SuMi TRUST Monthly Commentary July 2014

Key Points 1. Corporate Governance Reform as part of the Third Arrow of The Third Arrow of Abenomics, the growth strategy, is referred to as ‘Oriental Medicine’, compared to the First Arrow, quantitative easing, which was ‘Western Surgery’. Corporate governance reform is the cornerstone of the Third Arrow in the Revitalization Plan, which urges the Tokyo to draw up a ‘Corporate Governance Code’ by next spring through collaboration with the FSA which formulated the Stewardship Code this spring.

2. Our Focus: Mitsubishi Heavy Industries (7011) Among the companies undergoing change in corporate governance is Mitsubishi Heavy (MHI), which is this month’s focus. The heavy industry segment had a tendency to conduct business without much consideration for capital efficiency, however, today we are witnessing a change. The company has reorganized by reducing its 9 Divisions to 4 Domains, and appointed a CEO for each Domain. In every sense, they are trying to speed-up the decision-making in as much as possible.

3. The Japanese Equity Market in June 225 closed at 15,162, +3.62% MoM, whilst TOPIX rose by 5.09%. The market bottomed in May but has had an upward momentum as of early-June owing to expectations that GPIF will change its asset allocation and purchase domestic equities, and that PM Abe will commit to a corporate tax cut. From here, we expect the impact of the consumption tax hike on the economy will become clearer.

Cover 1. Corporate Governance Reform as the Third Arrow of Abenomics The Third Arrow of Abenomics, the growth strategy, is referred to as ‘Oriental Medicine’, compared to the First Arrow, quantitative easing, which was ‘Western Surgery’. Corporate governance reform is the cornerstone of the Third Arrow in the Revitalization Plan, announced on 24th June. The plan urges the to draw up a ‘Corporate Governance Code’ by next spring through collaboration with the FSA which formulated the Stewardship Code this spring. This is an attempt to change the corporate constitution autonomously and via external force and it is hoped these two Codes will play a key role in improving ’s corporate governance. With inflation on the horizon of the Japanese economy, cash is no longer king. To boost earnings, Japanese companies will likely activate a portion of their JPY 200 cash equivalent assets which had been accumulated under the deflationary period. In the UK, both the Stewardship and Governance Codes were published in 2010.

Return on Equity: ROE When we compare ROE’s among the US, Europe and Japan, it is apparent that Japan lags far behind. This stems from thin profit margins. Going forward, Japanese corporations must boost sales and profit margins and as such, increasing ROE is another goal of corporate governance reform.

Table 1: ROE of the G3 Figure 1: Real Interest Rates

ROE (%) 3.5 3 Manufacturing 4.6 2.5 Japan Total 5.3 2 1.5 Manufacturing 28.9 US 1 Total 22.6 0.5 0 Manufacturing 15.2 Europe -0.5 Total 15.0 2000 2002 2004 2006 2008 2010 2012 2014 Source: METI Real interest rate(=10YJGB-CoreCPI(lessFood/Energy) 10Y JGB Source: Bloomberg, SuMi TRUST New Index: JPX-Nikkei 400 A new equity index, the JPX-Nikkei 400, was launched in January. The Government Pension Investment Fund (GPIF) followed by announcing in March that it would use as a benchmark the JPX- Nikkei 400 in addition to TOPIX. The JPX-Nikkei 400 consists of companies of all market caps (including TSE 1st & 2nd sections, JASDAQ and Mothers) and its constituents will be selected in accordance with their ROE and profits. There are about 80 Nikkei 225 constituent companies which haven’t been selected to the JPX-Nikkei 400. We think this is a unique index which gives companies a strong incentive to raise their ROE. For example, Amada (6113) which was excluded from the JPX- Nikkei 400 announced in May that they will boost ROE in order to be selected by the new index.

From Deflation to Inflation Under deflation, cash was king for companies as real interest rates stayed relatively high versus low nominal rates. As a result, companies in Japan hold more than JPY 200 trillion cash equivalent assets. However, Japan’s deflationary era has come to an end, and we now have inflation and negative real interest rates. Thus, holding cash is no longer king. Companies are therefore seeking better use of their funds in addition to improved and effective governance.

We at SuMi TRUST are following closely the changes in Japanese corporate governance and are keen to see new investments and M&A activity to boost earnings growth on a mid-long term perspective. Merely relying on stock buy-backs is too myopic and does not fit the Japanese business landscape.

1 2. Our Focus: Mitsubishi Heavy Industries (7011) Illustration 1: Mitsubishi Regional Jet (MRJ)

We would like to introduce Mitsubishi Heavy as a

symbolic example of a company which has shed its

old skin in heavy industry; where companies tended

to prefer size over efficiency.

History Its history dates back to 1884 when Mr. Yataro Iwasaki, the founder of the Mitsubishi Group, rented a shipyard from the government in Nagasaki and started a shipbuilding business. Later, this company Provided by Mitsubishi Aircraft Corporation was renamed Mitsubishi Heavy Industries and Figure 2: ROE of Mitsubishi Heavy extended its business to thermal/nuclear power 10% plants, aircraft/rockets, transportation systems and (forecast) industrial machines. As a result, it became one of 8% the most well-known conglomerates in Japan. Business Size 6%

Sales in FY2013 was about JPY 3.3 trillion and 4% operating profits was about JPY 200 billion. Even with such size, the company has not received high 2% recognition from the market. They had been criticized for being too bureaucratic and slow in 0% making decisions. However, things started to 2010 2011 2012 2013 2014 Note: the ROE in FY2013 reached to 11%,but we exclude the change after Hideaki Omiya took office as CEO. special one-off factors to show the trend. Reorganization Source: Mitsubishi Heavy, SuMi TRUST Mitsubishi Heavy reorganized in April 2014 in accordance with former CEO, Hideaki Omiya’s, mid-term business plan which was published in April 2012. They integrated the business into 4 domains: Energy/Environment, Transportation, Defense/Space and Machinery/Equipment, and appointed a CEO in each Domain to make the final decisions. Until this change, the company was divided into 9 Units1.

At the annual meeting this June, Mitsubishi Heavy decided to cut its Directors from 19 to 12, whilst still keeping the 3 existing external Directors. Ten years ago, they had 28 Directors but today there are less than half, which has contributed to improving the decision making process. As result of this reorganization, they managed a tight schedule and made an offer together with Siemens to buy the energy arm of Alstom. Mitsubishi Heavy made an immediate decision and took quick action within a week. The former organization couldn’t have behaved like this. Although the French government chose GE’s proposal, Mitsubishi Heavy clearly showed a clear difference from the past.

Photo 1: Gas turbine for power plant Photo 2: H-ⅡA Rocket

Provided by Mitsubishi Heavy Provided by Mitsubishi Heavy 1) The 9 former units were shipbuilding, engines, nuclear power, machinery, aerospace, utility aircraft, cold utilization, machine tools and engineering. 2 Change in ROE More than 10 years ago, their then CEO mentioned that ROE wasn’t in their scope to manage the company, but things have turned around. When Hideaki Omiya became CEO, he announced the mid- term business plan, Plan 2010. Under this plan, they declared a departure from pursuing scale, and began to focus more attention on profit margins and ROE. It was first time that they had set ROE as a business target. Owing to the restructuring which included its exit from non-profitable businesses, to reducing costs and to reconsider production lines, the ROE reached 11% in FY2013. Even after excluding special one-off factors, it was at 7% plus. This is still low by global standards, but we can’t stop feeling the changes of this company when we consider that 3 years ago, the ROE was about 2%. We estimate that the ROE will exceed 8% in FY2014. The driving force will be their energy/ environment business which includes power generation systems.

Conclusion Mitsubishi Heavy is a symbolic example of ongoing changes in the corporate governance of Japanese companies. We can feel and sense these changes at Japanese companies, and believe that our active and constructive engagement based on the Stewardship Code will further stimulate companies towards better governance. 3. The Japanese equity market in June Table 3: Global Equity Market Performance The Nikkei 225 closed at 15,162, +3.62% MoM. (as of 30th June) TOPIX rose by 5.09%. The market hit the bottom in May but has had an upward momentum since Country Index YTD QTD June early-June owing to expectations that GPIF will USD 0.5% 6.7% 5.55% change its asset allocation and purchase domestic TOPIX equities, and that PM Abe will commit to a JPY -3.1% 5.0% 5.09% th Japan corporate tax cut. On June 4 , TOPIX recorded a USD -0.4% 6.5% 5.15% 10 consecutive business day rally for the first time MSCI Japan in 5 years. The market was quiet in mid-June JPY -3.9% 4.7% 4.70% whilst awaiting the FOMC decision, which was U.S. S&P500 USD 6.1% 4.7% 1.9% announced in a dovish tone resulting in higher USD 3.4% 2.1% -0.2% stock prices everywhere. Meanwhile, the BOJ Europe FTSE Eurofirst 300 decided to maintain its policy on the 13th, which EUR 4.1% 2.8% -0.5% had a marginal impact on the market as MSCI AC Asia Asia USD 5.1% 6.2% 1.9% expectations for a further stimulus was already (ex. Japan) low. The Japan Revitalization Plan on the 24th was Source: Bloomberg, SuMi TRUST a non-event as its contents were already reported in the news media. Going forward, the economic impact of the consumption tax hike will become more evident. The impact on the auto & housing sector remains to be seen, but the effect on the economy as a whole should be limited. We shall see confirmation that the Japanese economy is still in good shape thanks to a robust capex, and it is very likely that it will grow faster than the potential growth. The market will focus its attention on corporate fundamentals. Risks remain at the geopolitical level especially from the Middle East. Disclaimer This marketing communication is issued by Sumitomo Trust International Limited (“SMTI”). SMTI is authorised and regulated by Any enquiries regarding the products the United Kingdom’s Financial Conduct Authority (the “FCA”), whose address is 25 The North Colonnade, Canary Wharf, London, EC3N 2AA, United Kingdom. This marketing communication has been made available to you only because SMTI has classified you as should be made to: a professional client in accordance with the FCA’s rules. If you have received this marketing communication from a source other than SMTI, you should contact SMTI before using it or relying on it. You must not send this marketing communication to any other person without first having received written approval from SMTI. The information contained in this marketing communication (the “Material”) is Yusuke Karube being made available for information purposes only and is designed to provide information on the investment services which SMTI may offer to clients. Nothing in the Material amounts to or should be construed as an actual offer by SMTI to provide any investment Director, International Sales services to any person. If SMTI agrees to provide any investment services to any person, those services will be the subject of a Sumitomo Mitsui Trust International Limited separate written agreement between SMTI and that person. Furthermore, the Material has not been prepared with any consideration of rd the individual circumstances of any person to whom it is communicated. Accordingly, it is not intended to, and does not, constitute a 3 Floor, 155 Bishopsgate, personnel recommendation in relation to the purchase or sale of, or exercise of any rights in relation to, any financial instruments or London EC2M 3XU, UK advice in relation to any investment policy or strategy to be followed. The Material also does not contain the results of any investment research carried out by SMTI and is not intended to amount to a financial promotion of any particular financial instrument which may be Direct: +44 20 7562 8460 referred to in it. While SMTI uses all reasonable endeavours to ensure the Material is accurate, it has not been prepared with a view to any person relying on it. Accordingly, SMTI accepts no responsibility for any loss caused to any recipient of this document as a result of [email protected] any error, inaccuracy or incompleteness in the Material, nor for any error in the transmission or receipt of this communication. 3