The reform of corporate governance remains fundamental to Japan's transformation, as it addresses the structural inefficiencies that have historically hindered the profitability and valuations of Japanese equities. While cyclical factors such as rising inflation, wage growth, and the shift in monetary policy have captured investors' attention in recent years, this reform addresses the more entrenched structural aspects of the Japanese corporate fabric.
For decades, many Japanese companies accumulated large cash reserves, maintained extensive cross-shareholdings, and paid little attention to shareholder remuneration. As a result, the return on equity (ROE) remained at structurally low levels, and many companies traded at a discount to their book value.
The reforms initiated under the Abe government and subsequently expanded by the Tokyo Stock Exchange have led companies to pay greater attention to capital efficiency and shareholder value creation.
The momentum for reform is evident
Overall, the reforms have made significant progress. Dividend payout ratios are increasing, margins are improving, and in terms of shareholder returns (dividends plus share buybacks), Japanese equities are now generally comparable to European ones and more attractive than American ones.
Moreover, there is a solid consensus among policymakers to continue the reform of corporate governance. In this regard, various signs point to an acceleration of the process:
Faster reduction of cross-shareholdings. Not a week goes by without another Japanese company announcing the sale of its cross-shareholdings. Financial institutions have taken the lead, but consumer and industrial companies are facing increasing pressure to follow suit. Each position that is unwound frees up capital and removes an obstacle to improving governance and enhancing revaluation potential.
Growing interest in mergers and acquisitions. The traditional aversion to mergers and acquisitions in Japan seems to be structurally losing strength. Reforms pushed by the Tokyo Stock Exchange and new guidelines on mergers and acquisitions introduced in 2024 have questioned the usual practice of rejecting buyout offers, contributing to an increase in both domestic acquisitions and cross-border deals. Private equity investors and activists are increasingly focusing on underperforming companies, where operational improvements and greater balance sheet discipline can create value.
Activism is increasingly driving corporate change. Outside the US, Japan has become a key market for activist investors, whose interest in the country has reached unprecedented levels. Although historically activism has struggled to take root in Japan, management teams are showing a greater willingness to engage with them.
But not everything is evolving as expected
Policymakers, regulators, and academics are paying increasing attention to companies' ability to strike an appropriate balance between returning excess capital to shareholders and investing in fixed assets, R&D, and human capital, particularly through wage increases.
For Japan to definitively leave deflation behind, it is essential to strengthen domestic demand. In a country facing a demographic decline and with limited fiscal space, increasing business investment and higher wage growth are two of the main levers to bolster domestic demand.
New regulatory adjustments would consolidate the reform
The Financial Services Agency of Japan and the Tokyo Stock Exchange have just announced new improvements to the country's Corporate Governance Code. Chart 1 summarises the main changes incorporated with the revision of the Corporate Governance Code. These modifications not only strengthen the quality of corporate governance but also encourage boards of directors to prioritise long-term value creation.
Public pressure and pressure from the sector itself could be decisive
In practice, Japan relies more on indirect pressure mechanisms than on regulation to foster behavioural changes. In fact, the governance reform is supported by reputation and market signals.
Policymakers are likely to use these mechanisms to incentivise companies to demonstrate how their capital allocation contributes to sustainable value creation.
Strategic sectors are the most exposed to political pressure
Political pressure to improve capital productivity is expected to focus on strategically important sectors. Shortly after taking office in October 2025, Prime Minister Sanae Takaichi identified 17 areas of strategic investment aimed at channeling large-scale public-private investments into sectors deemed essential for growth, economic security, and technological leadership. Three priority areas stand out:
Energy security. The government is promoting the reactivation of nuclear reactors and increasing renewable generation capacity to reduce dependence on energy imports.
AI and semiconductors. Japan aims to strengthen supply chain resilience and reduce its exposure to technology value chains dominated by China. An example is the Japan Advanced Semiconductor Manufacturing (JASM) initiative, backed by more than $20 billion to revitalise domestic semiconductor manufacturing.
Defence. Prime Minister Takaichi has announced a series of measures to strengthen the Japanese defence industry, including raising military spending to around 2% of GDP, relaxing restrictions on arms exports, expanding domestic production, and investing in dual-use technologies such as AI and advanced systems.
Key companies for the development of these areas are likely to face greater political pressure to achieve an appropriate balance between shareholder profitability and investment.
A gradual shift is taking shape
Beyond these sectors, we anticipate a gradual adjustment in capital allocation, with a greater emphasis on growth-oriented investment over shareholder remuneration.
The increase in dividends and share buybacks has been a significant driver of the recent revaluation of Japanese equities. If political pressure gradually leads companies to allocate more cash to investments that drive growth and productivity, shareholder returns could moderate.
This would reduce investor backing for those companies whose investment thesis primarily relies on returning excess cash to shareholders. However, when capital is allocated productively, greater business investment can reinforce the macroeconomic fundamentals of reflation by boosting productivity, domestic demand, and wages.
For investors, the consequence would be a gradual change in the composition of returns, with a greater emphasis on profit growth over shareholder remuneration.
Selectivity is key
Companies capable of productively investing capital should benefit, highlighting the growing importance of management quality. Returning capital through dividends or share buybacks is straightforward; allocating it effectively is considerably more complex, especially in a rapidly changing technological and geopolitical environment.
Investors must now assess whether companies are willing to make difficult strategic decisions, such as downsizing, selling, consolidating, or exiting businesses.
An attractive investment theme for active management
From a stock selection perspective, companies with real improvements in their governance—greater transparency, fewer cross-shareholdings, and more appropriate management of cash surpluses—represent a significant potential source of superior returns.
This conclusion holds true whether the released capital is ultimately returned to shareholders or reinvested for growth. In our view, the key lies in identifying companies that combine improved governance with solid operational quality and excellent management. These companies should be able to successfully transition to a more reinvestment-oriented governance model without giving up the financial flexibility necessary to initiate or maintain shareholder remuneration.
For investors, successfully selecting these companies will require more rigorous analysis and top-tier active engagement.