Kei Okamura, a Portfolio Manager at Neuberger Berman, analyzes the potential for sustained growth in Japanese equities, driven by ongoing governance and capital management reforms. This post is based on his Neuberger Berman memorandum.
The Japanese equity market is entering a new and potentially transformative phase, marked by a significant shift towards growth-oriented corporate governance and capital management reforms. These initiatives, set in motion nearly two decades ago, are now poised to encourage Japanese companies to enhance their return on investment and accelerate earnings growth, akin to a jumbo jet reaching cruising altitude. This article delves into why these reforms are expected to support long-term value creation and present attractive opportunities for active equity managers.
Charting Japan’s Ascent
Japanese equities have demonstrated an impressive performance over the past 24 months, with both the broad Topix Index and the narrower Nikkei 225 Index outperforming their global counterparts. While expectations of accelerated earnings growth, fueled by capital expenditure investments related to artificial intelligence, have undeniably stoked momentum, a more fundamental transformation, rooted in corporate governance and capital management reforms initiated around two decades ago, is now well underway.
The Takeoff Phase: Catalyzing Shareholder Returns
The initial "taxiing" phase of Japan’s equity market transformation began during the early years of former Prime Minister Shinzo Abe’s "Abenomics" policy. The "third arrow" of his economic agenda focused on enhancing the effectiveness of corporate boardrooms and establishing the groundwork for future progress.
The "takeoff" phase, however, is widely considered to have commenced in early 2023 with the Tokyo Stock Exchange’s (TSE) Price-to-Book (PBR) Guideline. This initiative was designed to address a persistent issue: numerous Japanese companies traded at significant discounts, often below their book value, indicating a lack of investor confidence or perceived inefficiency.
The TSE identified that a contributing factor was the insufficient consideration of the cost of capital when companies allocated resources. The PBR guideline strongly advised companies listed on the TSE Prime and Standards markets to conduct thorough reviews of their capital allocation plans and to publicly disclose their findings annually. The underlying rationale was that increased transparency would invite greater investor scrutiny and, consequently, drive improvements in corporate performance.
This directive appears to have catalyzed a notable increase in shareholder returns through enhanced share buybacks and dividends. This ultimately fueled a significant market rally beginning in the latter half of 2023, leading to a substantial reduction in the number of companies trading below a one-time book value.
Cruising Altitude: Driving Long-Term Value Creation
We believe these growth-oriented reforms are now propelling Japan’s equity market into a "cruising altitude" phase, potentially leading to a long-term rerating of this historically overlooked, under-researched, and undervalued market. The ongoing focus on governance and capital management is expected to encourage Japanese companies to further improve their return on equity (ROE) and accelerate earnings growth, especially as the economy emerges from its prolonged "Lost Decades" of deflation.
For years, Japan has grappled with cost-push inflation stemming from COVID-19-related supply chain disruptions and a weakened yen that inflated import prices. However, demand-pull factors are now gaining traction. Businesses across various sectors are raising wages to attract and retain talent, contributing to structurally higher inflation. This environment presents both challenges and opportunities for future earnings growth.
Japan Goes All In on Growth
In response to these evolving economic conditions and to foster a more growth-centric environment, Prime Minister Sanae Takaichi’s administration, elected in early 2026, announced a significant public-private investment initiative. This ambitious program aims to deploy approximately 370 trillion yen (an estimated $2.3 trillion) across 17 strategic sectors deemed critical for both economic growth and national security. Key areas of focus include artificial intelligence (AI), semiconductor manufacturing, and shipbuilding.
The government recognizes that the success of this large-scale initiative hinges on robust private sector participation. Recognizing the substantial cash reserves held by Japanese companies—among the highest in developed markets—the administration views this corporate capital as a pivotal funding source. This strategic allocation of resources is intended to stimulate domestic investment and technological advancement.
Governance Reform: The Key to Unlocking Overcapitalized Balance Sheets
A cornerstone of Japan’s reform efforts has been the sweeping overhaul of its corporate governance and capital management regulations, designed to encourage companies to optimize their balance sheets and prioritize strategic growth investments.
A pivotal development was the revision of Japan’s Corporate Governance Code, implemented in the summer of 2026. Originally established in 2015 by the TSE and the Financial Services Agency (FSA), the Code outlines fundamental principles for effective corporate governance, which listed companies are expected to follow on a "comply-or-explain" basis.
While the Code has undergone several updates, the 2026 revision marked a significant overhaul, streamlining the number of Principles from 83 to 30. Notably, certain shareholder-protection provisions, including those related to anti-takeover measures, were reclassified from mandatory Principles to non-binding Interpretive Guidance. This shift initially raised concerns among institutional investors about a potential rollback of governance standards. However, Japanese regulators, with our concurrence, assert that the remaining binding reforms will now carry greater weight, thereby fostering a transition from mere compliance to genuine, high-quality governance practices.
A particularly impactful update within the revised Code strengthens Principles 4.1 and 4.2, which address the roles and responsibilities of the board. These principles now place a stronger emphasis on boards evaluating business strategies based on their potential to increase earnings and ensure efficient capital allocation. These revisions are deemed crucial given the historical challenges Japanese firms have faced in generating adequate returns on their capital investments. The Ministry of Economy, Trade and Industry (METI) estimates that approximately 65% of Japanese companies have struggled to surpass their average cost of capital, resulting in negative economic profits. METI advocates for companies to address this drag on corporate value by restructuring operations around core growth segments.
Although no explicit legal penalties are attached to non-compliance, the updated Corporate Governance Code is expected to hold Japanese boards more accountable for pursuing higher returns on invested capital. For instance, the revised Code promotes a more strategic utilization of "real assets." This could involve monetizing valuable real estate held for core business purposes, such as corporate headquarters or manufacturing facilities. Companies requiring capital have the option to divest these properties to Real Estate Investment Trusts (REITs) or other third-party entities. We believe that realizing the latent value within corporate real estate holdings and subsequent sale-leaseback arrangements could provide significant capital for reinvestment in long-term growth initiatives, thereby streamlining balance sheets.
It is estimated that Japanese companies hold approximately 71 trillion yen ($451 billion) in real estate assets leased for capital gains. Commercial properties dedicated to core business operations, which often have limited disclosure in public filings, could represent nearly double that amount, an estimated 139 trillion yen ($890 billion), roughly equivalent to 10% of Japan’s total market capitalization. Unlocking these hidden gains could provide a substantial pool of capital for reinvestment in growth strategies.
Board Quality: The Litmus Test for Sustainable Growth
As Japanese companies increasingly focus on enhancing return on invested capital and achieving sustainable growth, the quality of their boards, particularly concerning independence and skill set diversity, is becoming paramount. Despite notable progress in board independence, the proportion of Japanese companies with a majority of independent board members remains relatively low at approximately 18.5%.
Furthermore, our observations indicate that while many Japanese boards are well-populated with internal directors possessing deep operational expertise in areas such as manufacturing or sales, there is a relative scarcity of directors with extensive experience in traditional finance and corporate management. A recent survey of leading Japanese corporations revealed significant disparities in finance and management experience among board members compared to their U.S. and U.K. counterparts. This comparative lack of experience, in our view, may continue to impede returns on invested capital and the broader market’s capacity to generate shareholder value.
In response to these concerns, the Japanese government has been actively pursuing reforms to enhance board capabilities. Proposed amendments to the Companies Act, currently under deliberation, aim to streamline the shareholder proposal process. A significant change under consideration is the potential replacement of the current "300 voting units or more" requirement for submitting proposals with a more accessible straight 1% ownership stake. This adjustment, if enacted, could empower a wider range of shareholders to voice their concerns and influence corporate strategy, potentially leading to more diverse and experienced boards better equipped to drive sustainable growth.
Conclusion
The Japanese equity market is entering a new phase of transformation, characterized by a strong emphasis on growth-oriented governance and capital management reforms. These initiatives are expected to drive improvements in return on investment, accelerate earnings growth, and foster long-term value creation. However, the market is not monolithic. Companies that can effectively navigate the evolving economic landscape, characterized by structurally higher input costs and interest rates, by prioritizing strategic growth, robust governance, and efficient capital allocation, are poised to outperform. It is these companies, we believe, that will ultimately reach cruising altitude and deliver sustainable value for shareholders.
