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Japan’s Reforms Lift Stocks of Lowest-Quality Companies

Japan remains the single-largest country weight in the MSCI All Country World ex US Small Cap Index. However, the country’s weak economic growth, aging population, tight labor conditions, and chronic deflation have long made it a challenge to find high-quality, growing companies there.

Government regulators and the Tokyo Stock Exchange recently introduced a flurry of reforms aimed at improving corporate governance and shareholder returns. As discussed in our fourth quarter 2023 report, these actions have primarily benefited the cheapest stocks, given that they are typically associated with the least-profitable and slowest-growing companies. Additionally, the Bank of Japan has raised short-term interest rates, ending its decade-long era of negative rates. This landmark move boosted Japanese value stocks in the first quarter, further exacerbating the region’s style headwinds.

As the chart above to the right shows, the cheapest stocks in Japan outperformed the most expensive by nearly 1,600 basis points in the first quarter. For the trailing 12-month period, it’s worse: The spread between the most expensive and cheapest quintile was nearly 46%. The left and center charts show that investors also have favored slower-growing and lower-quality companies.

We don’t know how long this value rally will persist. In the short run, some of the changes have clearly exacerbated, and could prolong, style headwinds for higher-quality, faster-growing companies. But over the long term, the changes in Japanese business policy and mindset are positive developments. As more businesses raise their standards, the number of high-quality companies in Japan may increase.

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How Persistent Are Quality and Growth?

At Harding Loevner, we are quality growth investors, which means we seek to invest in well-managed, financially sound businesses that can sustain profitable growth across economic cycles. But what do we mean when we talk about quality and growth as attributes of a company? While there is no standard definition of quality or growth in the investing world, our quality rankings consider factors such as the stability, level, and trend of a company’s profitability as well as its balance-sheet strength, and our growth rankings consider historical and estimated future changes in sales, earnings, and cash flows.

How companies perform on those measures can change over time. Industry dynamics evolve, which can lead to a shift in competitive positioning. Macroeconomic cycles and deviations in management strategy can also alter the long-term outlook. Even companies that consistently rank highly for quality and growth must be continuously assessed for signs of deterioration in their financial health, competitive advantages, and other factors. The challenge isn’t just determining the businesses that meet our criteria today, but also which businesses will sustain their quality and growth characteristics over the long run.

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Japan Digging Out of Chronic Deflation One IT Worker at a Time

In Japan, it’s common for an employee to work for the same company for their entire career. Indeed, lifetime employment has been a central feature of the nation’s economy since World War II, and with such limited job mobility, nominal wages haven’t grown for three decades.

Japan’s Past Hints at China’s Future

China faces a demographic shift similar to Japan three decades ago. Portfolio manager Jingyi Li explains how that comparison can help guide investors looking at China today.

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