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INVESTING in JAPAN Japan’S Relevance to the Global Economy Japan Is an Established Global Economic Leader Across a Wide Variety of Measures

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INVESTING in JAPAN Japan’S Relevance to the Global Economy Japan Is an Established Global Economic Leader Across a Wide Variety of Measures November 2020 White Paper INVESTING IN JAPAN Japan’s Relevance to the Global Economy Japan is an established global economic leader across a wide variety of measures. It is the third largest economy in the world, behind only the United States and China1. Known for its economic diversity and sophistication, Japan has consistently ranked as the most complex economy in the world by Harvard studies2. It is home to leading companies in both production and technological advancements across a variety of industries. In addition to being the fourth-largest exporter in the world3, Japan also has a strong domestic economy powered by the third largest consumer market in the world4. Across various measures, Japan is an economic power to be reckoned with. Figure 1: Japan’s Economic Rankings: 10 Largest 10 Largest by 2019 GDP 10 Largest by 2019 Exports of 10 Largest by 2019 Household (US$ trillion) Goods and Services (US$ trillion) Consumption (US$ trillion) US $21.4 China $2.6 United States $14.0 China $14.7 US $2.5 China $5.4 Japan $5.1 Germany $1.8 Japan $2.8 Germany $3.9 Japan $0.9 Germany $2.1 India $2.9 UK $0.9 United Kingdom $1.9 UK $2.8 France $0.9 India $1.6 France $2.7 Netherlands $0.8 France $1.5 Italy $2.0 Korea $0.7 Italy $1.3 Brazil $1.8 Hong Kong $0.6 Brazil $1.2 Canada $1.7 Singapore $0.6 Canada $1.0 Source: World Bank as of 2019 Source: IMF as of 2019 Source: World Bank as of 2019 The Japanese equity market is no less significant. The Japan Exchange Group is the third largest exchange by market capitalization and second largest by number of listed companies, with over 3,670 companies representing over $5.7 trillion in market capitalization. The market is considered one of the broadest and deepest opportunity sets in the world5 and offers high levels of liquidity to investors and traders. Japan is the second largest country in the MSCI World Index, however, global asset allocators have long been underweight Japanese equities due to its significant underperformance over the past several decades. Figure 2: 10 Largest World Stock Exchanges by Market Capitalization 8. London Stock Exchange $2.0 T $3.2 T 3. Japan Exchange Group 9. TMX Group 4. Shanghai Stock Exchange $21.0 T $4.3T $5.3 T $5.7 T 1. New York Stock Exchange 6. Euronext $2.2 T $3.9 T $14.6 T $4.9 T 2. NASDAQ 9. Saudi Stock Exchange 7. Shenzhen Stock Exchange 5. Hong Kong Stock Exchange Source: World Federation of Exchanges as of August 2020 Japanese Equity Markets Explained Formed in 2013 by the merger of the Tokyo Stock Exchange (TSE) and Osaka Securities Exchange, the Japan Exchange Group operates multiple securities exchanges within Japan. While all stocks in Japan are listed with the Japan Stock Exchange, there is a wide array of listings, each with its own set of criteria, including the number of shareholders of the company, market capitalization, profitability and the number of years the company has been established. 1 Main Market6 The main market is where leading Japanese and foreign companies are listed. These listings are split into first and second sections, which respectively focus on large and mid-sized companies. The second section is considered entry- level, where mid-sized companies can list and later be upgraded to the first section upon meeting the required criteria. The main market, especially the first section listings, is among the largest and most liquid in the world. Foreign investors typically represent the largest part of trading volume among these companies. Mothers7 Mothers (Market of the high-growth and emerging stocks) is a trading market for high-growth start-up companies aiming to be upgraded to the main market. The aim of this market is to offer financing opportunities for less established companies early in their growth phase. As such companies within this category are required to demonstrate high growth potential but there are no restrictions in terms of size or business type. Given its nature, companies listing in this category tend to have business models that revolve around technology. Individual retail investors typically represent most of the trading volume among these companies. JASDAQ8 Like Mothers, Jasdaq is a listing category with bias towards growth and smaller companies. However, the criteria for Jasdaq listing tend to be easier to meet for companies that are still in early growth stages. The concept is that companies within this listing category should offer reliability, innovation and regional or international reach. These listings are further split into standard and growth sections: standard market is dedicated for growth companies of a certain size and performance while growth market is dedicated to companies with stronger future growth potential and unique business models. Individual retail investors typically represent most of the trading volume among these companies. Figure 3: Listing Category Characteristics Main Market JASDAQ Mothers 1st Section 2nd Section Standard Growth Market Cap. (USD B) 35,449 32 35 95 2.6 Number of Stocks 2175 480 327 662 37 Market Cap Range $19M to $215B $8M to $12B $15M to $9B $6M to $7B $10M to $322M Main Sectors / & Industrials, Industrials, IT, healthcare, Consumer, Healthcare, Industries consumer, IT, consumer, IT, consumer, industrials, IT, communications, communications materials communication healthcare IT, consumer Key participants by trading Foreigners Local Retail Local Retail Local Retail volume Number of Shareholders 2.200 or more 800 or more 200 or more 200 or more Minimum Number of 3 Years of more 1 Year of more - - Years of Business Operation Amount of Profits or Ordinary Profit: Total of ¥ 500 - Ordinary Profit: Total - Market Capitalization Million or more in the last 2 fiscal of ¥ 100 Million or years more in the last 2 Market Cap: ¥ 50 Billion or more fiscal years Sales: ¥ 10 Billion or more Market Cap: ¥ 5 Billion or more Source: Japan Stock Exchange as of September 2020 A plan to reform the Japanese exchange has long been discussed and more recently has started to take shape. The current proposals aim to reduce the number of market listings to three: Prime, Standard and Growth. In addition, the working group is looking to change criteria for each category, a response to critics who have hailed them as too ambiguous. The determinants for inclusion into Japan’s equity indices is also under review. While it’s too early to know if and how these reforms will occur, the potential for change should be on investors’ radars given the potential impact to listings and index compositions. 2 Japan: Opportunity for Active Managers After the highs of the 1980s, Japan's strong economic growth ended abruptly in the early 1990s with the bursting of the economic and financial bubble. What started as the “lost decade” extended to the “lost 20 years”, referring to the period of economic stagnation that lasted from 1991 to 2010. The general view was that Japan was a low growth economy with challenging demographics and lack of shareholder alignment. Despite stagnant economic growth in the 90’s and 2000’s, the Yen remained relatively strong as a safe-haven currency which made many export-oriented companies less competitive. Two decades of challenging performance and investor disregard has reduced Japan’s market visibility among global allocators, however, it remains the largest country weight outside the US in the MSCI World Index. More importantly, the lack of attention from global allocators has created inefficiencies and attractive opportunities for skilled active managers. Under-owned After a frustrating and extended period of performance, global allocators have largely abandoned Japan. Foreign investors have been net sellers of its equity market and remain underweight this market. Those that remain invested in Japan have tended to prefer passive investments. As foreigners account for more than 60% of market turnover, the effect of their outflows has helped to explain at least part of the market’s lackluster performance9. Meanwhile local retail investor allocation to equities remain low. While US households typically have a 34% allocation to equities, Japanese allocations are closer to 10%10. Figure 4: Foreigners have been Sellers of Japanese Equities ¥5 ¥- -¥5 -¥10 -¥15 Cumulative Net Foreign Flows from TSE Section 1 Stocks (in ¥ trillion) -¥20 Jan-15 Jan-16 Jan-17 Jan-18 Jan-19 Jan-20 Source: Japan Stock Exchange as of September 2020 Without a significant presence of foreign and local retail investors, the Bank of Japan and Japanese Government Pension Investment Fund (GPIF) have become increasingly relevant market participants as part of the Abenomics plan to revive the stock market. As of March 2020, the GPIF’s target allocation to domestic equities was 25% of its ¥150 trillion investment portfolio11. Meanwhile the Bank of Japan has spent the last 10 years ramping up its purchases of ETFs in an attempt to stabilize the market and encourage investment. As of April 2019, the Bank of Japan is estimated to own 77% of the nation’s ETFs12. The importance of these market participants and their indiscriminate passive purchases have at times led stocks to perform based on passive flows rather than stock specific fundamentals. ¥0 Figure 5: Bank of Japan Becomes a Significant Market Participant: Passive Investments in Japan 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 ¥40 BankBank of ofJapan Japan Holdings Holdings RestRest of the of Marketthe Market ¥20 ¥0 2011 2012 2013 2014 2015 2016 2017 2018 2019 Source: Bloomberg 3 Under-researched Having transitioned from a dynamic market darling in the 1980s to a “fallen angel”, the financial service industry naturally has shifted their attention away from Japan.
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