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How the sun set on Japan’s asset bubble

Japan partied like it was 1999 in the 1980s, but the underlying weaknesses in its structure of corporate governance caused the mother of all asset price crashes.
How the sun set on Japan’s asset bubble
  • This month the Japanese Nikkei has hit 28,000 for the first time since 1990
  • A return to the country's asset bubble and subsequent crash provides an important lesson for today's equity investors

Welcome to Tokyo in 1989. Vast leveraged property deals, karaoke bars, $3m golf club memberships, thousands spent on individual bottles of Beaujolais Nouveau and an asset bubble that saw the average price for 1 square metre of Tokyo rocket to $300,000. With a host of trophy purchases in the US – at one point a Japanese real estate company bought the Rockefeller Centre in New York – it was thought that Japan was about to decisively overtake its western competitors.

Until it all went very, very wrong. The crash in Japanese asset prices represents one of the biggest destructions of shareholder capital in stock market history. From peak to trough, shareholders lost some $2tn of wealth in just a couple of years. The consequences for Japan were grievous. The fallout from the bust crushed consumer confidence and condemned the country to two decades of low growth and falling prices, causing savers to squirrel ever more money away in low-interest Post Office accounts. It also contributed materially to job insecurity, exacerbated an already punishing culture of long working hours for those lucky enough to be in regular work, and it is probably a factor in the huge intervening decline in Japan’s birth rate.

The asset crash has clear lessons for today’s investors looking to invest in Japanese equities. Increasing numbers over the past five years have started buying Japan-focused funds because of the relatively low valuation of the Nikkei and Topix when compared with the S&P 500 and other major indices. The Nikkei trades at an average PE of 27, compared with 37 for the S&P. To put that into context, at the height of the Nikkei’s boom in December 1989, the average PE was over 70. That change is also reflected in weighted global market cap. In 1989, Japanese companies accounted for 45 per cent of global market capitalisation, today that figure is 8.4 per cent. Foreigners are currently responsible for approximately two-thirds of the trade on the Japanese indices – an indication perhaps of how fragile sentiment still is for Japanese investors.

 

The roots of the crash

Rather like the credit crunch in 2008, Japan’s market crash began with worries over the solvency of its banks. Japanese banks had been fuelling the property market in Tokyo, and overseas, with large amounts of lending based on an assumption of permanently rising asset prices. The root cause of this was that Japanese banks had a perverse incentive to expand their balance sheets, as the absolute return they could make was limited by strict regulation. This bled into the stock market via heavily backed property development companies. So, in effect, asset prices became a proxy for an individual bank’s market value – a highly dangerous combination. An indication of the scale of the overpricing is that the fall in absolute value of many Tokyo property developments was a mind-boggling 99 per cent. 

The other factor in the boom was what would later be clear was the absence of sensible corporate governance. An astonishing 70 per cent of companies on the Nikkei owned crossholdings in their direct competitors, leading to cosy cartels, deals between managements and a complete lack of thought for shareholder interests and returns. The actions of the government at the time, led by the permanently-in-power Liberal Democratic Party, were also highly dubious; companies with good political connections often had their share prices propped up via secret investment vehicles funded with taxpayer cash.

If you can get a copy, Mark Roth’s Making Money in Japanese Stocks published in 1989 is a fascinating contemporary record of the Nikkei’s bull run. What Roth’s book underlines is that most keen observers at the time agreed that there was something very wrong with how the Japanese market operated. Roth noted that day traders, rumour-mongers and opportunistic brokers were the dominant market force, along with the uniquely-Japanese phenomenon of Sokaiya, trouble-making shareholders with criminal links, who threatened companies with embarrassment at their general meetings. Roth cites one example were sokaiya questioned Sony’s board continuously for 13 hours about why the Betamax video player was losing out to the rival VHS format. Companies tended to pay them off rather than undergo a similar ordeal.  

When all this came out in the wash, it was clear that only a major reform of the country’s corporate culture would restore any kind of confidence.

 

How things have changed 

The fact that foreign investors are perfectly happy these days to invest in the Japanese market is down to the reforms enacted in the mid-1990s. Companies sold their crossholdings, accounting standards were tightened up (which ultimately revealed scandals at companies such as Olympus) and governance generally brought in line with global norms.

From a shareholder perspective, one of the most significant changes were laws that forced managements to take account of the views and rights of minority shareholders. Previously, only the largest shareholders in a company were consulted and often cosseted at the expense of the rest. The other big reform was that the market for M&A was significantly liberalised so that capital could be more efficiently deployed. Even something as simple as gaining a listing on the stock market became easier for many firms, which is why IPOs increased hugely during the 1990s. As an illustrative example, there were 19 Nikkei IPOs in 1988, compared with 50 in 1996, an indication that the effective closed-shop had come to an end.

If nothing else, Japan’s experience indicates that, like all stock market booms, sooner or later the party is going to end – sometimes suddenly, always badly.