Japan: cleaning up its act?
Japan has spent decades being the odd man out of the developed markets. Partly, this has been due to the exceptional state of its economy, with almost three decades of stagnation and deflation.
However, the other facet of the market that has challenged investors has been the country’s unusual approach to management and governance. An overrepresentation of family-run businesses and a complex system of social norms have left the Japanese market seeming relatively impenetrable and investors have approached it with significant caution.
The election of the reformist prime minister Shinzo Abe in 2012 set the ball rolling for change in both the country’s economy and its corporate governance. Here, four investors explain why it may be time to look again at Japan, as widescale changes to corporate governance start coming into effect.
Joel Le Saux, fund manager of the Oyster Japanese Opportunities fund at SYZ Asset Management
“Over the last few years, Japan has seen transformative change in its corporative governance structures with the adoption of Japan’s Corporate Governance Code in June 2015. New dynamics, in areas such as company disclosure and the appointment of external directors, are cultivating a more shareholder-friendly environment for investors. However, while these improvements are encouraging, investors must understand the context: this is a long-term process in a country with an engrained state-influenced corporate culture.
“Take for example, the rise in the appointment of external directors. A dramatic surge in this outside influence is certainly a positive, particularly when you consider the influx of women. However, enthusiasm needs to be curbed to an extent, as, in the past, most of the external directors were lawyers and university professors unlikely to challenge the status quo. Japan Inc. needs time to bring forward experienced external executives, as well as a new breed of young innovators from diverse industries; these are prerequisites for real corporate change.
“A key tailwind for an improving investor outlook has also been the increasing influence of the Government Pension Investment Fund. As it has increased its holdings in Japan’s equity market, it has heighted scrutiny of shareholder returns on equity. This is boosting dividend growth and share buybacks, powering stronger longer-term total returns for investors.”
Jeremy Lang, co-founder and partner, Ardevora Asset Management
“Japan has always been an unusual region in terms of management behaviour. You can get a sense of this when visiting a Japanese company’s corporate website – where aspects such as social responsibility supersede any ambition to achieve profitability.
Status is also a major factor in Japan, with many examples in recent decades of management prioritising empire building. Many large Japanese businesses have been trapped by stretching into too many areas and carrying an inflexible labour force. If it was anywhere else in the world, corporate raiders would come in and undertake radical restructuring. But as it is Japan, these behemoths have been able to drift along. Many global investors have been resigned to the fact these elements are so deep rooted in Japanese culture that management priorities may never change.
However, over the last six months we have witnessed evidence of change and a reshuffling of management priorities. Some Japanese companies are finally responding to efforts from Prime Minister Shinzō Abe, who is trying to undertake widespread corporate governance reform and create an improved shareholder-friendly culture.
But not all areas are responding. We have yet to see any evidence of change in the traditional large and highly-diverse Japanese conglomerates – names like Hitachi or Panasonic. Change is occurring in the mid-cap area of Japan, those operating simpler, more ‘Western’, business models.”
Archibald Ciganer, portfolio manager of the T. Rowe Price Japanese Equity Fund
“The Shinzo Abe-led Liberal Democratic Party has successfully broken the long-held tradition of policy inertia via its attempts to jump-start the economy and equity markets with the magnitude of its policy intent. Abe is also attempting to deal with the economy’s structural challenges: Corporate tax rates have been lowered, an enhanced corporate governance code has been implemented, while initiatives to encourage married women and foreign workers into the labour force have also been announced.
The instance of companies defying the sceptics by transforming business practices and governance standards is growing. This should help to deliver profit growth and generate shareholder returns. The volume of shareholder buybacks is increasing, while merger and acquisition activity is slowly emerging. Where implemented effectively, we expect transformational actions to be rewarded through higher valuations.
We firmly believe that the valuation case for Japan still holds and that Japanese corporate earnings growth is likely to exceed global peers. This view underlies many of our preferred stock ideas today. Macroeconomic data is improving and as unemployment falls, we believe we are positioned to benefit from labour shortages through our investment in staffing and work-related benefits companies. We also remain upbeat regarding many stocks central to Japan’s evolution, including those in the IT and machinery sectors.”
Louise Dudley, Hermes Global Equities portfolio manager, Hermes Investment Management
“Wide-ranging reform continues in Japan following Prime Minister Shinzo Abe’s ongoing rule in the nation’s upper house. The majority mandate has contributed positively to the outlook for the Japanese equity market and GDP in general and we expect this to persist. For Japan’s corporates, we believe this continues to result in further progress in the area of corporate governance.
The once staid and conservative boardrooms of Japanese companies have already embraced large-scale reform on governance issues following the implementation of an official Corporate Governance Code in June 2015. However, Japan remains a conservative society and companies will need the support of government to push through further effective reform. Progress is slow but moving incrementally forward. Recently this wave of progress has gathered pace due to the leadership that has been shown by GPIF, the largest asset owner in the world, who has become a signatory to the PRI and is driving local financial stakeholders to up their game on governance.
Focussing on ESG factors can deliver better returns to investors. In a study the Hermes Global Equities team conducted, we found that well-governed companies tended to outperform poorly governed companies by an average of over 30 basis points per month, over a period of five years. Capturing this consistent source of value can enhance the returns of equity strategies. Japanese equities present an opportunity to buy into this positive change story.”
David Osfield, co-manager Amity International Fund, EdenTree Investment Management
One of Abe’s key reform priorities was to improve corporate governance standards in Japanese listed companies. The primary success indicator on which the policy will be judged will be the improvement in Return on Equity (RoE).
The establishment of a good corporate governance index has been a high-profile tool and exclusion has driven change at the corporate level. Over the last twelve months increasing numbers of companies have announced plans to restructure or dispose of unprofitable businesses and address excessive cost base through major cost cutting initiatives. Additionally, Japanese companies have been looking at their governance structures and board independence.
While the pace of change is slow in a global context, some companies have brought in international executives to provide alternative perspectives and global best practice. All other things being equal, these kinds of measures should lead to an improving RoE profile and the potential for a re-rating towards other Asian peers is substantial. Identifying companies that are making credible steps towards global best practice is likely to be positive from am equity return perspective, particularly if the company has not been valued as a potential leader in corporate governance.