2023-07-26 07:15:00 ET
Summary
- Japan Exchange Group (JEG) is the largest operator of financial exchanges in Japan, with a monopolistic competitive position, steady growth, and high margins.
- The Japanese equity market is experiencing a revival due to factors such as corporate governance reform, redirected investment from China, and upcoming reform to individual retirement programs.
- Despite potential growth, JEG shares trade at an attractive valuation due to Japan's history of false starts; key risks include sluggish trading volumes, elevated technology expenses, and regulation.
The following segment was excerpted from this fund letter.
Japan Exchange Group ( JPXGY )
Japan Exchange Group (“JEG”) is the largest operator of financial (equities and derivatives) exchanges in Japan. The quick thesis:
- Attractive business model , similar to other global exchanges – monopolistic competitive position, steady growth, high margins (66% EBITDA), and defensive/volatility-linked model. This part of the thesis is straightforward, and I won’t elaborate further here.
- Likely accelerated growth ahead due to recent and expected changes to Japanese equity market structure and evolving institutional investor flows (e.g. re-allocation from China). This is core to the thesis, and I will discuss it in greater detail below.
- Attractive absolute + relative valuation , despite a relatively better backdrop and superior balance sheet (1.5x net cash ) – 11x EBITDA, 5%+ FCF yield. Modest valuation due to lower historical growth and history of fits/starts in Japan.
The Japanese equity market is currently experiencing a revival due to the convergence of a number of factors: rising commitment to corporate governance reform (after decades of desperately needing such reform), redirected investment away from China (with institutions generally underinvested in Japan to begin with), upcoming reform to individual retirement programs (huge boost to tax incentives for “NISA” plans, starting in Jan 2024; notably, the domestic population has about 1/4 and 1/2 the exposure to stocks as Americans and Europeans, respectively [4] ), the Nikkei 225 finally approaching its 30-year+ high, and investments from Warren Buffett and other higher-profile investors. While I acknowledge this could all be a trap and the end of a good run, the “long Japan” thesis makes a lot of sense to me. As relates to JEG, I’d be concerned if it were trading at a premium to global peers, with heroic underlying growth assumptions – but the opposite appears true.
While many Japan-focused investors have focused on deep value stocks, JEG is interesting because of both the quality of the business (classic exchange model) and the central role it’s playing in the Japan renaissance itself. The Tokyo Stock Exchange (TSE), owned by JEG, is a key driver of the biggest piece of the puzzle – corporate governance reform. TSE has helped drive reform by implementing a new market tiering system that encourages higher corporate governance standards and “constructive dialogue with global investors.” TSE believes these efforts should improve market valuations and increase domestic and global investor participation. With about 35% of revenue tied to domestic equities, JEG would benefit directly from success here, as both valuations and trade velocity increase, driving JEG revenue growth. Outside of equities, JEG could also see accelerated growth in its JGB and recently-launched ST interest rate futures businesses – areas that tend to thrive with macro volatility.
Despite the potential tailwinds, JEG shares trade at an attractive relative and absolute valuation. I believe this is due to the many false starts Japan has had over the past 3+ decades. JEG revenue growth has historically been…tepid, at best ( low single-digit) – largely due to lack of interest in the Japanese market. While I understand investor hesitation to underwrite an acceleration, the convergence of all the factors noted above strongly suggests an acceleration is likely. JEG’s relatively modest valuation seems particularly compelling in this context.
Key risks for JEG shares include: FX, continued sluggish trading volumes, elevated technology expenses and/or system failures, regulation, business model exposure to broader market valuations.
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Upslope Capital - Japan Exchange Group: Attractive Relative And Absolute Valuation Despite Potential Tailwinds