With Kenji Govaers’ permission, I’m thrilled to re-publish here his insightful analysis on Japan’s prospects in the post-globalization era. Kenji is a senior partner in Bain’s Tokyo office. This piece was originally posted on the Bain Macro Strategy Platform. Enjoy…

In recent months, interest in Japan as a potential investment locale has increased. The renewed attention is likely due to a variety of factors, including the country’s ability to absorb investment from companies looking to diversify from China and the appointment of Kazuo Ueda—an economist who has not hidden his interest in finding a way out of the country’s quantitative easing regime—as governor of the Bank of Japan (BoJ). At the BoJ’s first meeting under Ueda, in late April, the new governor maintained the cautious diplomatic tone required to keep financial markets calm but did announce a 12- to 18-month policy review. The review was viewed as a signal that change may be coming.

Japan’s economy, the third largest in the world by nominal GDP, is a powerhouse thanks to its advanced technology, its robust manufacturing capabilities, and the culture’s strong work ethic. The country is renowned for its cutting-edge innovations in industries such as electronics, automobiles, and robotics, with globally recognized companies like Toyota, Sony, and Panasonic leading the way. Japan has been consistent in its belief in globalized trade. Its leaders have pursued various free trade agreements—such as the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP) and the EU-Japan Economic Partnership Agreement—to further boost its trade and economic ties.

As a major creditor nation, Japan also holds significant foreign assets (i.e., about $1.1 trillion of US treasury securities as of January 2023), giving it considerable influence in the global financial market. It is a strong, stable (albeit externally silent) member of the G7 group.

But Japan’s unquestionable influence in the financial markets stands in sharp contrast with its diminished position in international GDP per capita rankings. Based on that metric alone, Japan would not even make it into the G20. Japan’s GDP per capita in 2021 was #30 in the world at $39,313—roughly on par with South Korea but far behind Germany ($51,204) and the US ($70,249). Many factors account for this underperformance, but we believe one is worth noting in particular: Individual average incomes have not risen in the last 30 years.

For many years, Japan’s unique culture—including the social stability that ensured that 30 years of deflation did not produce any riots—was viewed as a strength. But with time, perception changes. Characteristics that were viewed as assets of the Japanese economy in the 1980s and 1990s began to be perceived as liabilities in the 2000s. Harmony, collaboration, and long-term relationships, as well as cultural values like “nemawashi” (consensus building) and “kaizen” (continuous improvement) were viewed as strengths when times were good. When the Japanese economy began to struggle in the 2000s, the same values became liabilities: Harmony and consensus building led to decision paralysis, and kaizen was too incremental and didn’t produce fundamental change.

So what is different today? First, we want to note that this is not the first time that Japan has been hailed as “the next great investment opportunity.” At various points in the 2000s and 2010s, particularly during the early years of Prime Minister Shinzo Abe’s “Abenomics” economic policies, many expressed bullish views on Japan’s economy and stock market, citing factors such as corporate governance reforms, improving profitability, and attractive valuations. This promise has yet to be fulfilled. It is therefore important to be clear-eyed about Japan and exercise humility when assessing the country’s prospects.

That said, there is a little doubt that a window of opportunity is opening, although talk of “a new dawn” for Japan may be hyperbolic. Japan will never be the next China, but it is benefiting from the recent increase in global investors looking for new opportunities outside of China. Investors need look no further than at some hard facts that have always been on the radar screen but have attracted little attention until now. It is often reported that half of listed companies in Japan have a price-to-book ratio under 1. In addition, by the end of 2022, the average EV-to-EBITDA ratio of companies listed on the Tokyo Stock Exchange (TSE) stood at 6.5 (NYSE was at 13; the London Stock Exchange was at 10). And the median EBITDA margin of TSE-listed companies was 20% lower than global comps. If Japan can close the comps gap by 2035 as the impacts from governance improvement and reaction to activists are finally felt, then the upside in share prices will be close to two times.

Investors have noticed. Warren Buffett visited Tokyo this April for the first time in 12 years. Activist investors are setting up shops, and not a month goes by without an activist taking a large stake in corporate Japan. Obviously, these investors feel something that the world should know.

Japan’s government is aware that it has an opportunity to leverage the wave of interest from investors and entrepreneurs in the region. Over the last few years, the government has announced a series of support schemes for start-ups, similar to what the French and Israeli governments have pushed in the past: fiscal breaks for individuals (e.g., up to $80,000 invested in a start-up is tax free, every year) and government-sponsored non-recourse loans, among other measures. Venture capital funds still have a small footprint in Japan—$8 billion as of 2022 (many orders of magnitude smaller than in the US)—but the industry is growing rapidly with remarkable internal rates of return for older vintage funds, which augurs well for future returns.

Start-ups used to operate on the fringes of Japanese society, but that is no longer the case. Indeed, as an example, most of Japan’s management consultants who leave their jobs are joining start-ups directly (vs. joining large conglomerates, as they did in the past). This is a pool of talented people that numbers in the thousands. Japan’s start-up industry may be just one catalyst away from landing on a trajectory of significant growth in the long term.

Japan also appears to be on the verge of some meaningful political shifts in response to the geopolitical volatility of the post-globalization era. The country used to be the epitome of a pacific and homogenous country. As is typical of an economy reliant on trade, Japan has consistently been cautious on the global diplomatic stage. But in the wake of Russia’s invasion of Ukraine, Japan’s government has pivoted dramatically, pledging to double the country’s defense budget over the next five years. The additional $40 billion in defense spending will bring Japan’s defense budget to roughly $80 billion annually. This level of spending is less than the US and China’s current defense budgets but is consistent with the rest of the world’s highest-spending countries.

Japan is becoming less and less of a homogeneous country. As of October 2020, the population included 2.7 million foreign-born individuals (up by 835,000 vs. 2015). The government has recently “discovered” the acuteness of its depopulation issue (Japan loses 500,000 people per annum) and is trying to revive the birth rate with Europe-inspired schemes. These schemes, however, will only go so far, and leading economists are now urging more voluntary action on the immigration front. The day of reckoning on immigration may not be too far away.

Considerable uncertainties and unresolved issues remain. First and foremost is the fate of the country’s quantitative easing regime. Progress in unwinding the policy will be slow, but with such huge sums involved, the repercussions will be felt. The most likely impact will be a reallocation of financial institutions’ US dollar-denominated assets to yen-denominated assets, with a major repatriation of assets into Japan. A sudden surge in interest rates in Japan does not seem to be on the horizon, however. The country also still has a convoluted and punishing tax system that is not aligned with the rest of the world; a gaping lag in digitalization; and a “stop-and-go” climate policy, around which contradictions came to light at the latest G7 ministers of environment meeting last week. We should not expect these issues to be resolved overnight. Nevertheless, given the positive signs of change mentioned above, these issues should not bar investors from taking a fresh look at opportunities in Japan.