Bullish on Japanese Equities, TOPIX Target 4,300

Overview

This is a Japanese equity strategy presentation material (in the form of investor presentation/meeting minutes) released by Morgan Stanley MUFG Securities, with the core conclusion of continuing to be bullish on the Japanese stock market, setting a base target of TOPIX 4,300 by the end of June 2027 (corresponding to a forward P/E of approximately 17.5x). The report determines that if AI investment accelerates, accompanied by stable interest rates supported by Japan's fiscal credibility, growth stocks are likely to once again become market leaders, ushering in a 'great growth moment'. The report also emphasizes that current uncertainty remains high and provides specific ideas on how to manage the risk of AI market trend reversal while maintaining a bullish stance.

Core views

Overall Judgment: The report maintains a constructive bullish stance, believing that the structural forces supporting Japan's long-term bull market are further strengthening, and summarizes these forces into four main lines—rising household stock investment through NISA, continuous and stable inflation, expectations for the Koizumi Cabinet's long-term governance and faster growth strategy (including national security), and the advancement of corporate governance reform. The base scenario assumes a de-escalation of the Middle East situation and no major supply chain disruptions, with a TOPIX target of 4,300 points; the base EPS, considering the lagged transmission of rising oil prices, is about 2-3 percentage points lower than market consensus expectations. Political and Fiscal Mainline: The LDP led by Koizumi secured 316 seats in the House of Representatives, overwhelmingly exceeding a two-thirds majority on its own (the most seats for a single party since the war). The report believes this brings higher policy predictability, faster decision-making, and greater certainty in the execution of growth strategies, which is positive for medium-term earnings prospects and the risk premium required by capital markets. Recent overseas rate hikes, fiscal deficit concerns, and doubts about the BOJ being 'behind the curve' have jointly pushed up long and ultra-long-term Japanese government bond yields; however, the report suggests that if measures led by Finance Minister Katayama, such as the 'Japanese version of DOGE,' improve fiscal efficiency (the 2018 METI report estimated that tax revenue loss caused by special tax measures totaled about 10.1 trillion yen), thereby guiding JGB purchases and yen strength, concerns about the BOJ being behind the curve may also fade, promoting a revaluation of Japanese assets. Growth Strategy and Themes: Koizumi's '17 strategic fields' are viewed by the report as an interconnected ecosystem, with four long-duration themes most likely to attract capital allocation—economic security and supply chain resilience, AI deployment and computing power revolution, energy security and decarbonization, infrastructure renewal and national resilience. Government strategic capital expenditures roughly follow the path of 'upstream platform technologies (AI, power infrastructure, materials) → midstream (defense, robotics, communications) → downstream (drug discovery, quantum, cybersecurity, content/IP)', with the strongest capital inflows currently into upstream AI infrastructure/advanced semiconductors and next-generation power grids. Stocks with high exposure to the 17 fields have significantly outperformed TOPIX since the LDP leadership election last autumn. Regarding national resilience, the FY2026 budget is expected to exceed 5 trillion yen, with facilities built during the bubble period entering a phase of increasing reconstruction demand, indicating that the construction long cycle is entering an expansion phase. AI Market Trend and Risk Management: The report believes that the current market structure is narrowing, almost simplifying to 'AI vs. non-AI'. The capital expenditure/sales ratio (including leases) of hyperscalers may exceed the peak of the internet bubble, but unlike the unprofitable companies of that era, today's hyperscalers are highly profitable and low-leverage. The base scenario is for the AI trend to continue, but positions have quickly become crowded, and simply 'following the buys' carries risks. The report proposes an effective strategy: grouping 'high AI beta' stocks by valuation (book-to-market B/P), and since the 'liberation day' in April 2025, the low-valuation group has outperformed the high-valuation group, that is, 'sell expensive AI, buy cheap AI', showing that maintaining valuation discipline even within the AI theme can generate returns. It also recommends buying put options on stocks that have been inflated by AI narrative but lack fundamental earnings support, as a relatively effective risk management tool in the current environment. Exchange Rates and Earnings Resilience: The report points out that the yen exchange rate is no longer the sole driver of the Japanese stock market. USD/JPY is positively correlated with Japanese stocks, but the regression beta has shown a downward trend since Abenomics, and the sensitivity of exports to exchange rates has significantly decreased; Japanese companies have continued to improve profit margins in the post-pandemic period, making earnings less vulnerable to yen appreciation than in the past. The FX team expects USD/JPY to largely maintain current levels; authorities' efforts to stabilize the exchange rate may suppress export earnings expectations in the short term, but for foreign investors, restraining excessive yen weakness can also stabilize the dollar-denominated performance of Japanese stocks. Governance Reform—The Most Important Long-duration Theme: In the four years since the TSE market reorganization in April 2022, buybacks, dividends, sales of cross-shareholdings, shareholder proposals, and introduction of equity incentives have all reached new highs. In FY2025, TOPIX companies' total shareholder returns (dividends + buybacks) reached a record 43.5 trillion yen, a 13% year-on-year increase. The PBR of the Prime market has risen by about 35-40% since the start of reforms, mainly driven by PER expansion, with ROE improvement still insufficient. The report emphasizes that investors are not simply asking for 'maximized payouts' or 'increased investment', but value sustainable earnings growth, strong cash generation, and rational capital allocation; improving ROE requires exiting low-return businesses and concentrating resources in high-return areas. The report also warns that with the June shareholder meeting season and the upcoming revision of governance guidelines this summer, one should not indiscriminately short governance-related stocks. Household Fund Market Entry: The report believes that household preference for 'deposits over investment' is facing 'the beginning of the end'. As of June 2025, cumulative NISA purchases reached 63 trillion yen, exceeding the target ahead of schedule; a 'Children's NISA' is planned to be launched in January 2027. If Japanese household asset allocation shifts closer to European levels, with the stock ratio rising from 14.5% to 25.6%, potential household stock purchases could reach 270 trillion yen, equivalent to about 20% of the market capitalization of TSE Prime listed companies.

Analysis framework

Overall Mainline: The report first establishes a top-down framework of 'four structural drivers + macro scenarios', then applies it to sector and stock allocation and risk management. Scenario-based Valuation: Pricing TOPIX using bull/base/bear three-tier scenarios, with forward P/E as the anchor—17.5x for base, 18.0x for bull, and 12.0x for bear (Middle East escalation, oil price surge, global recession), explicitly opposing the simple use of historical P/E ranges from the 'low inflation/low transmission/low margin' era as the upper limit, reflecting the logic that 'the market discounts the future in advance'. Quantitative and Factor Tools: The report extensively uses factor/seasonal approaches—analyzing the seasonality of foreign capital flows (selling in March, buying back from April, with net buying often continuing until July), and the effectiveness of style factors like momentum, growth, and value at different times; observing style rotation through the cyclical/defensive index (forming long-short spreads by ranking sectors by beta); using the long-short returns of 'high AI beta' stocks grouped by valuation percentiles to demonstrate the effectiveness of valuation discipline. Fundamental and Governance Logic: Using DuPont analysis to break down the reasons for Japan's low ROE (net profit margin and asset turnover are relatively low compared to the US and Europe), and using ROIC consistently exceeding the cost of capital to explain the sustainable improvement in ROE of high EBITDA growth companies, emphasizing that 'quality of capital allocation' rather than investment scale or payout level is the key to enhancing corporate value. The valuation implications of governance reform are summarized as: reducing the high required investor returns (cost of capital) that have been penalized for the long term, thereby supporting stock prices through PBR/PER expansion. Theme Transmission Network: Viewing Koizumi's 17 fields as an interconnected ecosystem, tracking the rotational path of capital along upstream → midstream → downstream, and identifying beneficiary stock groups through analyst scoring of individual stocks' 'field exposure'.

Methodology notes

• Industry/Industrial Analysis FrameworkSupply and Demand Framework

  Preference for upstream B2B sectors in the supply chain, 'real asset era' logic

  The report suggests that under the background of inflation expectations, security premiums, and accelerated AI capital expenditures, upstream B2B industries (construction materials, machinery, chemicals, steel & non-ferrous metals, etc.) are more beneficiaries, reflecting a shift from demand-side focus to supply/upstream positioning, helping readers understand why overweight is on upstream rather than downstream consumer sectors.

• Valuation MethodPE/PEG valuation

  Using forward P/E for scenario pricing (base 17.5x/bull 18.0x/bear 12.0x)

  Price-to-earnings ratio = stock price/earnings per share, a commonly used valuation anchor for measuring how much the market is willing to pay for unit earnings. The report corresponds different macro scenarios to different forward P/E levels, then multiplies by expected EPS to derive the TOPIX target price, allowing readers to understand how the target price is 'calculated'.

• Valuation MethodPB valuation

  Using PBR to measure governance reform effectiveness, and decomposing into PER and ROE contributions

  PBR (price-to-book ratio) = stock price/net asset value per share, often used to judge market recognition of corporate capital returns. The report points out that the PBR increase in the Prime market since reforms has mainly come from PER expansion (i.e., cost of capital decrease), while ROE improvement is still insufficient, thereby explaining the source and subsequent space of reform dividends.

• Company Fundamentals and Financial FrameworkDuPont analysis

  Using DuPont method to decompose the reasons for Japan's low ROE

  DuPont analysis decomposes ROE into three components: net profit margin × asset turnover × financial leverage. Based on this, the report indicates that Japanese companies' net profit margins and asset turnover are relatively low compared to the US and Europe, so the key to improving ROE is enhancing profitability and asset use efficiency, rather than simply increasing leverage.

• Company Fundamentals and Financial FrameworkROIC–WACC spread

  ROIC consistently exceeding cost of capital driving sustainable ROE improvement

  ROIC (return on invested capital) exceeding WACC (weighted average cost of capital) means the company is creating value for every yen invested. The report uses this spread to explain how high EBITDA growth companies can achieve long-term ROE improvement by exiting low-return businesses and directing capital to high-return areas.

• Quantitative/Factor/Portfolio TheoryBeta/alpha analysis

  Building cyclical/defensive indices using regression beta and measuring exchange rate sensitivity

  Beta measures the volatility sensitivity of a stock or sector relative to the market (or a certain variable). The report classifies sectors into cyclical/defensive by beta to observe style rotation and points out that the regression beta of Japanese stocks relative to USD/JPY has shown a downward trend, indicating that the sensitivity of export profits to exchange rates is weakening.

• Quantitative/Factor/Portfolio TheoryStyle factor analysis

  Timing effectiveness of style factors like momentum, growth, value

  Style factor analysis groups stocks by characteristics such as value, momentum, and quality to observe which recent characteristics can bring excess returns. Based on this, the report points out that momentum and growth factors are more effective from April, and that the effectiveness of value factors may rise as the shareholder meeting season approaches.

• Event Trading and Behavioral FinanceCapital Flow/Chip Analysis

  Seasonal patterns of foreign capital flows

  By statistically analyzing the monthly patterns of foreign buying and selling historically (tending to net sell in March, buy back from April, with net buying often continuing until July), combined with position crowdedness, it judges the support of supply and demand for stock prices. Based on this, the report believes the probability of Japanese stock momentum maintaining before summer is relatively high, and also alerts to the pullback risk of crowded AI positions.

• Event Trading and Behavioral FinanceMargin of safety

  Maintaining valuation discipline within the AI theme and hedging with options

  Margin of safety emphasizes controlling risk through the discount of price relative to value. The report uses the outperformance of the low-valuation group over the high-valuation group within 'high AI beta' stocks to illustrate the value of valuation discipline, and recommends buying put options on high-valuation AI stocks lacking earnings support as a tool to hedge against trend reversals.

• Cycle and Economic Activity FrameworkCapacity/Equipment Cycle (Juglar)

  Using CF filter to estimate that the construction long cycle is entering an expansion phase

  By decomposing the cyclical components of construction activity data using filtering methods, the report determines that reconstruction demand for aging infrastructure built during the bubble period is pushing the construction long cycle into an expansion phase, meaning related demand has relatively long sustainability.

Asset mapping & comparison

Structured mapping from thesis to named assets (strengths, weaknesses, peers, risks).

• Upstream supply chain B2B sectors (construction materials, machinery, precision electronics, chemicals, steel & non-ferrous metals)

  Overweight: Highly aligned with Koizumi's 17 strategic fields, benefiting from inflation expectations, security premiums, and accelerated AI capital expenditures in the 'real asset era'

  Strengths

  Relatively high earnings growth certainty and visibility (semiconductors, infrastructure, construction installation, machinery related to AI, data centers, domestic capital expenditures); stocks with high exposure to the 17 fields have significantly outperformed TOPIX since last autumn

  Weaknesses

  Not elaborated in the report

  Comparison

  More favored compared to downstream consumer sectors, an overweight direction in top-down allocation

  Risks

  Not elaborated in the report

• Downstream/Defensive Sectors (Automobiles & Transportation Equipment, Retail, Food, Pharmaceuticals, Transportation Logistics)

  Underweight: Facing headwinds such as Middle East risks, rising fuel/raw material prices, US tariffs, rising interest rates, and increasing labor costs, which may suppress earnings growth

  Strengths

  Not elaborated in the report

  Weaknesses

  Automobiles, transportation logistics, and electric power/gas are sensitive to fuel/raw material and geopolitical risks, with high uncertainty; most companies' plans are significantly below consensus expectations

  Comparison

  At a disadvantage compared to upstream B2B sectors, an underweight direction in top-down allocation

  Risks

  Not elaborated in the report

• Banking Sector

  Maintain Neutral: Receiving more attention as a beneficiary of rising interest rates and one of the few trades not yet crowded

  Strengths

  Benefiting from rising interest rates, one of the few trade directions still not crowded

  Weaknesses

  The report believes market expectations for BOJ rate hike pace are too aggressive, and bank P/E is difficult to expand when rate hikes accelerate

  Comparison

  Despite increased attention, maintaining neutral rather than overweight

  Risks

  Not elaborated in the report

• Large Retail Leaders (liquid retail blue chips)

  As a hedge: Providing some hedging value relative to positions concentrated in AI semiconductors

  Strengths

  High liquidity, can serve as a hedge against concentrated AI semiconductor positions; real wages returning to positive territory provide some support

  Weaknesses

  Core CPI (excluding fresh food) may exceed 3% in the second half, real wage deterioration may temporarily stall private consumption

  Comparison

  Viewed as a segment with hedging attributes while maintaining overall underweight in retail

  Risks

  Not elaborated in the report

Key data

• TOPIX Target (end of June 2027, base case)4,300 pointsCorresponding to forward P/E of approximately 17.5x; bull scenario P/E about 18.0x, bear scenario P/E could drop to 12.0x
• TOPIX EPS Forecast216 for 2026, 234 for 2027Corresponding to EPS growth of approximately 9% (2026), 8% (2027); base EPS about 2-3 percentage points lower than consensus expectations
• LDP House of Representatives Seats316 seatsThe LDP led by Koizumi overwhelmingly exceeded two-thirds majority on its own, the most seats for a single party since the war
• BOJ Policy Rate Path0.75% → 1.0% (June 2026), 1.0% → 1.25% (April 2027)If inflation continues, may reach 1.5% by October 2027; terminal rate about 2%; market has priced in more than 2 rate hikes in the next 12 months
• TOPIX Company Shareholder Returns (FY2025)43.5 trillion yenCombined dividends and buybacks, record high, 13% year-on-year increase
• Prime Market PBR ChangeRisen approximately 35-40% since April 2022 reform startMainly driven by PER expansion, ROE improvement still insufficient
• Cumulative NISA PurchasesApproximately 63 trillion yen (as of June 2025)Exceeded 'Asset Income Doubling Plan' target ahead of schedule; government target was 56 trillion yen cumulative purchases and 34 million accounts by end of 2027
• National Resilience Budget (FY2026)Exceeding 5 trillion yenAddressing frequent natural disasters and aging infrastructure, a domestic demand-led theme
• Potential Household Stock PurchasesApproximately 270 trillion yenIf household stock ratio rises from 14.5% to 25.6% (approaching European levels), equivalent to about 20% of TSE Prime market capitalization

Impact & implications

The report believes that if the four structural drivers continue, and AI investment accelerates alongside stable interest rates, the Japanese stock market is likely to see a 'growth moment' where growth stocks once again lead, with TOPIX having upside potential. In terms of allocation, capital is more likely to flow to upstream supply chain sectors benefiting from economic security, AI deployment, energy security, and national resilience, as well as stocks with governance improvement options such as cross-shareholding unwinding, abundant cash, or large unrealized real estate gains. At the same time, due to high concentration in AI-related stocks, any event that shakes confidence in the sustainability of the AI trend could trigger unexpected short-term pullbacks, so the report views 'bullish + options hedging' as a safer portfolio approach in the current environment. The report only restates the above judgments without extrapolating to uncovered targets.

Risks

• Bear scenario: Escalation of Middle East situation triggers oil price surge and global recession, Japanese stocks may simultaneously face EPS downgrades and valuation compression, with forward P/E possibly dropping to 12.0x
• AI trend reversal risk: Positions highly concentrated in AI-related stocks, any event that shakes confidence in AI sustainability could trigger unexpected short-term pullbacks
• BOJ rate hike pace too aggressive: Bank P/E is difficult to expand when rate hikes accelerate
• Core CPI (excluding fresh food) may exceed 3% in the second half, real wage deterioration may temporarily stall private consumption
• Authorities stabilizing exchange rates and restraining excessive yen weakness may become headwinds for export earnings expectations in the short term
• Recent overseas rate hikes, fiscal deficit concerns, and doubts about the BOJ being 'behind the curve' have jointly pushed up long and ultra-long-term Japanese government bond yields

What to watch

• June shareholder meeting (AGM) season, and the upcoming (around July this summer) corporate governance guideline revisions
• July 'Basic Policy 2026' guidance on next fiscal year's budget priorities and policy directions
• BOJ rate hike process (key points like June 2026, April 2027) and terminal rate direction
• Whether valuation discipline continues within the AI theme, to judge if the market is 'healthy'
• Seasonality of foreign capital flows (net buying often continues until July)
• Technical: Whether TOPIX can hold the 20-day moving average, forms a pullback near the upper Bollinger Band rather than falling back after a breakthrough
• Stocks with governance improvement options such as cross-shareholding unwinding, abundant cash, and real estate containing unrealized profits