Japan: Finally change you can believe in
Corporate governance changes in Japan are real. Even on the most pesimistic view the market has a potential for 25% compound gains over the next two years. Morphic is increasing its overweight to Japan.
Seasoned investors in Japan have seen so many false dawns of improved corporate governance that they will probably be the last to believe it if it finally arrives – or fully appreciate its consequences.
For many it is this scepticism that capped euphoria about June 1st, 2015, the day that Japan’s new Corporate Governance Code became official policy. That could be a costly mistake in terms of opportunities forgone. At Morphic we are increasing our overweight to Japan now.
Unlike most of Asia, corporate governance problems in Japan rarely involve company promotors or management stealing money from their firms. But poor investment decisions and capital management are so deeply endemic that for years they have depressed valuations and shareholders alike.
It is Japanese corporate leadership’s emphasis on the apparent interests of stakeholders, especially employees, rather than shareholders, that is seen as the root cause for poor returns on equity etc that still plague the listed company sector.
As several speakers noted at a large gathering arranged by Columbia Business School Centre in late May on Japanese Economy and Business and the Development Bank of Japan devoted to studying recent Corporate Governance Reforms (1) this is not for lack of unambiguous shareholder rights being embedded Japanese corporate law. The problem is the institutional framework and the lack of enforcement of these rights.
Perhaps more telling however has been the lack of any serious attempt to seek to enforce them by domestic shareholders. Even foreign shareholders have more or less given up trying to test the black letter law following a series of corporate activist failures in the courts a decade ago, most notably the notorious Bulldog Sauce affair.(2)
In this context, cynicism over the recent unveiling of a new Corporate Governance Code for listed companies (3) and last year’s Stewardship Code for institutional investors (4) who own their shares is forgivable. But the strong recent performance of the Japanese stock market, which has just reached an eight year high, and is only 17% off getting to a 25 year high suggests the cynics are wrong. Nor is this all to do with the weaker yen: The Topix is up 36% in Australian dollar terms over the last year, 10% better that world markets have done in common currency terms.
The extent to which there further progress is warranted can be seen stocks in Japan remain stubbornly cheaper than the peers in the US and Europe, especially in price to book terms. Topix is trading at 1.4x book, compared to 2.7x in the US, and perhaps most relevantly 1.9x in Europe, where the index has a virtually identical Return on Equity (ROE) to Japan of about 8.5%.
The really interesting question is probably not whether the new regime, which comes into force in June, and is very much government driven as part of the micro-economic reforms embodied in Prime Minister Abe's so-called "Third Arrow", will result in changed behaviour. The question is how far reaching that change will be. What is even less clear is whether the government has fully thought through, and will be happy with the potentially significant consequences of what it has done.
Taking this to the extreme, one of the most striking things about the conference last week was listening carefully for what was not said. In this case the "Dog that did not bark"5 was any mention of the phrase takeover bid (or TOB, as this almost mythical, certainly rarely seen, phenomenon is colloquially called in Japanese).
One reason for confidence there will be change is that the new regime does not derive from global pressure resulting in fig leaf style reforms. The measures are home grown, and like the great economic reforms that created modern Japan in the Meiji Restoration almost a century and a half ago, they spring from Abe's belief that without a strong economy, the defence of Japan is in doubt: Unless the country makes deep, possibly painful, economic reforms, it faces existential threats, this time not from Admiral Peary's Black Ships, but it's nearer neighbour China.
Like the Meiji reforms, they follow a bureaucratic review of what foreign prototypes might be most easily retrofitted back in Tokyo. However as several insiders at the conference made clear the introduction of the new guidelines is very much demand-pull, rather than (foreign) investor push. Insiders say that even the powerful industrial top managers’ association, the Keidanren, which would once have walked over broken glass rather than endorse this unprecedented encroachment on its prerogatives, is inside the tent, and did surprisingly little to water down the terms of the governance code during the consultative phase.
Exactly what Japan Inc wants out of these changes, or even what it expects is hard to know. No government agency appears to have done any econometric modelling of the potential macroeconomic implications of the new regime.
Given the potential for significant change to the landscape of the Japanese economy if the reforms work, as some see them intended to, this seems remarkable, almost desperate.
If there is a grand plan, probably high among the objectives is improving returns to Japanese investors, including the Government Pension Fund (GPIF) which has recently more than doubled its weighting in domestic equities, and sharply reduced exposure to its formerly dominant asset, government bonds, with the help of a Bank of Japan eagerly hoovering all the bonds it can buy as part of its Qualitative and Quantitative Easing money printing program.(6)
In this context it is probably significant that the GPIF has been a leader in signing the Stewardship Code, and requiring its external managers to adhere to it.(7)
The demand that companies lift their ROE to at least 8% if they want to be included in the prestigious new JPX Nikkei 400, points to a desire for shareholder returns to improve, and suggests that two ways of getting there are rising dividend payout ratios and better internal corporate capital allocation decisions.
Perhaps more significantly, the pressure to maintain higher ROE and higher dividend pay-out ratios might result in better investment decisions.
The still bigger opportunity for capital currently committed to equity investment to ‘return to the pool’ would come from at least some of the kind of ‘deequitization’ we have seen drive up ROE in the US and many other developed markets. Certainly Japanese companies have plenty of capacity to do this, with net cash on their balance sheets at record levels. In fact cash on company balance sheets has virtually tripled in the last three years, which is striking compared to the US and Europe, where cash levels have hardly budged in this time – mainly because of dividend payments and share buybacks.
Much of the hope for this derives from what are widely held to be two powerful Japanese national characteristics: the so called ‘shame culture’, and a natural inclination to copy what is seen as smart or expected behaviour. Certainly this gels with the ‘comply or explain’ motif that pervades the Corporate Governance code in the place of Scandinavian style mandated balances for director balances by gender and independence.
Cynics might suggest that the high turnout of large company executives at the Columbia conference just shows planning for what kind of minimum imitative compliance was going to be expected of them as they re-circled the wagons to get back to business as usual as much as possible.
The slow progress of Japanese companies to make much change in the highly visible appointment of independent, female, or foreign directors shows that it is not as though any head of steam has been established in this regard so far.
Further questions arise as to whether changes to the composition of Japanese boards, and even wider introduction of the common western use of board committees, including remuneration and nomination committees dominated by independent nonexecutive directors will make as much difference as proponents of these changes hope for.
As one panellist at the Columbia colloquium with wide experience as a foreign director of Japanese companies noted, a central problem not yet dealt with is that Japanese boards are very far from being the supreme decision making bodies they are elsewhere in the world. As a result they have far less input on strategic planning than is perhaps needed to avoid the kind of costly miss-investment decisions for which Japanese companies are notorious.
Another, Japanese, panellist with extensive experience at serving on US venture capital boards also reported ruefully that the culture of consensus on Japanese boards can be intimidating, and that excessive questioning of executives could lead to extreme encouragement to make way for a more compliant, notionally independent director.
But if these salutary remarks suggest there will be limits to depth of any effects on Japanese corporate governance, it is worth taking stock on how signifi- cant merely lifting pay-out ratios in Japanese companies could be. Assuming pay-out ratios rose to 35% for the year generally ended March 31st, 2016 from the 30% currently expected, and even allowing for the market dividend yield on the TOPIX rising to 2% from the currently expected 1.8%, suggests the market could rise nearly 25% from 1675 today to reach 2070 in a year’s time. Assume pay-out ratios get to 40% in 2017 and yields stay the same, the market could then reach 2650 for a further annual gain of nearly 30%. Similar gains emerge if one imagines that Japanese pay-out ratios reach European levels of 60%+, and the market values these dividend streams at the same market yield of about 3.2%.
This would be good – but it is unlikely that the objectives PM Abe wants from the new corporate governance regime can be achieved without the threat of hostile takeovers to poorly managed Japanese. Examples of such companies remain legion, and even if such entities valuations pick up a bit through minimal compliance with increased dividend rates, many will still look ripe for the force that would feed off such anomalies in any other major developed market: Private Equity.
Discussion with stockbroking equity strategists in Tokyo suggests that there is no sign as yet of Private Equity firms piling resources into Japan to pick off opportunities in one of the few markets they yet have to make major inroads into.
However what they also say that the institutional attitudes to any attempt to carry out Public to Private transactions from a respected global player such as Carlyle, TPG or Bain Capital would be a far cry from those in the Bulldog Sauce era. The general view is that unless the target company was iconic, or regarded as operating in a strategic area, MOF and the FSA would be keen to see the market make its own judgement on even a hostile bid, and that whatever the probably more jaundiced view of METI, the courts would probably pick up on this shift to judge any issue strictly on its merits, eschewing the remarkably partisan and inflammatory language that featured in its Bulldog rulings.
If Private Equity firms are looking for straws in the wind that the time may be coming for them to commit more research resources in Japan they need look no further than the GPIF’s initial report on the Stewardship Code, cited at footnote five above, which points to the remarkable extent to which poison pill style takeover defences have already been demolished.
If one hostile bid, from Private Equity, or a competitor firm seeking to improve industry structure through consolidating capacity succeeds, it seems plausible to expect many more, given how rich the Japanese market is with worthy candidates.(8)
About the author
He is the Managing Director and Joint Chief Investment Officer and has been a regular visitor of Japanese companies for more than 20 years.
(5) For the origins of this metaphor for inductions based on negative evidence, see: http://en.wikipedia.org/wiki/Silver_Blaze. Here, the reference is more precisely to Sherlock Holmes’s induction of evidence of an “inside job” in the case.
(6) For summary of how fast the GPIF is moving to change it capital allocation see: http://www.pionline.com/article/20150227/ONLINE/150229878/japans-gpif-posts-52-gain-for-quarter-as-equity-allocations-increase .
(8) The concept was most famously espoused in a ground breaking book written by Ruth Benedict to advise US government policy during World War Two http://en.wikipedia.org/wiki/The_Chrysanthemum_and_the_Sword
Although not universally accepted either inside or outside Japan, consensus that it does still apply can be seen in commentary such as: http://awshamecultureinjapan.blogspot.com.au/