As wealth and asset managers continue to set out their ideas on strategy and portfolio positioning for 2024, we give this example of a viewpoint about Japan, a country that has gone through a reappraisal of its stock market from international and local investors.

Japan is going through “durable fundamental improvements and lasting change in attitudes toward shareholders,” according to US-based investment house GMO Asset Management. The firm sets out four “4s” which it says underpin its views about the country’s stock market.

The firm said its seven-year asset class forecast framework sees Japan small value equities poised to deliver absolute returns of 12 per cent, ranking them amongst its highest forecasts. 

GMO set out the four “4s”: 

-- 1. 4 per cent real returns due to fair valuation: Japan broad equities look about fairly valued and priced to deliver 4 per cent real returns; 
-- 2. 4 per cent new initiatives: Four recent policymaker initiatives should provide support for company fundamentals and shareholder returns; 
-- 3. 4 per cent Alpha from tilting to small value: Active managers who dial into cheap small value stocks stand to capture an additional 4 per cent of returns; and 
-- 4. 4 per cent tailwind from cheap yen: If the yen reverts slowly back to fair value, dollar-based investors stand to pick up a 4 per cent tailwind.

While Japan has been in the headlines early in 2024 for grim reasons – the earthquakes and a major airport accident – recent financial and economic news in the Asian nation has been more encouraging. As recounted by a number of wealth managers, corporate governance reforms, an end to deflationary pressure in Japan, and changing supply chain patterns, have buoyed the country’s economy. (See examples of commentaries here, here and here.)

The comments at GMO come from Drew Edwards, head of its Usonian Japan equity team and a partner at the firm; and John Thorndike, co-head of the firm’s asset allocation team.

On its returns forecast point, Edwards and Thorndike write: 

“Two key drivers underpin GMO’s forecasts: valuations and fundamental growth. After the recent run in Japanese equities, valuations look fairly valued for the broad universe. The interesting part of the story lies with fundamentals. While many believe recently strong fundamentals are a head fake and will revert to lower levels, evidence suggests otherwise.

“Most investors do not realize that Japan has been delivering superior fundamental growth for years. Exhibit 1 (below) charts the returns shareholders earn from distributions and fundamental growth, ignoring the effects of valuation change. The smooth 4.5 per cent annualised return line is consistent with what we expect stocks to earn in our “Low” base-case forecast scenario, and it’s roughly what we think equity markets should have delivered over the last 10 years,” they write.



The authors continue: “The key question is what is more relevant going forward – the past 10 years or the 30 years before? Are we going back to the old normal of 3 per cent real fundamental performance, or has Japan changed in an enduring way where we should expect something better? Understanding our estimates of return on capital (ROC) in Japan helps answer these questions. After all, it’s return on capital that generates the cash flow that can either be distributed to shareholders or reinvested for growth."

“Over the last five years since we made the change, ROC has remained high, except during the depths of Covid, and is very close to the developed market norm today. If we roll our structural break model forward, it still sees roughly a 95 per cent chance that ROC is not reverting around that old historical norm,” they write. “If profitability slowly continues to improve toward global norms, fundamental performance should be better in Japan going forward than it was before Abe’s reforms.” (This is a reference to the supply-side, fiscal and monetary measures enacted by the Shinzo Abe administration. Abe died in July 2022.)

“Today Japan trades right around what we would consider fair value, so our forecast from valuation change is immaterial. Essentially, all the return that we expect comes from fundamentals, which we model to deliver 4.2 per cent. Combining these effects, Japanese equities should deliver 3.9 per cent in real terms. Not particularly exciting, but not bad, either,” they conclude.