Japan’s Market Boom Is Just Getting Started. 2 Big Reasons Why.

About the author: Patrick L. Springer is an institutional-equities business developer and Japan and Asia market specialist. He worked at Morgan Stanley in management roles for more than 20 years.

Japan just concluded a 34-year trek in the wilderness of deflation and ended its nearly 20-year negative interest-rate policy. The stock market has responded by achieving new all-time highs, last seen in 1989, rising 35% in the past year.

This might look like the top, but a closer look at Japan’s market suggests that the end is just the beginning for the world’s third-largest market. This year likely marks the beginning of a multiyear Japan market revival that will start a major new capital markets cycle. Japan’s companies are just beginning to celebrate a long-awaited return of pricing power supported by an enamoured global investor base looking for international ideas in a friendly market.

Investors should focus on two trends. First, new micro and macro forces are at work to make Japan a preferred non-U.S. destination for several years. With the U.S. dollar at 20-year highs, portfolio managers know that it is typically time to diversify and buy cheaper overseas markets, but where to go? Europe is cheap but challenging, and the I of India is what currently remains best of the emerging markets BRICS grouping. Exposure to Asia is important for global portfolios given it is 45% of global gross domestic product. Yet strategists say that we now live in a “multipolar world,” a euphemism for the highest level of geopolitical risks in the world in decades. This limits China investment allocations for now.

But Japan is a pre-eminent security partner for the U.S. Japan also is quickly becoming a key partner in U.S. reshoring strategies, especially as an alternative supplier of semiconductors and technology components. The reshoring trend is compounded by the yen’s weakness. At nearly 152 yen to the dollar, Japan’s currency is trading at the lowest ratio since 1990. That means Japan is also likely to regain market share that it lost over the past 20 years to China in automobile components, industrial products, and machinery. Status as a security partner matters to investors now, which will keep allocations to Japan higher for longer.

Second, Japan’s differentiated market structure may provide more alpha-idea opportunities than investors might expect from an older, developed economy. In the U.S., megacaps and the Magnificent Seven rule the world for investors—and for good reason, given their recent outperformance. The high level of exchange-traded fund penetration in the U.S. also favors large-caps over small- and medium-capitalisation stocks. But in Japan, the list of Japan’s largest companies remains unchanged: Excluding SoftBank, all were established pre-1960.

According to Abrdn Investments, 45% of Japan’s benchmark Topix Index of 2000 constituents have no analyst research coverage, compared with just 3% of the Russell 3000 universe for the U.S. As inflation sparks growth, earnings surprises and inflections of Japan’s under researched companies will lead to significantly higher alpha capture opportunities.

Additionally, the Japanese government and the Tokyo Stock Exchange have initiated important corporate-governance reforms, and 26% of all listed companies have submitted specific plans to improve their stock valuation. But many more companies have yet to respond, providing more opportunities for investors.

Sorting Japan’s nearly 3,900 stocks into market segments is revealing. Japanese mid-cap and small-cap stocks have lagged behind large-cap stocks by 40% and 60% year to date, respectively, and have lagged by 25% and 46% on a one-year basis.

Such underperformance by itself is one thing, but for the many investors who have never seen inflation, wage growth, and domestic sales gains in Japan, they may find a discovery universe of new stocks with interesting characteristics such as these:

Organo , a $2 billion market-cap water treatment company that has traded over $60 million a day on some days and counts Taiwan Semiconductor Manufacturing as one of its key growth customers.

Nakanishi , a $1.5 billion dental-equipment and precision-tools maker that grew sales 23% last year, sports a 2.5% yield and a 24% return on equity, and has 12% of its stock price in net cash.

Chugoku Marine Paints , a global top-three maker of marine paints that has a 20% global share and a 15% return on investment capital, sells at nearly 11 times earnings, and has a 2.6% dividend yield.

Overall, this analysis finds nearly 100 companies with a market cap above $1 billion with net cash equal to 20% or more of their stock price.

The bottom line is that Japan’s culture of innovation, combined with an end to deflation, is likely to produce a new wave of capitalisations. During the decades of deflation, corporates and consumers alike were incentivised to save more, spend less, and underinvest. But with nominal GDP growth now running at a whopping 5% and record wage growth, inflation incentivises new capital investment, stimulating a new investment-banking cycle of financing.

There are risks to this outlook. Double-digit market rallies can lead to pullbacks, and investors need to watch for threats to Japan’s inflation and currency levels and to its appetite for reform. But what’s most important for investors to realise about Japan is how much has changed there, amid a changing world.

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U.S. investors’ enthusiasm over Japanese stocks at this time last year turned out to be misplaced, but the market is again on the list of potential ways to diversify. Corporate shake-ups, hints of inflation after years of declining prices, and a trade battle could work in its favor.

Japanese stocks started 2024 off strong, but an unexpected interest-rate increase in August by the Bank of Japan triggered a sharp decline that the market has spent the rest of the year clawing back. Weakness in the yen has cut into returns in dollar terms. The iShares MSCI Japan ETF , which isn’t hedged, barely returned 7% last year, compared with 30% for the WisdomTree Japan Hedged Equity Fund .

The market is relatively cheap, trading at 15 times forward earnings, about where it was a decade ago, and events on the horizon could give it a boost. Masakazu Takeda, who runs the Hennessy Japan fund, expects earnings growth of mid-single digits—2% after inflation and an additional 2% to 3% as companies return more to shareholders through dividends and buybacks.

“We can easily get 10% plus returns if there’s no exogenous risks,” Takeda told Barron’s in December.

The first couple months of the year could be volatile as investors assess potential spoilers, such as whether the new Trump administration limits its tariff battle to China or goes wider, which would hurt Japan’s export-dependent market. The size of the wage increases labor unions secure in spring negotiations is another risk.

But beyond the headlines, fund managers and strategists see potential positive factors. First, 2024 will likely turn out to have been a record year for corporate earnings because some companies have benefited from rising prices and increasing demand, as well as better capital allocation.

In a note to clients, BofA strategist Masashi Akutsu said the market may again focus on a shift in corporate behavior that has begun to take place in recent years. For years, corporate culture has been resistant to change but recent developments—a battle over Seven & i Holdings that pits the founding family and investors against a bid from Canada’s Alimentation Couche-Tard , and Honda and Nissan ’s merger are examples—have been a wake-up call for Japanese companies to pursue overhauls. He expects a pickup in share buybacks as companies begin to think about shareholder returns more.

A record number of companies have also delisted, often through management buyouts, in another indication that corporate behavior is changing in favor of shareholders.

“Japan is attracting a lot of activist interest in a lot of different guises, says Donald Farquharson, head of the Japanese equities team for Baillie Gifford. “While shareholder proposals are usually unsuccessful, they do start in motion a process behind the scenes about the capital structure.”

For years, money-losing businesses were left alone in large corporations, but the recent spate of activism and focus on shareholder returns has pushed companies to jettison such divisions or take measures to improve them.

That isn‘t to say it is going to be an easy year. A more protectionist world could be problematic for sentiment.

But Japan’s approach could become a model for others in this new world. “Japan has spent the last 30 to 40 years investing in business overseas, with the automotive industry, for example, manufacturing a lot of the cars in the geographies it sells in,” Farquharson said. “That’s true of a lot of what Japan is selling overseas.”

Trade volatility that hits Japanese stocks broadly could offer opportunities. Concerns about tariffs could drag down companies such as Tokio Marine Holdings, which gets half its earnings by selling insurance in the U.S., but wouldn’t be affected by duties. Similarly, Shin-Etsu Chemicals , a silicon wafer behemoth that sells critical materials, including to the chip industry, is another potential winner, Takeda says.

If other companies follow the lead of Japanese exporters and set up shop in the markets they sell in, Japanese automation makers like Nidec and Keyence might benefit as a way to control costs in countries where wages are higher, Farquharson says.

And as Japanese workers get real wage growth and settle into living in an economy no longer in a deflationary rut, companies focused on domestic consumers such as Rakuten Group should benefit. The internet company offers retail and travel, both of which should benefit, but also is home to an online banking and investment platform.

Rakuten’s enterprise value—its market capitalization plus debt—is still less than its annual sales, in part because the company had been investing heavily in its mobile network. But that division is about to hit break even, Farquharson says.

A stock that stands to benefit from consumer spending and the waves or tourists the weak yen is attracting is Orix , a conglomerate whose businesses include an international airport serving Osaka. The company’s aircraft-leasing business also benefits from the production snags and supply-chain disruptions at Airbus and Boeing , Takeda says.

An added benefit: Its financial businesses stand to get a boost as the Bank of Japan slowly normalizes interest rates. The stock trades at about nine times earnings and about par for book value, while paying a 4% dividend yield.

Corrections & Amplifications: The past year is expected to turn out to have been a record one for corporate earnings in Japan. An earlier version of this article incorrectly gave the time frame as the 12 months through March. Separately, Masashi Akutsu is a strategist at BofA. An earlier version incorrectly identified his employer as UBS.