Japan’s Corporate Reforms Create a Catalyst for Equity Returns

A new culture of reform at Japanese companies offers exciting potential for equity investors.

Corporate reform in Japan is accelerating efforts to streamline businesses, boost profitability and unlock value. Equity investors may find that Japanese governance improvements offer a roadmap to return potential that is less vulnerable to uncertainty over trade and macroeconomic growth.

It’s not hard to conjure up the stereotype of a Japanese listed company. After decades of stagnant domestic economics, many Japanese firms stopped borrowing and hoarded cash. Earnings from profitable business segments often subsidized unprofitable legacy operations and long-term research projects to safeguard pensions for existing directors and employees.

High Barriers to Reform 

Reforming corporate Japan is a Herculean task. Many Japanese companies were protected from activist shareholders by multi-generational cross-shareholdings with other large Japanese corporates as well as a historically tolerant and passive regulatory culture. Entrenched boards could protect entrenched management teams, leaving disgruntled shareholders with little recourse. For years, in Japan’s zero-interest-rate environment, ultra-low funding costs discouraged change. As a result, most Japanese companies delivered the lowest returns on equity (ROE) of all developed markets.

That legacy is still evident today. While Japan is cheap on price-to-book ratios, its low ROE at 8.5% means the market is expensive on quality measures (Display). At the opposite end of the spectrum, the US market defines the efficient frontier that investors should pay for high-quality fundamentals.

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.

Green Lights for Growth

Will all Japanese companies change? Of course not. That’s why investors must identify companies with clear paths to improve ROE and management teams that are willing to do it. Active judgment and experience are essential.

Quantitative screens for net-cash balance sheets in Japan will surface plenty of companies that are ripe for reform. However, investors must distinguish opportunity from symptoms. That means finding companies willing to distribute cash or raise prices to leverage a strong business position. The difference between an ROE improver and a value trap often comes down to governance. Introducing performance-based pay, increasing director skin in the game and recent board refreshment are all good signs. The appointment of a new CEO with a mandate for reform is another positive signal.

Active investors can also engage* with companies to provide suggestions for improving profitability and efficiency. We believe the most effective engagement approach requires cultivating long-term relationships with open-minded management teams as a trusted advisor and being active without being an activist.

Case Study: The Synthetic Rubber Market

Japan is home to some of the world’s largest synthetic rubber manufacturers, alongside tire and auto manufacturers. Across the industry, producers have moved to improve profitability by venturing into other lines of specialty chemicals used in electronics that are more lucrative than their original, mature businesses.

We engaged with management at one such firm to recommend they unwind their crossholdings with other Japanese corporates, cut back investment plans on legacy products and distribute excess cash to shareholders. While the synthetic rubber market is weak today, a more reform-minded CEO has spurred the unwinding of more crossholdings, frozen additional capex at a loss-making overseas plant and tripled the total payout to shareholders last year. Now, we expect improving returns on capital at the company to catalyze positive investment returns.

Rising Through the Ranks

Japan’s equity market is undergoing meaningful change in corporate governance, driven by domestic reform and shifting macroeconomic conditions. But not every company is the same—which is good news for active managers.

Real investment opportunities abound for selective investors who identify businesses that are ripe for reform and are run by management teams motivated to execute improvements. Ownership and engagement with this slice of corporate Japan should allow investors to capture outsized profit growth and a positive re-rating of companies as they head toward profitability levels of global peers and rise through the ranks of global corporate valuations.