Japan in the First Innings of a Digital Shift

Yet such enthusiasm to visit Japan seldom extends to Japan’s stock market, which remains well below the 1989 bubble peak. The subsequent “lost” decades of sub-par economic growth have entrenched an unbalanced view that Japan, struggling with weak consumption, high government debt, poor wage growth, and ageing demographics, is an unattractive place to invest. Moreover, Japan appears to be slipping further behind. According to the latest 2022 IMD World Competitiveness Center rankings, Japan now ranks 34^th globally for overall competitiveness, at odds with the stature of being the world’s third largest economy.^[2]

This decline in Japan’s relative competitiveness reflects a number of well-trodden structural issues. These range from micro issues, such as weak productivity, employees lacking skills relevant in the digital economy, and increased competition in product markets with lower-cost Asian competitors, to macro issues, such as a lack of meaningful corporate rationalisation, managerial risk aversion, a seniority-based wage system, and a rigid labour market.

As investors, we do not see these as reasons to avoid Japan. Quite the opposite, in fact. Instead, we see tremendous opportunities to invest in companies that are trading well below their intrinsic value and taking steps to realise higher corporate value. One of the many factors that interest us is that policymakers and corporates now acknowledge that investment in human capital is key to maintaining living standards over the longer term while alleviating worker shortages and underpinning wage growth.

A recent trip to Japan by members of our investment team underscored how accelerating investment in IT and software solutions is one of the keys to unlocking latent productivity and economic growth. Japan’s IT industry has evolved differently to elsewhere, with a user preference for mainframe-based, customised IT solutions. Deployment of IT has been much slower in Japan than seen elsewhere, due in part to higher costs and perceived limited benefits. This is partly due to a high reliance on IT outsourcing, and engineering expertise tends to reside with external IT service vendors rather than in-house at user firms. However, an overdue reassessment of the benefits of IT is now occurring, spurred by the pandemic, which revealed an economy overly reliant on manual analogue processes. The government is encouraging this shift via subsidies increasing IT investment as well as mandating the adoption of digital processes through regulatory changes.

The emergence of cheaper, cloud-based package software as a service (SaaS) solutions means that IT can now be readily adopted by a broad range of enterprises seeking to raise productivity. Corporates now increasingly view such solutions as a tool to boost growth while lowering costs and addressing labour shortages. It is not surprising that corporate IT budgets continue to rise in absolute and relative terms, and we can also see an underlying shift in that spending. Since 2016, demand for packaged software (including cloud-based software) has been rising steadily in a period when demand for custom software has stagnated (see Fig. 1). With the latter being some 4x as large, we can see there is massive scope for ongoing growth in packaged software. Japan has several years of digital catch-up ahead, and the recurring message we heard was that the economy is only in the first innings of this significant structural shift. While this implies a new leg of sustained growth for the IT services industry, we should also expect the benefits of improved productivity to flow through to better corporate performance, which could underpin higher valuations in a market that remains cheap.

Travelling to Japan is now cheaper with the fall in the yen, making a holiday there even more enticing. Visit soon though, as it is unlikely that Japan will be on sale forever.

Fig. 1: Japan Tertiary Industry Activity Index – Software Services (2015 = 100, seasonally adjusted)