Japan stocks are on fire this year. Here are 3 reasons why the rally could have 'staying power'

Published Sat, May 27 20237:48 AM EDT

Never mind Treasury bills, Artificial Intelligence or crypto. Here's one far more surprising place that's attracting investor interest in 2023 — Japan. The country's equities recently reached 33-year highs. Last week, the country's Tokyo Stock Price Index (TOPIX) almost reached 2,200 — closing at its highest level since August 1990 . Back then, Japan boasted the world's second-largest economy, threatening to overtake the U.S. But after a real estate asset bubble burst, Japan spent the next generation unsuccessfully fighting persistent deflation as consumers sat on savings and companies hoarded cash. Today, however, there are some signs that Japan's turning itself around, boosted by structural reforms and new manufacturing investment. "Some of the changes that we're seeing there make us excited about it," said Krishna Mohanraj, portfolio manager at Diamond Hill Capital Management. The firm recently sent a three-person team to Japan to attend an investment conference and research companies, and Mohanraj said he's "cautiously optimistic" about the opportunities he's finding there. Here's what investors say are three reasons to be excited about Japanese equities: 'Ridiculous price' One reason Japanese equities got another look this year came when Berkshire Hathaway CEO Warren Buffett traveled to Tokyo and made a big show of confidence in April. Soon after the billionaire investor raised his stakes in five of the largest Japanese trading houses — Mitsubishi Corp., Mitsui & Co., Itochu Corp, Marubeni Corp. and Sumitomo Corp. — international investors snapped up $7.8 billion in Japanese stocks during five days of trading through April 14. The "Oracle of Omaha" said he's been "confounded" by the opportunity. Not only are the businesses large and diversified, somewhat like Berkshire itself, but he sees them trading at cheap valuations. "I just thought these were big companies. They were companies that I generally understood what they did. Somewhat similar to Berkshire in that they owned lots of different interests," Buffett told CNBC's " Squawk Box " during the April visit . "And they were selling at what I thought was a ridiculous price, particularly the price compared to the interest rates prevailing at that time," he added. Since then, Japanese equities have rallied. Even so, Strategas Securities' Chris Verrone has remained optimistic on Japanese equities, saying this week that the rally is not yet overbought. "Momentum often begets momentum in this business, and only the best trends are able to truly get overbought and sustain it – we continue to suspect Japan falls into this category," he wrote in a Tuesday note. Meanwhile, JPMorgan chief market strategist Marko Kolanovic said in a note, also on Tuesday, that the rally in Japan still has "staying power." Improved corporate governance Another draw in Japan is a greater emphasis on corporate governance. When newly appointed Hiromi Yamaji took his post as chief executive at Japan Exchange Group, he publicly urged Japan's publicly-traded companies in April to start a "constructive dialogue" with investors , according to Nikkei. At the time, he lamented the fact that more than half the firms on the Tokyo Stock Exchange were trading below book value, as companies sat on cash. For international investors, those remarks signaled that Japanese companies may be more transparent with shareholders in the future. Japan-listed companies can be frustratingly opaque, given the number of stocks that are owned as cross-shareholdings by allied firms. "In the past, you've had U.S. investors come in, [and] ... take activist positions. Those things almost always never work in Japan, because of the culture. You're seen as a troublemaker," Diamond Hill's Mohanraj said. "I think what is happening now is instead of thinking of it as outsiders coming in being a troublemaker, the Japanese government and especially the regulators saying, 'hey, can we from the inside, change, peer pressure change, how Japanese management thinks about these things from the inside?'" "So we think there is genuine change happening and it will happen over time," he said. In fact, Bloomberg reported that activist investors are set to make a record number of shareholder proposals in Japan this year. Semiconductor growth Like other countries around the globe, Japan is expected to ramp up its semiconductor manufacturing. However, unlike the U.S. and other nations, Japan has an advantage — it already has the infrastructure in place to set up a foundry relatively quickly, especially when pooling the knowledge of firms such as SoftBank, Sony and Toyota. That could help bolster state-backed foundry Rapidus, which the country hopes will compete with Taiwan Semiconductor (TSMC), South Korea's Samsung , and others. "Because they have the ecosystem between the materials, equipment and the engineering talent, it's less of a lift for them compared to other parts of the world," said Dina Ting, head of Global Index Portfolio Management at Franklin Templeton, who also took a recent trip to Japan. What's more, Japan may benefit from rising tensions between the U.S. and China that redraw global supply chains in Japan's favor. Earlier this month, Micron spiked 11.9% in one week after saying it plans to manufacture DRAM chips in Japan. Investing in equities For investors, there are a couple different ways they can tap into Japan. Exchange traded funds devoted to Japan have seen a rise in inflows this year. For example, the iShares MSCI Japan ETF has $11 billion in assets under management, and notched $753 million in inflows this year, according to FactSet data; It's up 9.5% this year. Meanwhile, the JPMorgan BetaBuilders Japan ETF , which has roughly $8 billion in assets under management, gained $496 million in inflows this year. Elsewhere, the Franklin FTSE Japan ETF (FLJP) recently crossed $1 billion in assets under management for the first time, boosted by roughly $186 million in inflows this year alone. The FLJP has a scant 0.09% net expense ratio. Investors can also take a company-specific approach, according to Diamond Hill's Mohanraj, who favors Japanese companies that boast differentiated products. The fund manager cited Nintendo as an example, saying the video game company's products have an appeal that spans generations. He cited the recent success of The Super Mario Bros. Movie, which broke box office records after crossing $1 billion in ticket sales. Nintendo is "not like any other company you've ever seen," Mohanraj said. "Disney is probably the only company that comes close." He also touts Astellas Pharma, a Japanese biopharmaceutical company that's one of several in the sector that have expanded their reach beyond Japan to become global companies. Astellas made its name with the Xtandi prostate cancer drug. "We think there's lots more innovation coming in that company in the pipeline and the market is not realizing it," Mohanraj said. To be sure, investors should know that there has been more than one occasion in the past three decades when capital returned to Japan on rumblings of government reforms only to be disappointed by yet another false start. But Mohanraj believes this time is different: "We think there is genuine change happening, and it will happen over time."