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April 12, 2021  |  Global Equity
The Digitalization of Japan

GLOBAL RESEARCH ANALYST

Jayesh Kannan, CFA, is a global equity research analyst. He covers small-cap technology, media, and communication services companies. Before joining William Blair in 2018 as a research associate focused on technology, media, and communication services, Jayesh was an associate in the institutional equities division at Morgan Stanley in New York City and Singapore. In this role, he focused on emerging market and Asian equities. Jayesh is a member of the CFA Institute and the CFA Society Chicago. He received a B.E. in computer engineering from Nanyang Technological University, Singapore, where he graduated as a Singapore Airlines-Neptune Orient Lines scholar with first-class honors, and an M.B.A. from the Sloan School of Management at the Massachusetts Institute of Technology (MIT), where he was a Martin Trust Community Fellow.

Japan is one of the most wired countries in the world, but cloud adoption is less than half of what it is in many other countries, and fewer than 10% of government administrative procedures in Japan can be completed online. Something is getting lost in translation, as we saw in Sofia Coppola’s 2003 film, and that means there may be a large opportunity for growth ahead.

Evolution, Not Revolution

Much of the productivity in different economies around the world has historically come through labor and capital. More recently, however, a large part of productivity has been driven by technology-led innovation—technology that makes it easier for us to access products and services.

Digitalization goes beyond the implementation of technology; it’s about driving deep change to entire business models.

At its core, this technology involves digitalization, which is distinct from digitization. Digitization involves moving processes from analog to digital—transitioning from human-based work to machine-based work, often through the internet. It is faster, cheaper, more efficient, and frictionless. Digitalization, meanwhile, goes beyond the mere implementation of technology; it’s about driving deep change to entire business models in a way that can provide access to new and differentiated revenue opportunities.

Digitalization isn’t revolutionary; it is evolutionary. It has been happening for the better part of 20 to 30 years, since the onset of the internet. But adoption has been different in different countries—faster in the West, slower in emerging markets.

Japan is a peculiarity: although the country is a traditional hub of innovation and home to numerous technology companies, a recent survey by The Economist of 30 OECD countries ranked Japan last in providing digital services. Fewer than 10% of its citizens requested anything from the government online in 2018 (versus 80% of Iceland’s citizens). Japan is even behind countries considered relative technological laggards, such as Mexico.

Speaking more broadly, IT spend in Japan has been focused on outsourced (or custom) development, rather than packaged or standardized software, with a near 85:15 split versus a more evenly balanced 50:50 ratio in the United States. Adoption of cloud software is less than 20% in Japan, lagging many other countries, where it is over 40%.

Tailwinds to Growth

That means there is likely a huge opportunity for growth, and today a few tailwinds are bringing the topic of Japan’s digitalization to the forefront of global investing.

Digitalization is critical to ensuring Japan’s productivity when much of the population is out of the labor force.

The first is demographics. More than 20% of Japan’s population is over 65 years old, the highest proportion in the world. By 2030, one in every three people in Japan will be 65 or older. Digitalization is critical to boosting the country’s productivity when much of the population is out of the labor force.

More recently, COVID-19 emphasized some of the problems with the country’s paper-based culture. To get licenses and participate in most social programs, for example, Japanese citizens must physically show up at a government office and get a stamp called a “hanko.” This was problematic when COVID-19 struck, because the employees responsible for stamping the hanko couldn’t get to work, and approvals thus didn’t get processed. Productivity declined.

In addition, Suga Yoshihide, Japan’s prime minister since September 2020, has made the digitalization of Japan’s government one of his priorities, including the setup of a dedicated agency to focus on digital transformation. Government incentives that drive cashless forms of payment is one example of this.

Why the Excitement?

The size of the Japanese economy and the fact that growth in digitalization is coming off a low base presents a compelling opportunity, in our view.

According to the Daiwa Institute of Research, a Tokyo think tank, moving government services alone online could permanently boost per-capita GDP by 1%.

Thus, we see a long runway for growth—we are in the early innings, but the pace of adoption is rapid. For example, e-commerce penetration in Japan, at 10%, is significantly behind that of both developed countries and Asian peers.

Opportunities on the Horizon

We see opportunities in three key areas.

The first is software-as-a-service (SaaS), an opportunity that increases as more applications move to the cloud, providing standardized software that can be used by multiple different clients. SaaS business models are common in the West but still rare in Japan. Opportunities include the digitalization of expense management; e-invoicing; cybersecurity; and the facilitation of document e-signing.

The second is IT services. Once a company has purchased software, it requires support services—installation, maintenance, integration, and quality control. There are also opportunities in external software validation and testing. Digital transformation efforts and a focus on customer experience are leading to IT service providers moving away from their legacy, lower-value-additive system integration businesses toward newer-age, higher-value-add innovative services.

In the West, we use online communities to find organizers and nannies, but the Japanese use these marketplaces to find elder care and funeral services.

Lastly, we see opportunities in online marketplaces, where Japanese citizens can connect with service professionals. Familiar examples include lawyers and accountants (which, while familiar in the United States, are unique in Japan). But end-of-life services marketplaces also offer potential. In the West, we use online communities to find organizers and nannies, but the Japanese use these marketplaces to find elder care professionals and funeral services.

It is also noteworthy that many of these companies are entrepreneur-driven and founder-led, a departure from legacy conglomerates with bureaucratic processes and a culture of seniority outranking merit. In fact, some of these companies are focusing on becoming global best in class on talent management: they emphasize a strong sense of company culture, innovating constantly, hiring the best talent, being competitive, and using best-in-class technology.

The ESG Component of Digitalization

It is easy to see how digitalization helps facilitate the environmental aspect of environmental, social, and governance (ESG) considerations: it reduces the use of paper and travel transport, so there is less waste and carbon intensity.

From a social angle, the digitalization we have discussed helps the elderly get the care they need, helps small and medium enterprises get online for the first time, and helps a rural demographic access information and services in a transparent way.

In addition, from a governance perspective, digitalization involves the use of innovative practices to drive entrepreneurial organizations with best-in-class cultures and incentive structures that are based on merit and productivity.

Addressing Risks

Sofia Coppola’s 2003 film Lost in Translation showed us just how foreign Japan’s culture can feel; how does that affect our investment case?

Everything is relative. Compared with the United States or Western Europe, Japanese corporates have a lower level of corporate governance disclosure in general. Yet a push for reform over the past five years under former Prime Minister Shinzo Abe has led to an increased focus on areas such as independent board membership and gender diversity. New listing and capital market requirements set to come into effect starting in 2022 could be another catalyst for increasing transparency.

At the same time, language and cultural barriers exist, and skill is required to appreciate the nuances of a highly localized business model—knowledge of local business practices, experience in engaging with corporate management teams, and appreciation of the society’s moral norms and constructs.

A good example of this is within cybersecurity. Companies around the world specialize in this service, but in Japan the successful model needs a high level of local contextualization because identity management requires integration with hundreds of locally developed software solutions that enterprises use, along with 24/7 customer support. Integration with the local technology ecosystem is hard for global software providers whose solutions are first developed for use in the United States and then exported to Japan. The same is true for other software, whether it facilitates electronic signatures on documents or provides an expense management platform.

The Role of Active Management

That is why we believe active investment management is so important. It is difficult to take a global solution and apply it to Japan, or for that matter any market with a highly localized culture and context. You cannot take any piece of software, translate it to Japanese, and set it to work. Many local problems require local solutions, and uncovering those solutions requires active management.

GLOBAL RESEARCH ANALYST

Jayesh Kannan, CFA, is a global equity research analyst. He covers small-cap technology, media, and communication services companies. Before joining William Blair in 2018 as a research associate focused on technology, media, and communication services, Jayesh was an associate in the institutional equities division at Morgan Stanley in New York City and Singapore. In this role, he focused on emerging market and Asian equities. Jayesh is a member of the CFA Institute and the CFA Society Chicago. He received a B.E. in computer engineering from Nanyang Technological University, Singapore, where he graduated as a Singapore Airlines-Neptune Orient Lines scholar with first-class honors, and an M.B.A. from the Sloan School of Management at the Massachusetts Institute of Technology (MIT), where he was a Martin Trust Community Fellow.

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Glossary

INDICES
The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, mortgage-backed securities (agency fixed-rate and hybrid ARM pass-throughs), asset-backed securities, and commercial mortgage backed securities.

The MSCI ACWI IMI Index is a free float-adjusted, market capitalization-weighted index that captures large, mid, and small cap representation across developed and emerging markets.

The MSCI ACWI ex-US IMI Index is a free float-adjusted, market capitalization-weighted index that captures large, mid, and small cap representation across developed and emerging markets, excluding the U.S. The Value and Growth Indices are a subset of the Index that adopt a framework for style segmentation in which value and growth securities are characterized using different attributes. Multiple factors are used to identify value and growth characteristics.

The MSCI ACWI Small Cap Index is a free float-adjusted, market capitalization-weighted index that captures small cap representation across developed and emerging markets.

The MSCI Emerging Markets Index is a free float-adjusted, market capitalization-weighted index that is designed to measure the equity market performance of emerging markets.

The MSCI World Index is a free float-adjusted, market capitalization-weighted index that is designed to measure the equity market performance of developed markets.

The Russell 2000 Index is a market capitalization-weighted index designed to represent the small cap segment of the U.S. equity universe.

Index performance is for illustrative purposes only. The indices are unmanaged, do not incur fees or expenses, and cannot be invested in directly.

TERMS
Alpha is a measure of an investment's return in excess of the market's return, after both have been adjusted for risk.

Beta is a measure of the volatility of an investment relative to the overall market, represented by a comparable benchmark.

Half-life is a statistical measure of the time required for the discrepancy between price and value to contract by half of its starting value. Fundamental value estimates are based on the Dynamic Allocation Strategies team's proprietary research.

P/E Ratio is a measure of valuation which compares share price to earnings per share, calculated using estimates for the next twelve months.

Standard deviation is a statistical measurement of variations from the average.

QUANTITATIVE MODELS – FACTOR DEFINITIONS
The William Blair Earnings Trend Model captures information about short- and medium-term changes in analyst estimates in an attempt to anticipate future estimate changes and stock performance. The score combines measurements of earnings revisions, momentum, and earnings surprise.

The William Blair Valuation Model combines varying metrics used to characterize the relationship between the stock’s trading price and its intrinsic value. By going beyond using only one or two measures, the model attempts to build a more holistic version of a stock’s worth vis-a-vis the market. The score combines measurements of earnings/cash flow based, asset-based, and model-based factors.