Corporate Governance Practices Are Changing
But Japan’s perpetually low profitability is poised to change. Positive catalysts include improving growth and higher inflation, which have lifted interest rates and the cost of capital. Most importantly, structural and regulatory reforms of corporate governance practices—with a focus on improving ROE for shareholders—have created new domestic momentum for improvement.
Corporate cross-shareholdings have more than halved from over 60% in 1990 to around 25% at the end of 2023, according to the latest available data from Japan Exchange Group. Foreign investors, with 32% of total ownership, have more influence. Japanese management teams are increasingly getting to grips with the reasons for Japan’s inferior returns—low profit margins, insufficient operating leverage and inefficient balance sheets, with many companies in net-cash positions. The turnaround potential is huge: Morgan Stanley recently predicted that Japan could generate ROE of 13% by 2030—a bold forecast that could prompt a corresponding improvement in valuations if realized.
Management Teams Prioritize Growth—and Returns
That outlook doesn’t seem like a wild fantasy anymore. Many Japanese companies can control their own destinies by pursuing governance reforms, which makes their returns less dependent on external forces and macroeconomic conditions. We think this is a particularly attractive feature of Japan’s market as tariffs, inflation and geopolitical tensions fuel global uncertainty and volatility.
US companies are attractive investments because they’re already highly profitable, with efficient assets and strong shareholder returns; in other words, it can be harder for them to improve. By contrast, Japanese companies can grow earnings and profitability simply by selling or shutting down subscale business divisions, engaging in rational competition, increasing operating leverage or distributing cash on their balance sheets. As we see it, these are appealing features that create a useful diversifier to existing equity allocations.
Picking ROE Improvers? Active Management Required
But how can investors pick those reforming Japanese companies?
Not all are improving at the same pace, and some aren’t improving at all. We’re seeing more companies streamline balance sheets by distributing excess cash through dividends and buybacks, which many investors seek. But that’s just the tip of the iceberg.
Profitability is the key differentiator between Japan and the US (Display). Of course, balance-sheet efficiency gains from distributing idle cash through dividends and buybacks are always welcome. Yet companies that are serious about improving fundamentals can deliver a step-change in ROE and provide investors multiple ways to win through both faster profit growth and higher valuations.
