Japan's governance reforms could be a game changer

Shareholder engagement is on the rise in Japan, and valuations are going to reflect an increased focus on ESG

David Brenchley 12 April, 2019 | 2:00PM
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Japan may be known as The Land of the Rising Sun, but it’s a country that has never really shone as far as investors are concerned.

Years of deflation and economic stagnation saw the 1990s dubbed as “The Lost Decade” for the country. In reality, its trouble extended well into the 2000s. In fact, between 1995 and 2002, real GDP growth in Japan stood at just 1.2 per cent on an annualized basis – lower than all of its G7 counterparts.

During that time, the headline Topix index, in yen terms, almost halved. Morningstar data shows the total return for the Topix in local currency since January 1989 was just 2.75 per cent.

Over most long-term timeframes, the Japanese large-cap market has well underperformed its peers. Despite that, investors go through phases of bullishness, mainly on valuation grounds.

“But many investors who have been seduced into investing in Japan have been disappointed, after a short while, that nothing really changes and Japan remains a cheap market,” says Joe Bauernfreund, lead manager of UK-based small-cap Japanese equity fund.

Still, there are plenty of reasons for optimism today. Over five- and three- years, returns from the Topix and MSCI World are similar in sterling terms, though the past 12 months have been tricky.

Abe’s arrows of attack on investment obstacles

Things certainly look set to change, thanks to the third prong of Prime Minister Shinzo Abe’s attack on Japan’s historic issues. The first two arrows have largely been implemented. Now, commentators are getting excited about the third.

This third arrow is strategies aimed at enhancing and encouraging private investment. In particular, the introduction of corporate governance and stewardship codes.

The corporate governance code was implemented in 2015 and takes the form of five general principles aiming to ensure shareholders are treated fairly and equally, encourage “appropriate information disclosure and transparency” and “constructive dialogue with shareholders”.

Previously, the interests of shareholders have been superseded by the interests of all other stakeholders, including employees, pension recipients, customers and society at large.

"Skin in the game", meanwhile, is not something that has been pushed in Japan, says Bauernfreund. “When you run a company in Japan, most of the managers and directors we’re talking to don’t hold shares in the company; they’re not interested in the share price.”

The push from the Government has meant company attitudes towards shareholders have visibly changed. “For the first time, not only do you have a cheap market and a cheap universe of companies, but you had a catalyst for unlocking that value.”

The potential of a positive feedback loop

Ratings provider MSCI monitors its "feedback rate", which measures how much companies re-engage with shareholders by providing extra information or asking questions of them on their ESG ratings.

According to Linda-Eling Lee, head of ESG research at MSCI, the feedback rate from Japanese companies has increased from around 14 per cent to almost 70 per cent over the past three years.

The improved governance has shown itself in a number of ways. The most obvious is through better total shareholder returns. Dividends are beginning to creep up, while firms continue to buy back their stock.

Payout ratios in Japan are still low, at around 30 per cent, but that’s expected to improve – Joel Le Saux, manager of a UK-based mid-cap Japanese fund, thinks it would get to as high as 40 per cent in the coming couple of years. “This would mean the dividend yield of this market will be above 3 per cent [from 2.4 per cent today].”

Indeed, with companies raising dividends and continuing to buy back shares, at an average of 1 per cent per year, Japan now has an almost unique mix of returns. “It’s not like Europe where you just have dividend yield and it’s not like the US where you mainly have share repurchases,” says Le Saux. “In Japan, you have both.”

Meanwhile, Alexei Jourovski, head of equities at Unigestion, says investing in Japan is a big help in terms of diversification. "Japan is one of the investment regions which is the least correlated to the global equity market," he says.

Further, "the yen has some defensive properties and tends to appreciate in times of market stress". Therefore, an allocation to domestic Japan in times like this could be a good strategy.

A further governance improvement is the make up of the board of directors. We’re seeing a move for more external directors and board members, while the type of person on the board is now changing from being mainly lawyers or university professors to actual businesspeople.

Meanwhile, Le Saux says firms are being more receptive to cutting down the amount of general meetings they call. Some companies are having 20 board meetings per annum. “That’s nonsense,” he says. It’s a number he wants to see at least cut in half.

Activist pressure could lead to better outcomes

Bauernfreund also says he and other activist shareholders are keen to encourage management to participate in their future success. He’s pushing for incentive plans and increased share ownership by chief executives and senior managers. “That’s slowly gaining traction,” he says.

The shareholder return strand of this is helped by the fact that Japanese companies are extremely cash rich. The companies Bauernfreund invests in on average hold between 60-70 per cent of their market capitalization in cash. In some cases, they have double their market values in cash. “That is something that you can’t find elsewhere in the world.”

True, this has been the case for decades. But now, they’ve run out of excuses for this hoarding and they’re beginning to accept they have to either spend it on something accretive or return it to shareholders.

Bauernfreund’s activist approach to investing in Japan has had some big early wins, including with the large-cap Tokyo Broadcasting Systems. The firm is mainly a television company, similar to the likes of ITV. However, it also owns real estate that it lets out as well as an investment portfolio of around a dozen companies.

That portfolio is worth around $3 billion as many of its investments have done extremely well. However, explains Bauernfreund: “It means that investors who think they are buying a steady television company are actually buying real estate and equities.”

Bauernfreund wrote a series of letters before setting out a proposal for the firm to reduce the size of what it calls its "strategic shareholding portfolio". That proposal won support from other investors as well as the media. In February, Tokyo Broadcasting sold a chunk of its portfolio.

“Whilst it doesn’t go far enough in our eyes, the fact that they have conceded that they can reduce it and that the driver was the revised corporate governance code is a very important sign.”

Elsewhere, Ernst Glanzmann, manager of a UK-based large-cap Japanese fund, points to automation firm Fanuc as having improved its governance. “It’s moved to a different remuneration policy, we’ve seen more disclosures, more open investor relations meetings, things like this,” he says. “You really feel it; you get a sense things have changed.”

A similar story has played out at another Bauernfreund holding, Kanaden, which distributes products manufactured by Mitsubishi Electric. It’s announced a series of share buyback programs and has started to unwind part of its cross-shareholdings. That’s boosted the share price.

“What has happened in the past is if a Japanese company has $1 on the balance sheet, the market values it at 50 cents,” Bauernfreund explains. That’s because you’ve never been likely to get that cash back, so it’s not actually worth $1.

“Although these are small, incremental steps, what they are doing is removing the justification for discounting cash like that.”

As a result, valuations are likely to start creeping up and there may come a time when Japan is no longer eternally cheap.

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David Brenchley

David Brenchley  

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