So the story goes something like this…
In the 1980’s, a US manufacturer struck a deal with a Japanese component manufacturer to provide parts for the machines in their factory. Within the purchase agreement, which was standard in their previous contracts, was an allowance of up to 2% of components that were permitted to be ‘faulty’. When the parts were shipped to US, the delivery contained two separate shipments. One with the exact quantity requested, all made to a perfect standard. Another containing the 2% of faulty parts with a note which read “we are unsure why you require a small amount of faulty parts, but please find enclosed with our compliments!”.
Is this true? I have no idea. But it illustrates the Japanese obsession for getting the details right. The instructions may have been lost in translation, but the Japanese manufacturer couldn’t conceive that any shipped goods would be substandard. Japanese corporations have long had a reputation for precision and high quality manufacturing,
The Rise and Fall
After the Second World War, Japanese companies, working hand in hand with the government, forged reputations built on strict hierarchy, obedience and consensus. Their bureaucratic and regimented approach was the envy of the business world and by the end of the eighties Japan was the biggest stock market on the planet, after an incredible rise in stock prices. Then, in 1989 the bubble burst, and Japan entered a multi decade malaise.
After the Berlin wall came down, and the global economy opened up, the things that made Japanese companies so successful became part of their problem. Making physical goods was replaced with the information age of the internet. Software became the new hardware. Many businesses became more open and collaborative, whereas Japanese firms became even more risk averse, even more insular and the culture of the company man ‘job for life’ set in. Compounding this were cross-shareholding agreements between ‘friendly’ companies which protected failing management teams and led to zombie companies that were not run for the benefit of their shareholders.
During this long period Japan had several bouts of deflation, collapsing real estate prices and frequently suffered from deflationary spirals. This is when consumers believe that prices will be lower in the future➡️ they put off purchases to a later date ➡️ which reduces companies’ profits➡️ which pushes companies to reduce wages / lay off staff/ reduce prices➡️ which in turn leads to deflation. Rinse and repeat. This is why central banks will move heaven and earth to avoid deflation. This is also why Japanese prime ministers didn’t tend to last more than a year <insert Liz🥬 Truss joke here>.
Abe-cadabra
The revolving door of PM’s changed in 2012 when Shinzo Abe was elected and his economic reforms began to jump start the economy. The reforms had three ‘arrows’. The monetary and fiscal arrows had immediate impact but the third arrow, which focused on economic growth and corporate governance improvement was always going to take much longer, but had the potential to make the biggest difference.
The past 10 years have seen continuing improvements in how companies are being run, and earlier this year the Tokyo Stock Exchange announced they would publish a list of companies who have disclosed plans to increase their capital efficiency. Given the Japanese culture of compliance and uniformity, this strategy of publicly naming the firms who are delivering shareholder returns and making good use of their cash is likely to hit home with firms who don’t embrace these changes. It is no coincidence that Japan has become the destination of choice within Asia for private equity deals (probably a good time to open a shop in Tokyo selling Rolex’s and Patagonia gilets!) and Japan has once again captured the attention of foreign investors.
We all thought it would never happen, but last month the stock market finally got back to its previous high of the bubble era. Good news is obviously like buses in Japan, as a week or so later the Bank of Japan was confident enough to end its negative interest rate policy after eight years, and is cautiously taking a first step towards normalising their monetary policy.
Defeating deflation and the confidence it brings is so important for Japan. Since 1990 inflation in the UK has been 236%. Over the same period in Japan inflation has been a mere 14%. Think about that, for 34 years prices of goods and services in Japan have hardly changed. This is why the inflation experienced in the past few years has not hurt Japanese consumers in the same way that Western consumers have felt the impact of surging prices. A small amount of inflation can bring confidence. If consumers believe their wages will go up in the future they are more willing to borrow and spend now and running a business when prices are rising by 2-3% a year is a heck of lot easier than doing so when prices are falling every year.
It’s not all plain sailing for Japan, who have had to deal with terrible demographics for years, which is inherently deflationary. The government has attempted to reverse the situation, but its incentives to increase the birthrate, get more women in to the workforce and increase immigration have only had a limited effect so far. This is a problem that many other countries are going to have to deal with, especially Western Europe, Taiwan, Korea, China and the UK. In fact three-quarters of nations are projected to fall below population replacement birth rates by 2050. Japan is just ten to fifteen years ahead of everyone else.
There are other issues, such as the scale of Japanese government debt, Japan being a net importer of energy and the equity market being fairly cyclical so is more prone to global economy slow down. On balance, however, there are reasons to be cheerful about Japan.
Don’t say the D word
“This time it’s diff…” Don’t say it!!🤫 This phrase is the Voldemort of Japanese investing. Since 1990 there have been six big market rallies, all of which ultimately fizzled out. But over the last decade Japanese equities have actually produced solid returns, not that you would know it from the little coverage it gets. Indeed, Japanese equities have been in a bull market, and have achieved this without valuations getting too expensive.
Many abandoned Japan during the long, painful bear market following the 1989 peak, so the return of foreign investors is a potential driver for the market, but the real kicker for sustainable returns will be when the Japanese start to invest in their own market again. Inflation will help. There is a vast $7.7tn of savings currently held in cash and deposits by Japanese households, which looks less attractive when prices start to go up. Also, 20 million Nippon Individual Saving Accounts (NISA), modelled on the UK ISA, have now been opened, with people in their 20s and 30s appearing to be taking their first steps into investment. Younger investors have the added advantage of not having the scars of investing in Japan through the worst years after the crash.
For years Japan has been largely forgotten, but global investors are now starting to take note. If domestic investors also wake up to the opportunity then things could get interesting.
