Despite the Japanese stock market already breaking long-standing record highs this year, we believe there is more in store for Japanese equities, in particular for selected small-cap investments. The recent surge in equity markets has been driven by earnings growth and significant corporate governance reform as advocated by specialist investors like ourselves. In our view the largest impact of these ongoing reforms is still to be fully realised. Let us explain our observations below.

Japan has more listed companies than the United States, including a vast small-cap universe with attractive investment targets. Most are overlooked by global investors who pay little attention to the long tail of under-researched investment opportunities. With more than 3700 companies listed on the Tokyo stock exchange, less than half are followed by institutional analysts.

Still, over the past decade, the Japanese equity market has experienced a strong revival, propelled by low starting valuations, improving profitability and a surge in shareholder returns. How did that come about?  In our view, the answer lies largely in improving corporate governance, gradually introduced by the Japanese regulator since 2012.

This has created a unique set of opportunities with companies now more open to advice from specialised investors who are willing to share their global expertise and best practice to improve shareholder value. While this already has had positive outcomes, the full potential is yet to be achieved.

A little bit of history or ‘why reform’? 
Japan’s population is aging and its workforce declining rapidly. Therefore, for Japan it is a matter of national security to increase its capital and human resource productivity. Without drastic reforms it would be a challenge to maintain current living standards.

Historically, Japanese corporate governance has been characterised by a focus on stakeholder interests, including employees, customers, and society at large. Although this approach nurtured stability and harmony within organisations, it often resulted in opaque decision-making processes and a lack of accountability to shareholders.

In addition, due to its cultural and language barriers, Japan’s corporate board rooms are partly isolated from the rest of the world. Board members in Japan tend to be less financially educated compared to most developed markets. Japan does not have a well-developed Private Equity or Venture Capital infrastructure, and until recently, most companies we visited would not understand the concept of return-on-invested-capital.

Introducing reforms
Acknowledging the situation and to enhance corporate governance standards, Japan regulators and policymakers have set out on a journey of much needed reform, initiated by the late Prime Minister Abe in 2012. The introduction of the Corporate Governance Code by the Financial Services Agency (FSA, the supervisor to the financial sector) in 2015 marked a significant milestone. This voluntary code aimed to promote transparency, accountability, and shareholder engagement among listed companies. Key reforms targeted board efficiency and engagement with shareholders.

More regulations and guidelines were introduced in later years. For example, in January this year the Tokyo Stock Exchange began issuing a list of underperforming companies which they now distribute monthly with the aim of enforcing compliance to improve capital allocation.

Our message on corporate governance
As active managers we robustly engage with Japanese companies on matters of corporate governance. Being engaged shareholders means that we see it as our mission to share our opinion with the board members at our investment companies. We aim to act as a catalyst to accelerate change: supported by Japan’s reform agenda we reinforce what companies have been told by the regulatory bodies and provide suggestions on how it can be achieved.

Our objective is to ensure that the most suitable leaders are at the helm of the companies we invest in. We aim to ensure guidelines and frameworks are in place so that our investee companies can thrive in a sustainable manner. Simultaneously, corporate governance also necessitates a well-thought-out capital allocation policy and strong shareholder rights.

To enhance shareholder returns, our engagement with companies focuses on:

• Board Composition – highlighting the importance of independent directors and diverse skill sets on corporate boards to facilitate effective decision-making and oversight. We are convinced that an independent board that values shareholders’ views and is aligned in terms of risks and rewards  is essential for enhanced shareholder returns. 
• Incentives & Renumeration - advocating for transparency and alignment of executive compensation with long-term performance and shareholder interests. 
• Improved Reporting & Communication – focusing on improving disclosure in English and publishing relevant information promptly, as well as proactively engaging with shareholders to enhance mutual understanding.  
• Capital Policy– we aim for a comprehensive capital allocation policy including a meaningful and sustainable improvement in ROE. 
   

The impact of change
Japan is known to be a traditional society and with that, Japanese corporates find it difficult to change. No wonder global investors can get frustrated with the slow speed of change. However, changing leadership mentality is a slow process as it targets lasting transformation.

We believe that the steady shift towards transparency and accountability has now hit an inflection point:  we already see that the number and amount of share buybacks has drastically increased and with it, valuations expanded. As mentioned in the introduction, the major benchmark indices made headlines in April by surpassing its end-December 1989 peak. Furthermore, board members recognise that their actions have a positive impact on the company’s share price and with that awareness this can become a self-sustaining process.

What the future can bring
In line with the Van Lanschot Kempen Global Small Cap strategy investment philosophy, we follow a  disciplined, bottom-up investment process, solely targeting quality businesses that trade at attractive valuations. In Japan we still see considerable valuation upside as further governance enhancements are implemented.

For instance, quality companies in Japan tend to be overcapitalised, with significant cash on hand and cross shareholdings. Our engagement work advocates for higher dividend payout ratios and share buybacks to effectively deploy excess capital and enhance shareholder returns.

The corporate governance revolution marks a significant milestone in the country's economic evolution. Japan’s revival extends beyond its equity market: the country has seen a boom in tourism, an increased popularity of Japanese consumer products and a ubiquitous presence of its design and manga. Japanese brands have become synonymous with quality, engineering excellence, customer satisfaction and durability.

With Japan embracing a new era of transparency and accountability, investors have the opportunity to participate in a market that is becoming increasingly aligned with global standards. By understanding and navigating these changes, we can capitalise on the potential long term re-rating and value creation offered by Japan's revitalised corporate governance landscape.

Video update: What about the small cap premium?
Small caps are currently trading at a discount to large caps, why is this? With many influencing factors, we dive into the details to identify the most important issues for investors to consider. We invite you to register to view the video session featuring Jan Willem Berghuis and Ingmar Schaefer from our Global and European small cap team.