Escaping Japan's Potential Value Trap

Escaping Japan's potential value trap requires good corporate governance.

• The Nikkei 225 has already rebounded some 18% from March 17 lows. While the economic and profit environment continues to deteriorate, foreign investors, the major drivers of Japanese stock prices, have again returned as net buyers from April. With any luck, the Nikkei 225 could see a bullish “golden cross” with the 13-week MA moving above the 26-week MA, as the Nikkei 225 has moved above its 13-week MA.
• This would completely negate our bearish call of NK 225 downside to 10,000 and a JPY/USD run to JPY80 that was predicated on a continued deepening of the credit crisis, which for now does not appear to be the case. The “luck” that the Nikkei 225 would need is, a) a weaker trend in JPY, b) falling/stable oil prices, and c) a shallow US/global recession.
• Since Japan does not have the growth potential of its BRICs neighbors, the main price driver is expected to be value, not growth. To avoid becoming a mere value trap, Japan needs quality corporate management with good corporate governance with a commitment to enhancing shareholder value. Yet management of most Japanese companies in Japan seem to have missed the sequel to “the world after the Heisei Malaise” and are a bit like Rip Van Winkel waking to a very different world.
• Over the past couple of years, one of our recurring themes has been that a rising tide in Japan would not lift all boats. In other words, only the truly global will prosper. This has resulted in a Japanese market of stocks, not a stock market. From 2003 to 2006, even the weakest companies rebounded as bankruptcy risk discounts disappeared. But the past year has separated the wheat from the shaff.
• Japanese companies can still be divided into those that are linked in a positive way to the global economy versus those hopelessly flailing away at globalism; and those managements who “get” the idea that good corporate governance is necessary for sustainable growth versus the clueless. Our strategy is to concentrate on those Japanese companies that “get it” regarding globalization and good corporate governance.

Comments

[William L. Florida, CFA]

Interesting idea. How are you measuring which companies are global and have strong governance. Will you create a fund or an index of such stocks?

[Darrel Whiten]

William;

The Japan Corporate Governance Research Institute ( JCGR.org ) releases annual JCG indices for individual Japanese companies that is available for free. Others like Governance Metrics International, Northern Trust and State Street sell their governance indices to institutions and even to the companies they rate.

Ironically, JCGR has found that Japanese firms with highly rated JCG are more likely to undergo corporate governance reforms after experiencing poor financial performance. However, they admit that the relationship between the JCG Index and performance may actually be negative--thereby indicating the tricky nature of using governance metrics to measure medium-term stock performance.

More ironically, the pitfalls of "cookie cutter" governance rankings are highlighted by the fact that Nomura Holdings topped the JCG Indices in 2006, only to be brought down by an insider trading and other scandals that will hurt their investment banking business. In addition, the JCG indices cover 312 of some 3,800 listed Japanese companies.

Thus a corporate governance "score" is only one, and a tricky one at that, to measure the quality of management and corporate governance--and an even trickier way of measuring potential stock price performance. A better measurement might be foreign ownership (and the corporate governance pressures that implies) and the lack of stable domestic shareholders, such as a parent company or Japanese banks/insurance companies.

At any rate, good corporate governance is only one (increasingly important) factor to consider when picking stocks, and I have my doubts about the effectiveness of a fund or index based soley on simple corporate governance scores.

Instead, we look for evidence that management "gets the joke" about the effects of globalization on their business, and of providing competitive returns to their shareholders, and shows this with visible action, as going from "poor" to "good" corporate governance can be as powerful a stock price driver as a text-book corporate governance structure--coupled of course with a corresponding improvement in shareholder returns.