Why Investors Are Looking to Japan for Returns

Japanese stocks awakened from a deep slumber in 2023 and are off to a good start through the first three months of 2024—but they’re still well behind US stocks. Despite a 24.0% gain over the trailing 12 months through March 2024, the Morningstar Japan Index returned just 2.9% annualized over the trailing three years, much less than the 10.0% for the Morningstar US Market Index. Japanese stocks trail European stocks to a lesser degree over the three-year stretch but have pulled closer on a trailing five-year basis.

Corporate governance reforms are at the heart of increased optimism behind Japan. While it isn’t the first time that bulls have used this narrative, efforts this time seem to have more staying power. Companies with sagging stock prices (particularly those with a price/book ratio of less than 1.0) are being cajoled by regulators to act quickly to improve their capital efficiency. Those that do not comply are publicly singled out. Other initiatives include the expansion of English disclosure practices to encourage more foreign investment.

Investors are starting to take notice, as evidenced by strong net flows into Japan-stock funds in 2023. Even so, better returns could be ahead if early reforms take hold given the comparatively lower valuations than for US stocks.

The managers of AMG Yacktman Global YFSNX have gone big on Japan. The fund, which has a Morningstar Medalist Rating of Bronze, had a 17.5% stake versus just 6.3% for the Morningstar Global Value Target Market Exposure Index as of December 2023. The portfolio holds lesser-known small-cap Japanese stocks with depressed valuations, which the managers say possess greater upside than large-cap bellwethers. The fund has an even bigger bet on Korea, with over 32% of assets stashed there, partially because the team thinks reforms are due to hit that country next. The managers spread their Japanese and Korean bets using a basket approach to help mitigate single-stock risk in this opaque corner of the market.

Jed Weiss, the manager of Silver-rated Fidelity Advisor International Small-Cap Opportunities FOPIX, also has a bullish stance on Japanese small/mid-caps. His portfolio held 32% of assets in Japan as of December 2023, much more than the Morningstar Global Markets ex-US Small-Mid Cap Index’s 18.4%. Weiss targets profitable firms with strong pricing power that can outlast their competitors, but he goes on offense when markets fall and these normally high-quality companies go on sale.

Bronze-rated Matthews Asia Growth MPACX is an option for investors looking for an even bigger contrarian bet. This growth-leaning fund has suffered from stylistic headwinds, poor stock picks, and personnel change, though its new lead manager has a good resume and is employing a sound process. Michael Oh took the reins in December 2023 after a few years as a comanager. Oh is a Matthews veteran who has good records on his other charges using a similar quality-growth process, and he’s looking to restore this fund’s shine. The fund cruised through the second half of the past decade, but the market’s pivot away from growth stocks beginning in 2021 sent performance spiraling downward. The fund’s investor share class trailed its MSCI AC Asia Pacific prospectus benchmark by about 11 percentage points annualized over the trailing three-year period ended March 2024. As of December 2023, the portfolio held 45% of assets in Japanese equities.

This article first appeared in the April 2024 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor by visiting this website.