assets. Return on equity is a gauge of a company’s profitability.

These companies must now show how they plan to improve their capital efficiency, since the data points suggest they may be trading below cost of capital and therefore unlikely to be capital efficient. Part of those rules require them to demonstrate how they have engaged investors and to begin publishing public disclosures in English.

If a company doesn’t meet enhanced listing criteria by the end of the ongoing transitional period and a further year-long “improvement period,” its securities may be put under supervision and could face the prospect of delisting within six months.

“Delisting or any punishment or any enforcement is quite unlikely, but the good news in Japan is there is the peer pressure factor,” said Nomura’s Ikeda. “If rival companies are doing great improvements in corporate governance, others will tend to follow that move.”

In a document published end-March, the Tokyo bourse operator wants to ensure companies achieve sustainable growth and increase corporate value over the mid- to long-term by focusing on the cost of capital and profitability based on the balance sheet, rather than just sales and profit levels on the income statement.

In other words, they want to see real strategic changes made in tandem with shareholders.

These reforms are part of a broader, multi-year structural overhaul that can trace their genesis to Abenomics — an aggressive set of economic policies that the late Shinzo Abe launched in the early 2010s, when he was prime minister.

Corporate governance is the “third arrow” of the three core tenets of Abenomics — monetary easing and fiscal stimulus are the other two. The much-touted economic policy was aimed at reviving economic growth and combating the chronic deflation that has plagued the world’s third-largest economy since the 1990s.

While the initial euphoria in Japanese stock markets over Abenomics was short-lived back in the early 2010s, investors now see a potential for a fundamental re-rating of Japanese equities should these latest corporate governance reforms take root.

“Investing in Japan equities is not investing in Japan macro, it’s not investing in themes,” said Shuntaro Takeuchi, a San Francisco-based Japan fund manager with Matthews Asia.

“It’s investing in more of a profit growth opportunity coming from margin improvement, return on equity improvement, total return improvement.”

“There is a pressure from investors, especially foreign ones to comply,” said Asli M. Colpan, a professor of corporate strategy at Kyoto University’s Graduate School of Management and Graduate School of Economics.

“Better corporate governance has been attracting more international investors including the recent ones like Warren Buffett’s Berkshire Hathaway; and more international investors are putting more pressure for compliance — forming a virtuous cycle,” she added.

In a world that is combating stubbornly high inflation and confronting anemic growth prospects, that’s just adding on to the appeal of the Japanese equity markets — with the help of Japan’s accommodative monetary policy, its comparatively more moderate inflation after years of chronic deflation, the weak yen, and relatively cheap valuations.

“We’re probably just halfway through that journey of corporate reform,” Lee said.