After 30 years without inflation, the Land of the Rising Sun may be the Land of the Rising Prices once again. Forecasters expect Japan’s consumer prices to rise by almost 2%. To see that level of consumer price inflation, companies would have to not only absorb some of the costs associated with the current global spike in prices, but pass some of them on to customers.
It has been a long time since corporate Japan has faced this challenge, but we are confident it can do so. In particular, we see an abundance of pricing power and fundamental strength among the under-researched “hidden gems” of Japan’s small- and mid-cap markets, where we focus our efforts. Some of these companies could be positioned to take full advantage should inflation return as a tailwind behind corporate earnings.
Pricing Power
Consumer prices have been rising around the world on the back of the reopening of economies following the COVID-19 pandemic and ongoing supply chain disruptions exacerbated by the conflict in Ukraine.
For the first time in 30 years, Japan is no exception. In fact, inflation here is being amplified by the weakening yen, as the country is a net importer of a wide variety of inputs, including energy and hard and soft commodities. As the Bank of Japan has not followed the hawkish lead of the U.S. Federal Reserve, widening interest rate differentials have pushed the yen down to almost 130 to the U.S. dollar, its weakest level in more than two decades. This has prompted sell-side economists to forecast Japan’s consumer price inflation to reach 1.8% this year. Outside the so-called “tax years” of 1997, 2014 and 2019, when Japan raised its sales tax, that level of inflation has not been sustained since the 1980s.
We believe a price normalization could mark a turning point for Japanese companies, giving them the chance to wean themselves from the deflationary spiral of the so-called “Lost Decades” and finally seek to achieve long-term sustainable growth. But will they be able to deal with rising costs given this long history of low inflation, disinflation and even deflation?
Given the broad-based and structural nature of the current inflationary trend, we believe companies have little choice but to adjust pricing in the near term. The Bank of Japan’s latest quarterly “Tankan” survey of business confidence reports that both manufacturing and non-manufacturing firms expect their selling prices over the coming year to increase by 1.9% and 1.1%, respectively, versus the previous survey in January.
Companies are apparently looking to break away from past traditions of bearing all their rising costs themselves. But to sustain that over the longer term, we believe business fundamentals will be the deciding factors—most notably scale, pricing power, cost competitiveness and robust balance sheets.
We find these factors in abundance among the under-researched and often attractively valued “hidden gems” of Japan’s small- and mid-cap markets, where we tend to focus our efforts. In fact, when we consider the four “baskets” into which we categorize these hidden gem businesses, we find a big overlap with these factors in at least three of them.
Small Giants, Lost Decade Survivors and Emerging Disruptors
“Small Giants” is how we describe market leaders in growing niche industries that are protected by a strong competitive moat, giving them considerable pricing power. Companies that have spent years building similar competitive moats by successfully consolidating industries with high entry costs are categorized by us as “Lost Decade Survivors”. And the “Emerging Disruptors” are those next-generation innovators that tend to have asset-light and therefore low-cost and cash-generative business models.
Among “Small Giants” are companies like Shoei, whose top-of-the-line motorcycle helmets boast a loyal, global following of bike enthusiasts willing to pay premiums for quality, safety and durability. The company claims to have more than a 60% share of the global market in premium helmets as of April 14, 2022. It is seeing robust demand from emerging markets in Asia, resulting in an order backlog equivalent to roughly one year’s revenue, according to the company’s first quarter earnings data. We believe this gives the company strong pricing power to pass on rising input cost pressures to help protect margins.
Like Shoei, Yamaha is also a “Small Giant”, with the biggest share of the global market in musical instruments, according to company data as of April 14, 2022. That has enabled it to maintain and, in some cases, increase pricing during the current inflationary environment. We also view the company as a “Lost Decade Survivor” that has strengthened its business amid industry consolidation, partly by establishing integrated production and sales structures in key end markets such as the U.S. and Southeast Asia. This restructuring has allowed the company to tailor products for individual market needs while reducing earnings volatility from foreign currency mismatches between its costs and revenues—a growing risk in an environment of inflation and central bank policy divergence.
Among “Emerging Disruptors”, we could highlight Japan Elevator Service Holdings, the country’s largest independent elevator maintenance and repair services provider. The recurring fees of this business are attractive in an inflationary environment, particularly as the safety aspect makes them difficult to defer. Its asset-light operations make it unlikely to experience significant margin pressure from inflation, and that has enabled the company to maintain its competitive pricing and continue to take market share from established peers. We believe that is a foundation for sustainable growth through acquisitions in key population zones, such as the Tokyo metropolitan area, where many elevators installed during the 1980s real estate bubble are due for repairs.
Potential
Even companies that we categorize as “Deep Discounts”—those open to shareholder engagement on structural issues that cause them to be undervalued—can include businesses that are well positioned to be resilient against inflation. Take commercial refrigerator maker Daiwa Industries, for example. Over the long term, we believe constructive dialogue is necessary to improve transparency into how Daiwa manages its cash surplus, which is currently bigger than its market capitalization and that of any other company in its sector, and a substantial drag on its capital efficiency. During the pandemic, however, its overcapitalized balance sheet helped it continue investing while competitors tightened their belts, and during the current inflation spike it is helping to absorb rising input costs.
This year could be a pivotal one for Japan, as it looks to bid farewell, once and for all, to the “Lost Decades” of deflation. A return to moderate inflation could be a lasting tailwind behind corporate profitability, particularly for the many small- and mid-cap “hidden gems” that combine sound fundamentals, strong competitive positions and pricing power with a growing willingness to address their material environmental, social and governance challenges and engage on corporate governance, capital management and sustainability reforms. In our view, companies like these are the most likely to thrive should Japan fulfil its potential to become not just the Land of Rising Prices, but the Land of Rising Corporate Value.
