Investors can participate in Japan's ‘digitalization’ in these two ways

Bernstein analysts highlight two investment avenues in Japan's digital transformation: "DX Stocks" identified by METI, which have outperformed the TOPIX since 2022, and "DX Enablers" in IT services, software, and telecommunications. While these sectors have high forward P/E ratios, they have shown significant outperformance recently, with IT services, software, and telecom sectors posting returns of 52%, 46%, and 16% respectively since the second half of 2024, compared to the market’s 11% return.

Analysis

Japan's national priority of digital transformation, accelerated by the 2019 METI "Digital Cliff" warning and the COVID-19 pandemic, presents distinct investment opportunities highlighted by Bernstein. Investors can target "DX Stocks" and "DX Noteworthy Stocks," which are METI-identified companies leading digitalization efforts. Since 2022, DX stocks have achieved a 7.2% compound annual growth rate (CAGR) and DX noteworthy companies a 6.7% CAGR, outperforming the TOPIX's 6.4% CAGR. Notably, DX stocks have consistently outperformed the market in JPY over the last three years, with Softbank (SFTBY) and SG Holdings named DX Grand Prix winners for 2025. Alternatively, investors can focus on "DX Enablers"—companies in IT services, software, and telecommunications that facilitate this transformation. The IT services sector has demonstrated a 17% CAGR over the past decade, and telecom an 11% CAGR. More recently, performance has been robust: since the second half of 2024, IT services returned 52%, software 46%, and telecom 16%, significantly outpacing the market's 11% return. Since October 2022, IT services have yielded 4% annualized alpha, and software has outperformed the market by 2% annually. Despite these strong returns, these enabler sectors trade at high forward price-to-earnings (P/E) ratios: IT services at 23x (1.5 standard deviations above its 10-year average), software at 26x (0.78 standard deviations above), and telecom at 15.7x (1.5 standard deviations above), which Bernstein suggests is supported by improved earnings momentum. The article also notes that AI-driven tools, such as those from InvestingPro, are being used to assess valuations, for instance, regarding SFTBY.

Key Decisions for Investors

• Investors should consider strategic allocations towards Japan's digitalization theme, given the strong government impetus and historical outperformance of both METI-designated 'DX Stocks' and 'DX Enabler' sectors.
• While 'DX Enabler' sectors like IT services, software, and telecommunications offer compelling growth (recent returns of 52%, 46%, and 16% respectively since H2 2024), their elevated forward P/E ratios necessitate careful scrutiny of ongoing earnings momentum to justify current valuations.
• For specific stock selection, such as Softbank (SFTBY), which exhibits very strong positive sentiment (0.85) and is a 'DX Grand Prix winner', diligent valuation analysis is crucial to identify potentially undervalued assets within this high-growth, but potentially richly priced, investment landscape.