373. Japan’s new era of innovation

30 October 2025 (pre-recorded 13 October 2025)

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[INTRODUCTION]

Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. Japan’s stock market is back in the spotlight with political change, corporate reform, and a wave of innovation. From rising inflation to AI leadership, discover what it all means for investors looking at Japan today. Please not that this interview was recorded prior to the election and the subsequent highs of the stock market.

James Yardley (JY): I’m James Yardley, and today I’m joined by Thomas Patchett, investment specialist on the Baillie Gifford Japanese fund. Thomas, thank you very much for joining us today.

Thomas Patchett (TP): Hi James, thanks for having me.

[INTERVIEW]

JY: Now, Thomas, I mean, the big news in Japan at the moment is the election of Sanae Takaichi – hopefully I’ve pronounced that correctly – who is set, I believe, to become Japan’s first female prime minister. I believe she’s a big fan of Margaret Thatcher and she wants to continue the Abenomics legacy. So what is the impact you think this will have on the market?

TP: Thanks, James. Yeah, I mean, I think the market quite liked the news. It seemed to rally on what came known as the Takaichi trade. There’s a lot of excitement around the prospect of fiscal spending. And the idea that rates would be kept lower for longer. To me, I mean, I personally think it’s probably a little bit of an overreaction. There’s quite a few issues that she’s likely to face.

The party and the coalition that exists at the moment is quite fractious. So if she is elected as Prime Minister, it could be on a pretty weak mandate. And Japan is similar to a lot of other countries, I think, suffers from very little latitude for more fiscal profligacy. So I don’t think there’s much really that she can do on that front. And if she were to pursue that in the long term, that could have repercussions for the bond market. We’ve seen yields kind of climb quite materially. So the cost of capital, not just in Japan, but around the world, could rise as a byproduct of that.

JY: At a headline level then, her sort of ideas were cut taxes and increase defence spending. And is that, what has the bond market a bit worried? Is that right?

TP: Yeah, it is the same that we’ve seen in various markets around the world with a lot of countries boosting defence spending which I think the market likes this idea of even more liquidity in the short term, but longer term, it does have implications to say for the cost of capital.

I would caveat that even though this might impact mood and the sentiment of the market in the short term, to us it’s more of a side show, a bit of a distraction. More noise rather than signal. And the reason being is that when you are investing in growth companies for what they could achieve over the next five years and beyond, politics really doesn’t have much of a bearing on that. It’s kinda structural change, the developments we’ve seen in AI or healthcare provision or changing consumer preferences, they’re the kind of things which seem to steal our attention far more so than the politics in Japan.

JY: Well, I mean, it’s fair to say though, that the whole start of Abenomics has been a big positive for the Japanese market, hasn’t it? And I mean, if she continues on with that legacy in terms of the ongoing corporate governance reforms, then that can surely only be a positive.

TP: Definitely. I mean, I think Abenomics was slightly different. I think he very much bolstered the momentum in corporate reform. But I think that baton has now been passed on to the stock exchange, which is pushing for greater corporate governance for the main index constituents. And you’ve got other pressures as well on companies a huge rise in activism and inflation, which I think will be an even greater force for change within Japan. So I think politics will play more of a backseat in Japan’s corporate reform story. And that’s obviously where Abenomics was key in the past.

JY: Japan has long been associated with value traps and these large entrenched industrial companies struggling in this kind of deflationary environment. I mean, has that changed now? Do you think that reputation is still justified? I mean, I know of course, as a house, Baillie Gifford generally prefers growth. But this fund I think has venture occasionally into maybe more core or value areas at some point. So where are you thinking at the moment and where are you investing and finding the best ideas?

TP: Yeah, I mean, first of all, in terms of perception I mean, I’ve been covering Japan for over five years now. I think it’s a fascinating market, one of the most enigmatic opportunity sets out there with huge, potentially in various different growth themes, which we can get into later.

What’s really exciting at the moment though, is that in addition to all of that, we are generally seeing a dramatic rising tide improvement in the economic and corporate backdrop within Japan. And there’s a few things you can point to, such as the market reaching new highs, which I think has huge symbolic effect in that the market’s no longer operating in the shadows of the past. But AI is happening at a beautiful time in Japan where the labour market is becoming incredibly tight.

But the most important one is with regards to inflation. Because if you take a step back, deflation has been the defining narrative that has coloured investor perceptions for the past 30 years. And so the rise of inflation is huge and could really shake up the system by putting a lot of pressure on idle assets and, you know, penalising efficiency. Because if you consider the fact that for 30 years there was effectively zero cost of capital or no cost of capital and hoarding cash was actually a clever or good thing to do, that’s completely changed. Now with inflation, it will start to eat away at the value from the cash that sits on the balance sheet. So it creates a huge impetus for better balance sheet management. And we are starting to see tangible results. We’ve seen that in terms of share buybacks, there’s been huge amounts. And then that obviously has the impact to the potential to disproportionately boost earnings per share.

And something that’s gone a little bit missed, I think by investors is that the deadwood is being cleared from the index. And what I mean by that is that the TOPIX constituents has fallen dramatic dramatically. 500 companies have left the TOPIX in the last 12 months alone. And this kind of pruning, if you like, should strengthen the market’s inevitability as the bad start…

JY: So what’s driving that? Why have all these companies left the index? Is that private equity coming in and buying them? Is that mergers of existing companies?

TP: Yeah, yeah, yeah. So it’s a mixture of all of those things. So charge listings are being removed. You’re seeing a lot more M&A activity, a lot of more buyout activity. And a lot of companies are choosing themselves to leave the index if they don’t have a decent amount of free float. If they are if they have very, very, very poor return equity characteristics, then they no longer hit or meet the bar that is being set by the TOPIX. So that I think should help, you know, almost in a kind of survivorship bias type of sense, lift the numbers for the overall index and make it more of an appealing index relative to other developed market indices around the world.

JY: Very interesting. And I mean, we’ve been hearing about obviously the improving corporate governance, the increased buybacks, the increased dividends, et cetera, for a long time now. But I mean, how far has that story now played out? Is that not already in the price of a lot of these stocks? I mean, or is this just a very long slow burn thing, which has still got years ahead of it?

TP: Yeah, I think for a long time, corporate governance has been incorrectly framed as a way of creating a quick fix for vast parts of the market, you know, if you, through payouts, et cetera, of mature businesses with very little growth prospects beyond that we see its impact as broader based, because a lot of the issues that are, that have been addressed are systemic, you know, cash holding and cross shareholdings can be found a across the board in Japan and, you know, traditional value companies as well as traditional growth businesses internet businesses, as well as manufacturing companies. So the benefits are likely to be slow but enduring over the years.

And so we definitely still believe it is a rising tide type event, something that will be beneficial to earnings in the long term. But for us, it’s never been the sole story for investing in a company. It’s very much a side a story beneficial if you like, to the overall investment case.

A lot of companies that we very much like because of their structural growth opportunities a good example would be Shimano, the company that has a dominant that has dominance in making bicycle components. And there’s a big opportunity for them with electric bikes. But in addition to that growth opportunity, they also have about a quarter of their market cap in net cash, which if they were to reduce the buybacks, canceling some of the shares that could have a meaningful uplift on its earnings per share. So it’s not the main focus or main reason we invest in the company, but it will be beneficial to returns in the long term.

JY: Yeah, and I mean, that’s a very interesting stock example. Obviously with the Lime bikes and everything seemingly taking off everywhere. I mean, is is there still good value in a name like that? Or is it trailing very quite? Is it quite expensive?

TP: No, I think the biking in industry was hit hard by COVID. There was a lot of inventory buildups. So there is that bull with perfect, which is impacting Shimano and a number of other players within that industry. But we believe it is still being able to maintain its market share, and they have quite a nice diverse church of of products tailoring to both the high-end very expensive road bikes as well as entry level bicycles. So they’re nicely diversified across the different biking segments. And so because of the kind of general industry malaise that they are suffering from at the moment, the share price has derated providing us with quite a nice entry opportunity into what we believe will be an enduring compounding opportunity over time with, as I say, this additional catalyst potential from better balance sheet management if they were to address some of that cash on the balance sheet.

JY: Very good. I mean, and how are the US tariffs and things impacting Japan at the moment?

TP: For us, it’s not that much of an issue. And the main reason being is that we don’t hold any car companies and these are the businesses that are feeling most of the pain from the tariffs. If you look at Toyota alone, they estimate that they will probably see about a $10 billion impact on their operating income this year alone from tariffs. So in terms of a relative positioning, we’re in a very strong position.

But obviously we do have some exposure to businesses that do export or have business in America. But even there, because of our preference for businesses with very strong fundamentals businesses with competitive edges or pricing power, they have an ability to withstand and even benefit from what we’re seeing come through from tariffs.

So a few examples of that. A lot of the automation stocks that we have within the portfolio benefit from really strong incumbency high switching costs. So something like Fanuc, which is the world’s leading robotics company, they have a 50% global market share in CNC machines, which are effectively like the brain within a factory that controls all the robots. So a business like that will actually benefit from reshoring, nearshoring and some of the other knockout effects of these tariffs.

And then we’ve got other businesses like Daikin company, which makes air conditioning units. They have a very, very diverse distribution network. So they have a policy of market localised production, meaning they’ve got about 110 manufacturing sites around the world. So they’re less impacted by some of the cross border policies and disruptions that are emerging because of the geopolitical fights that we are seeing play out on the international stage.

And then one other example, which I think is quite a a nice example of a business that seems to be almost immune from what’s happening on the geopolitical front is Nintendo which I think is emblematic if some of the businesses in Japan that have very, very loyal customers and strong brands or IP, Nintendo benefits from that, in addition to a very flexible manufacturing base, they’ve shifted a lot of manufacturing of their switch device from China to Vietnam and pricing power. So at the time when all of these tariffs were coming through Nintendo released the switch to device as well as a whole list of games to accompany that, one of which was the Mario Kart World game which retail for $80, which has effectively set a new price ceiling for games. So their ability to introduce a game at a higher price than anything else has ever seen at the time when tariffs should be eating away to their margins. Evidence is just how strong that business is and how immune it clearly has been from some of these tariffs.

JY: Yeah, I mean, the Nintendo is an interesting one there. I mean, I guess there has to be a level though, where they will start to upset the consumer if they keep on increasing the prices forever and ever. I mean, speaking as a parent, I can’t say I’m very happy with the $80 a Mario Kart, but no, I take your point. It’s a very strong franchise and a very strong business.

But I mean, what are the kind of the biggest structural changes you see in the Japanese economy over the next five to 10 years? I mean, and how are you kind of positioned there? I mean, are you worried about the demographics at all? Obviously that’s often cited in Japan, but of course it’s a weakness everywhere now, really, but or in most of the developed world anyway.

TP: Yeah, no, I actually think that could be a tailwind for a lot of companies in a few ways. I guess one of the biggest changes that we’re seeing at the moment is that shift from deflation environment, a slack rich environment to one of pricing power and inflation that I think will likely be supported by Japan’s chronic labour shortages. And those things together combined could help increase profit margins and increase productivity across the board at Japan. And the reason being is that even though Japan’s demographic demise has been talked about for a long time, the workforce actually only just peaked last year.

So you, even the work in age population, I think that peaked many, many years ago, the workforce continued to climb because there was greater and greater participation amongst the female population as well as the elderly. But it’s now reached kind of that critical point where the bloated baby boomers who are now in their late seventies, and many of them are still working, are beginning to leave the workforce. And as they do so, companies are going to need to invest in labour saving CapEx AI automation to offset that reduction.

And to put some numbers on that, it’s estimated that about 11 million adult there will be, sorry, an 11 million worker shortfall by 2040. So in the rest of the world, whilst we fear about AI taking over our jobs in Japan, it’s happening at a very, very propitious moment where there aren’t the people to do the jobs. So they are in dire needs to invest in these labour savings solutions, which could really help the productivity of companies boost profit margins, making it a far making the country and the companies, they’re far more appealing relative to those elsewhere. So I think, yeah, the demographic situation often cited as a problem from Japan is definitely an opportunity for a lot of companies that exist there.

JY: I mean, Japan has always been a world leader in automation and robotics. Do you think, will that translate into these potential humanoid robots and things? I mean, as you say, Japan would seemingly be the perfect place to kind of test them out, because that’s probably where you need the most help or something. If you’re an elderly person living by yourself at home and you need help doing the dishes or whatever it can, are you seeing any signs that, you know, Japan can translate that robotic expertise into these other new potential growth areas of robotics?

TP: We are. I mean, so I think one of the reasons why Japan is so strong in automation is because of Toyota and the car industry. You know, it really much grew off the back of that. But for the last 10 years it has been shifting away from the auto line into other industries. So into healthcare, into retail consumption. It is starting to broaden in terms of its application. So we are seeing that and we expect that to continue as the dexterity and vision capabilities of automation continue to advance.

What’s really exciting that something that’s happened really recently is SoftBank’s Group, a large Japanese investment company that invests in open AI and arm alongside a number of listed and, and unlisted companies around the world within its vision funds has just announced that it will acquire ABB something that should complete next year.

ABB is a very large Swiss automation and robotics company. So this is really interesting because up until this point, SoftBank has been mostly focused on the software application of AI. This though suggests that they are extending that more towards hard, tangible assets where AI meets the physical world. So it has huge implications for SoftBank, but also for Japan’s wider automation and robotics industry.

JY: And SoftBank, of course, I think, is it still the largest position in the fund or is it one of the largest still?

TP: Yeah, it is still still the largest it’s been its share price has done very, very well. Year to date, the position had got to about 10%. We have cut that back now to about 6% as the discount to the sum of the past has narrowed materially. But to us, it still represents a fantastic opportunity. It has a huge position in open AO, which is clearly becoming one of the leading players within artificial intelligence through Chat GPT it still has a 90% stake in arm which provides leading architectural design plans for CPUs. So every mobile phone around the world will lightly rely on arm’s architectural designs. And then alongside that, it has a whole host of optional positions, if you like, in AI related businesses within its vision funds. So it really does to us represent a collection of hugely attractive businesses, which are starting to work together quite nicely. And yet the company still trades on a discount to the sum of its parts making it probably one of the most under-appreciated AI proxy plays out there. And arguably something which is emblematic of what we see elsewhere in Japan, an under-appreciated technology leader.

JY: Perfect. Well, that seems like a good place to leave it. So thank you very much for joining us today, Thomas. That was very interesting.

TP: Thank you very much, James. Appreciate it.

SW: Baillie Gifford has a very strong Japanese equity team and a significant amount of local knowledge built up over decades. The Baillie Gifford Japanese fund has been one of the most consistent in the sector and has proven itself in many different market environments. To learn more about the Baillie Gifford Japanese fund please visit fundcalibre.com