The Opportunity in Japan

Japan's Equity Market Reform Has Shifted from Policy to Execution: Short-Term Results Are Significant, but Long-Term Potential Is Even Greater

The report argues that the capital efficiency reforms driven by the Tokyo Stock Exchange (TSE) are reshaping Japan's equity market away from its "value trap" label, but the process remains in its early stages. The author notes that the TSE reforms can be traced back to Abe's "three arrows" (2012), with key milestones including the 2015 Corporate Governance Code and the 2021 Guidelines for Investor and Company Engagement. Currently, over 50% of Japanese stocks have a price-to-book ratio (PBR) below 1x, and the TSE requires companies to raise their PBR above 1x. Short-term results include: 40% of Prime Market constituents (approximately 1,600 companies) have disclosed "capital improvement plans," and total shareholder returns (dividends plus buybacks) have hit record highs for the third consecutive year. However, the author emphasizes that 46% of Japanese companies still hold net cash balance sheets (a legacy of the post-bubble economy), compared to less than 20% in the U.S. The author's original words are: "But there is still a long way to go."

Multi-Party Forces Drive Reform in Concert, with Proxy Voting Agencies and Activist Investors Forming a Synergy

The report argues that the TSE is not acting alone; the Ministry of Economy, Trade and Industry (METI), proxy voting agencies such as ISS and Glass Lewis, and overseas activist investors are forming a reform synergy. Specific details include:

• METI's M&A reforms: Aimed at reducing obstacles to mergers and industry consolidation.
• Voting recommendations from ISS and Glass Lewis: The author's original words are: "recommendation that institutional investors vote against Japanese executive teams and their boards if non-operating assets are excessive." On average, about 25% of Japanese companies' net assets consist of non-operating assets such as domestic and foreign stocks. Meanwhile, in 2022, the average proportion of independent directors on Japanese boards was only 35%, compared to over 85% in the U.S.
• Activist investor activity: Overseas activist investor activity is near historical highs, targeting companies with large holdings of non-operating assets (including land valued at historical cost), excessive net cash, or those that could unlock value through spin-offs or divestitures.

Industry Consolidation and the Return of Inflation Provide Additional Levers for Improving Returns on Capital

The report points out that Japan's high degree of industry fragmentation, combined with the aging of small and medium-sized enterprise owners, creates structural opportunities for M&A-driven industry consolidation. For example, Japan has over 10 listed drugstore chains, more than 9 major pharmaceutical companies, and hundreds of regional banks. Meanwhile, the corporate finance firm Nihon M&A estimates that 930,000 private companies in Japan have owners aged 70 or older. The author argues that industry consolidation will free up capital and improve returns, and that consolidated industries find it easier to push through price increases—a factor that had been absent for years before the return of inflation over the past 18 months. The author's original words are: "Companies in consolidated industries can find it easier to push through price increases – a further lever to improve returns on capital."

Investment Implications

Hosking Partners adopts a diversified strategy to capture opportunities in Japan, with a portfolio of over 50 stocks, of which more than 50% have a market capitalization below $5 billion. The author emphasizes avoiding concentrated bets, as the reform process is non-linear and the greatest divergence between price and value exists in less liquid small-cap stocks. The portfolio includes: bloated paper and packaging companies with hidden world-class technology divisions, an oligopolistic refinery, a niche medical technology company under pressure from activist investors, and a media company with globally recognized intellectual property but negative enterprise value. Institutional perspective bias: The author defends the portfolio's holdings by arguing that the "value trap" label is outdated and using narratives such as "this time is different." Readers should note that this is a perspective from a position-holder, and the actual execution of reforms and the sustainability of inflation still require verification.

Position Moves