By Daisuke Nomoto, Senior Portfolio Manager
A critical aspect of Japan's growth strategy is overhauling corporate governance to harness the power of private enterprise. While Japan's corporate sector has lagged the rest of the developed world in terms of efficient use of capital, there is reason to believe that may be changing.
We have written how Prime Minister Abe's "three arrows" represents an opportunity to lift Japan from the economic malaise it has suffered for over two decades. While some have criticized the third arrow (structural reform) as having been too slow in reaching its target, changes underway in the field of corporate governance may have important implications for equity investors. Senior Japanese government officials came all the way from Tokyo to communicate the Japan Revitalization Vision, which represents a huge mindset change in government policy. The Japan Revitalization Vision consists of several measures to stimulate investment in Japan, including reforms of the corporate tax code and changes in the asset allocation of the GPIF (Government Pension Investment Fund), the largest pool of pension assets in the world; but we believe corporate governance reform could be the single most important agenda item that they wanted to discuss with investors.
Why is better corporate governance important?
We believe that better corporate governance should help unleash the value that has been in Japanese equities hidden behind inefficient balance sheets and poor shareholder policies. Two of the major objectives of changes to corporate governance incentives are 1) eliminating conflicts of interest that exist between managements and shareholders and 2) ensuring the company's assets are used effectively in the best interests of stakeholders. There is a positive correlation between the level of corporate governance and ROE in Japanese companies. The average ROE of Japanese companies is relatively low from a global perspective (Exhibit 1).
Exhibit 1: ROE: Japan vs. United States and Europe
Source: Columbia Management Investment Advisers, LLC
In order to fix this problem, Japan's Financial Services Agency proposed a Stewardship Code earlier this year. This code is based on a similar concept introduced in the UK in 2010, but while the underlying objective of the UK code is to safeguard the interests of stakeholders, Japan's code endeavors to promote sustainable growth in the corporate sector in addition to achieving fair investment returns for clients and beneficiaries. 127 institutional investors endorsed Japan's Stewardship Code, and further, the GPIF, the most influential government fund in Japan with $1.27 trillion in assets along with other government sponsored pension plans, announced unanimous acceptance of the Stewardship Code. We believe that these efforts will significantly improve engagement between corporate management and shareholders, which should ultimately lead to higher returns for holders of Japanese equities.
Appointing external directors are almost a requirement
This is a major change that will help safeguard external interests from Boards that previously favored insiders. Additionally, under the Tokyo Stock Exchange's (TSE) revised listing rules, companies are not required but highly encouraged to appoint at least one external director with a high degree of independence. These measures should help reduce the risk of conflict of interest, which should provide further comfort to investors investing in Japanese equities.
Inclusion in the JPX Nikkei Index 400 as indication of "a good company"
Nikkei and TSE have co-developed a new index called the JPX-Nikkei Index 400. Constituents are selected based on criteria such as ROE, the appointment of at 2+ independent external directors and the adoption of IFRS. Being selected as a member of the index is almost like receiving an award for being "a good company," and not being selected will have a fairly strong social stigma, particularly for the large companies that typically comprise the major indices. The GPIF announced that it would adopt the JPX-Nikkei Index 400 as one of its benchmark indices. This is a symbolic event because all the pension funds in Japan are influenced by every move that the GPFI makes. Companies that are currently constituents of the index have to maintain good corporate governance and high ROE to stay there, and those that hope to be included have to make efforts to improve their capital efficiency - hugely positive for ROE anyways!
Higher dividends and higher buyback
We are starting to see Japanese companies significantly increase dividends and share buybacks (Exhibit 2). With a record $2.3 trillion total cash on corporate Japan's balance sheet, it is highly likely that Japanese companies will increase dividends and do further share repurchases to mitigate the drag of excessive cash balances on ROE. Under the deflationary environment that Japan experienced until last year, piling up cash made some sense as real returns on savings were reasonably high. But now that real interest rates are negative in Japan, returning excess cash to shareholders is a reasonable management decision since cash balances earn a negative return after inflation. The amount of authorized share repurchases in the first half of this year is 50% higher than the same period last year, and it is expected that the majority of these programs will be executed in the second half of this year.
Exhibit 2: Total shareholders return of listed Japanese companies
Given the aforementioned structurally positive forces, we are focused on companies with the ability to generate sustainable free cash flow, earn returns significantly above their cost of capital and regularly conduct shareholder friendly capital management. We are excited about further improvement in Japanese corporate governance, which should present greater investment opportunities. In many Asian countries outside Japan, corporate governance is still very poor and even government governance is undeveloped, particularly in emerging Asia. However, we believe that equity markets will pay a premium to certain companies for even a gradual improvement in corporate/government governance.
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