CIO Corner: Capitalizing On Japan - Part III w/ Andrew McDermott

Key Concepts

• Japan’s Re-emergence: A shift in global perception of Japan from a disregarded investment destination to a potentially pivotal economic and geopolitical force.
• Abenomics as a Geopolitical Strategy: The understanding that Abenomics was primarily designed to bolster Japan’s political independence through economic strength.
• Investment Opportunities in Quality & “Hard Power”: Focus on undervalued Japanese companies with strong fundamentals (“ficundity”) and those involved in defense, semiconductors, and critical technologies.
• FOIP & Regional Strategy: Japan’s evolving geopolitical strategy centered around the “Free and Open Indo-Pacific” (FOIP) and building partnerships from India to South Korea (“Greater Japan”).
• Demographic & Political Shifts: Positive demographic trends with Chinese expatriate influx and optimistic outlook on the new Prime Minister Takiichi’s leadership.
• Undervaluation & Research Gap: Japan is significantly under-allocated in most portfolios, with a lack of equity research coverage, particularly for small and micro-cap companies.

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Historical Context & The Rise of Abenomics (2010-2012)

Prior to 2012, Japan was largely ignored by global investors, with Japanese equity markets characterized by apathy. Companies traded at low valuations, sometimes below net cash and securities. A transition from an export-oriented economy (“Japan Outside”) to a domestically focused one (“Japan Inside”) led to decreased competitiveness against lower-cost Chinese competition. Politically, Japan’s role was diminishing. The introduction of Abenomics in 2012 is considered a “singular and seminal event,” not merely a monetary stimulus package, but a strategy to strengthen Japan’s economic foundation to support its political independence. The “three arrows” initiative aimed to address demographic decline, increase female workforce participation, and reshape Japan’s diplomatic posture.

Current Investment Landscape: Perils & Opportunities

The current market presents risks, particularly investing in companies trading at high multiples despite compromised fundamentals, often fueled by private equity and activist investors. Caution is advised regarding companies heavily reliant on the Chinese market due to geopolitical tensions. However, opportunities exist in recognizing the latent strength of Japanese balance sheets and income statements revealed by the shift from deflation to inflation. Companies with strong fundamentals and pricing power (“ficundity”) are undervalued. A key focus should be on capable management and understanding the underlying businesses, contrasting this with financial engineering-driven approaches. The rise of “hard power” companies – those involved in defense, semiconductors, and critical technologies – is a significant trend.

Geopolitical Strategy & Regional Influence

Japan is actively pursuing a strategy of building influence within the “Free and Open Indo-Pacific” (FOIP), defining “Greater Japan” as the region from India to South Korea. This contrasts with the US’s historical reliance on China and potential risks associated with that dependence. The relationship between Japan and Taiwan is strengthening, with Japan providing crucial technological and economic support as a strategic response to China’s growing influence. Japan’s renewed commitment to nuclear power, including the restart of existing plants and development of Small Modular Reactors (SMRs), is a significant advantage, particularly in contrast to the US’s struggles in the sector.

Emerging Trends & Political Shifts (Post-2023)

Approximately two million Chinese expatriates are migrating to Japan, indicating a preference for Japanese values and freedoms. The election of Prime Minister Takiichi is viewed optimistically, with her decision to dissolve parliament seen as a high-risk, high-reward move reflecting a broader sentiment regarding China. This political shift is expected to foster enthusiasm both domestically and internationally.

Investment Strategy & Research Gap

Investors are encouraged to move beyond under-allocation to Japan, actively research Japanese companies – particularly small and micro-cap companies – and question biases towards Chinese investments. Direct company analysis is emphasized over reliance on consultants. There is a significant gap in equity research coverage for Japanese public companies with market caps under $5 billion. The US equity market has seen a decline in listings (from 7,500 to 3,500 over the last 20 years) while Japan has seen an increase. Japanese AI companies are described as more “practical,” focusing on “machine learning and applied manufacturing.”

Conclusion

Japan is undergoing a significant transformation, presenting a compelling investment opportunity driven by a combination of economic revitalization, geopolitical strategy, and demographic shifts. The country’s focus on quality, innovation, and strategic partnerships positions it as a potential leader in the evolving global landscape. Successfully navigating this landscape requires a shift in perspective, diligent research, and a willingness to look beyond conventional investment wisdom. The potential for Japan to reshape global capitalism and reduce reliance on traditional power structures is substantial, with a roughly 50/50 chance of avoiding kinetic conflict with China while simultaneously achieving significant economic and political success.