by David Ruff
The Bob Dylan anti-establishment, frustrated-youth song that became the anthem for change during the U.S. civil rights movement could also apply to corporate Japan today. Japanese equity investors, frustrated with decades of poor returns, are calling for significant change. It’s beginning to happen.
It may seem surprising for us to project better equity returns from Japan. After all, in our October 28th 2019 commentary titled The House of the Rising Sun Will Have trouble Rising we argued that in spite of Japan’s growing trade relationship with the world’s fastest growing major economy, China, the Land of the Rising Sun economy will struggle to rise meaningfully. Further, although valuations appear attractive, we believed overall Japanese-based equity returns will likely not rank near the top of country returns in the near future. This turned out to be prescient. In the iShares ETF tracking the performance of the MSCI All Country World Index, Japan posted a return of 1.13% for the year ended October 2020. Not dreadful in this period of a global pandemic, but given Japan’s better handling of Covid-19, its ranking of 18th seems disappointing compared to other parts of Asia, including China (+41.77%), Taiwan (+25.71%), and South Korea (+15.57%), and especially lacking relative to multiple countries hit much harder by the epidemic, for example, the U.S. (+11.69%), Denmark (+31.35%), and Portugal (+6.75%). Although structural problems still exist, we look for a better ranking from Japan going forward.
True, Japan’s problems are pervasive and not easily solved. We highlighted in the earlier piece that the country still suffers from a creativity-stifling, rote-based education system, an aged and shrinking population, a high corporate tax rate, and a very large number of loss-making/marginally profitable (zombie) companies. The major negative we expect to remove from the list, however, is poor corporate governance. The importance of good governance or an engaged, active board of directors cannot be over emphasized. Heretofore, Japan’s public company governance model was badly flawed. Far from the ideal of seeking competitive company performance to maximize shareholder value, Japan corporate boards were comprised of individuals whose interests were misaligned with shareholders, which resulted in lower returns on capital and less favorable equity returns. Indeed, historically, profitability measures like return on invested capital and return on equity routinely measured significantly lower in Japan compared to global averages.
Part of the problem is cultural. The Japanese value collegiality, consensus, and deep respect for elders. While admirable, these qualities stifle the board’s crucial function of asking difficult questions, raising objections, fostering intense debate, and holding management accountable for mistakes. Japanese boards tend to be far larger than global averages. Members are frequently older, typically octogenarians whose careers entailed climbing the corporate ladder at the one company, and joining the board as a reward for a lifetime of service. Even if the board has a few qualified, motivated, future thinking outsiders, their input will be overwhelmed by the high proportion of lifer, former employees. Further, the financial interest of directors is the board fee with little or no share ownership. This insular board tends to approve management proposals without question. (Why make waves? You may make management want you removed from your cushy board position.) Far too frequently these proposals involve acquisitions that lack strategic merit and do not provide an acceptable return on investment. These proposals help management pursue what I call “empire building”. After all, bigger companies pay bigger management salaries. Sadly, I’ve met with too many Japanese managers who seem to view minority shareholders with disdain, not as co-owners of the business. Japanese investor relations plays a perfunctory role.
When you think of the best performing global companies you realize they are frequently the founding owner operators – think Jeff Bezos of Amazon, Warren Buffet of Berkshire Hathaway, Mark Zuckerberg of Facebook. Since these highly motivated owners have almost perfect alignment with minority shareholders, extra power in their hands is usually a positive. If their companies need another board skillset, they find high-quality people to fill the void. There are not many of these types of owner operators in Japan, and the extra power afforded to an individual is usually to the board Chairman who has little share ownership. This is almost always a negative. Moreover, corporate committees do not enjoy the same legal standing as they do in the U.S. Members of the audit committee, risk committee, compensation committee, and other committees can be and are overruled by the Chairman. Since Japan has not been all that receptive to activists recommending best practices in response to regulatory issues, significant problems can develop. Major accounting scandals at Toshiba and Olympus provide examples. Indeed, “activism” is a bad word in Japan. Hostile takeovers are not done. CEOs are not replaced. Performance-based pay does not exist. Clearly, Japan needs more diverse boards with a variety of talent and perspectives to help companies adjust to new business environments and make better strategic decisions. Without this diversity, boards lack dynamism, relegating strategy toward the same old path in spite of new industry challenges and competitive threats.
Former Prime Minister of Japan, Shinzō Abe, recognized these governance problems and pursued the so-called third arrow of structural reform to help lift the Japanese economy out of its multi-decade period of economic stagnation. One of the key measures included the creation of a new index called the JPX-Nikkei Index 400, which includes only companies meeting minimum return on equity and independent director requirements. Implemented in 2014, initially largely ignored by corporates, the standards were set very low to find enough constituents. For instance, the number of independent directors was initially set at one. However, the government continued to push this as a core national policy, essential for Japan’s future. With Japan’s culture of shame avoidance, companies now make every effort to achieve these regularly raised standards, which seek to eliminate the problems indicated above. It’s having an impact. Return on equity and other measures of profitability are rising, reaching 80% of global averages compared to 50% five years ago. Although the term “activism” is still not favored, companies increasingly use “corporate engagement specialists” to help reach institutional investors and implement reforms.
We applaud these trends and note that it’s becoming less difficult to find Japan-based investment ideas with acceptable governance practices for our ADR portfolio. We recently added a global leading maker of semiconductor fabrication tools to the portfolio and have other Japan-based candidates under review. Yes, even without an anthem, we and other equity investors in Japan will finally sing if the movement toward better governance continues. I wonder if Bob Dylan knows Japanese?
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