“Buy my Abenomics,” begged Japan’s former Prime Minister Shinzo Abe in 2013 when he visited the trading floor at the New York Stock Exchange, rang the bell and called out his home stock market. Ten years on, it looks like investors finally are.

I say finally because while the market did bottom in Abe’s time (he followed up his speech with various corporate governance reforms that began to change sentiment), it didn’t exactly catch fire. By the end of last year, the Tokyo Stock Price Index was up only 61% since the big bell ring. The S&P 500 gained 127% in the same time frame (even after an utterly miserable 2022).

This year, however, everything looks a little different. Japan’s TOPIX is up more than 20% year to date. The S&P 500 is up by just under 15%. Japan is also catching up over longer time periods. Over five years, you’d have made 57% in the U.S. but a still solid 28% in Japan. 

So what’s driving the sudden burst of outperformance? Cheap stocks—and a new understanding that there is a clear catalyst to make them less cheap.

Let’s start with cheap. Around 50% of Japan’s companies trade on a price-to-book ratio of under 1. The median price-to-book ratio is just over 1 (in the U.S., the equivalent number is 3.9 times). Those book values might even be artificially low—assets in Japan are carried at book cost or market price, whatever is the lower (this is a legacy of deflation). Price-to-earning ratios look good too.

It took a long time for valuations in Japan to recover from the 1980s (think average P/E of over 45 times) and the 1990s (a lesser bubble with average P/Es peaking at more like 32 times), but the 12-month rolling forward P/E has now been lower than that of the world average since 2014. Right now, says Schroders Plc, around 25% of TOPIX trades are on a forward P/E of between 5 and 10, and a good 65% are under 20 times. You don’t see that in many countries—and particularly where the average company is also high-quality and awash with cash.

Cheap is as cheap does, of course. Japan, as Abe noted, has been cheap for a long time. On then to the catalyst, the thing that is making it less cheap—and should continue to do so. It is that the Tokyo Stock Exchange has had enough. Companies with a price-to-book ratio of less than one (remember that is over 50% of Japan’s listed companies) are being told to disclose their plan to change those ratios. The exchange has allies. Back in 2014, says UBS Group AG, there were fewer than 10 activist funds operating in Japan. Now there are around 70, all focused on trying to make Japanese companies think about their balance sheets, and get those book value ratios up along the way.

One obvious point, as the analysts at Verdad Research point out, is that just ordering the 50% of Japanese companies trading below book value to do something about it is about as useful as ordering the seas to whip up at a king’s will. After all, while low book values might have been one reason investors avoided Japan for decades, “markets set prices and a Japanese company cannot directly control the numerator of that P/B ratio,” according to Verdad.

Yet the truth is that companies can control the denominator by paying out the surplus profits on their balance sheets rather than retaining them indefinitely. It is about time they did that. Japanese companies have become “significantly more profitable” since Abenomics but have also stayed “highly inclined” to hoard all that lovely cash, says Verdad. Over the last decade, for example, the total payout ratio in the U.S. (including buybacks) has been about four times higher than in Japan.

That number is on the move: Share buybacks hit a record high in Japan last year and look to do so again this year. If that change continues—and with 70 activist firms devoted to nagging the lowly valued pretty much full-time, why would it not?—so does the whole dynamic of the Japanese stock market.

Exciting times. But anyone who now rushes off to check on the 20% rise in the Japan funds in their portfolio is likely to be disappointed. It won’t be there. That’s partly down to currency (the weak yen drags down sterling returns), but it’s also about the kind of stocks most funds hold. They don’t hold the small, value stocks trading under book value: Very few analysts cover them and they aren’t that easy to find. They also don’t hold the larger value stocks, which are easier to find and have been the default buy option for those listening to the Japan story.

Instead, most investors in Japan tend to hold more growth-oriented stocks, says Zennor’s David Mitchinson, the ones that feel more comfortable but that were also already knocking around international valuations. A shame given that value has firmly outperformed growth in Japan recently (with banks and basic materials being the big winners).

Look at the U.K.’s listed Japan trusts and you get the idea. There is some double-digit action. Nippon Active Value stands out with a 23% year to date (it actually does invest in small and midcap value stocks), the Schroder Japan Trust comes in at 13%, and the AVI Japan Opportunity Trust at 8%. All are explicitly run by value investors. But there is also a sorry list of rather worse performances—the BG Japan Trust on 1.4% and the Atlantis Japan Growth Fund on -5% being a few examples.

The point here is simple. It may be that a rising tide lifts all boats in Japan. But if the reason to invest in it is because solid but cheap stocks are likely to get less cheap, they are probably those you want to be holding over the medium term. Warren Buffett gets that. In 2020, he bought into a large group of Japanese trading companies on the basis that they were both high quality and cheap. He’s doubled his money since—and is clearly hoping to do so again.

“We’re not done” investing in Japan, he says. The rest of us probably shouldn’t be either—as long as, like him, we are in the right Japan.

This article was provided by Bloomberg News.