Investment Research Are Japan’s Corporate Governance Reforms Working? Scott R. Anderson, CFA, Director, Portfolio Manager/Analyst Japan, home to some of the world’s most renowned companies in terms of operational excellence, has lagged its global peers in the areas of profitability and capital efficiency over the past three decades. This gap, which can be largely explained by the country’s approach to corporate governance, is showing signs of narrowing. While there have been setbacks and disappointments in the past, policy reforms ushered in by Prime Minister Shinzo Abe are driving corporate change and we are starting to see a difference in our interactions with management teams. Better corporate governance has driven improved profitability and, we believe, could lead to a rerating of the Japanese markets. 2 A Brief History of Japanese Corporate Exhibit 1 Tradition Nearly 60% of Japanese Companies Are Cash Rich In the aftermath of World War II, the pre-war “Zaibatsu1” Percentage of Companies Where Cash exceed Interest-bearing Debt (%) industrial and financial business conglomerates re-emerged as 60 informal alliances known as “Keiretsu”. Companies in these groups invested in each other as a means of solidifying their business relationships—a practice known as cross shareholding. Over time, 40 high levels of cross shareholdings encouraged company manage- ment to focus on business relationships, and not profitability. In the Keiretsu system, a “main” bank—not the capital markets— 20 provided not only financing, but also comprehensive financial and business advice. Faced with the turmoil of labor disputes in the 0 1950s, Japan’s bureaucrats and politicians worked with the main US Europe Japan banks to direct corporate capital allocation to achieve national As of 7 August 2018 growth and unity, in a system that came to be termed “Japan, Inc.” Source: Goldman Sachs, FactSet This bank-led governance system persisted through the period of rapid economic growth through the stock and real estate market Exhibit 2 bubble in the late 1980s. It led to a corporate culture that empha- Japanese ROE Lags Global Peers sized overinvestment and risk aversion which has resulted in low (%) profitability. 20 Things began to change after the bursting of Japan’s massive stock and real estate bubble in 1990. The subsequent decline in asset 15 prices caused a solvency crisis for the overly leveraged banks, which led to a credit crunch and period of economic contraction in the 10 mid- to late-1990s. As a result, banks increasingly abandoned their roles of lender and advisor. Corporations viewed this withdrawal 5 as a “betrayal” and responded by reducing debt and accumulating cash in order to distance themselves from the banks.2 0 US Europe Japan This history led to the current situation in corporate Japan where As of 7 August 2018 stable shareholders and insider-dominated board structures have Source: Goldman Sachs, FactSet shielded underperforming management teams from external disci- pline. There are a number of unfortunate results that remain in effect today. First, the amount of cash on corporate balance sheets Exhibit 3 is excessive. Nearly 60% of Japanese companies outside the finan- Japanese Valuations Are Also Lower than Their Global Peers cial sector hold more cash than interest-bearing debt, compared to just 15% and 20% for US and European companies, respectively (Price-to-Book) (Exhibit 1). 5 4 Second, these bloated balance sheets have depressed capital effi- USA ciency. The average Japanese company’s return on equity (ROE) India Denmark 3 Switzerland is 10.5%, well below US and European companies’ ROEs of 18% Canada and 14%, respectively (Exhibit 2). Third, as a result of Japanese 2 UK Australia France corporations’ lower capital efficiency, their valuations are lower Germany than their developed markets peers (Exhibit 3). 1 Italy Hong Korea Kong 0 Singapore We believe Japanese companies have the ability to increase their 8 Japan 12 16 20 corporate value through improved capital allocation and share- (ROE %) holder returns. Significant changes in management behavior As of 10 August 2018 are happening already, in part due to recent policy initiatives to Source: Lazard, FactSet promote improved corporate governance. 3 Policy Reforms A series of powerful policy initiatives began to take shape in 2013, when the Abe administration made corporate revitalization a key plank in its growth strategy. The administration believed corporate governance reform was an important response to a number of challenges Japan faces, including demographic headwinds and the rise of China. Key Reforms Objective Progress The Stewardship Code Encourage investors to engage with company The Stewardship Code has improved the quality of management to "promote sustainable growth of meetings with company management. However, proxy companies through investment and dialogue." It requires voting support for underperforming management teams investors, in some cases, to disclose their proxy votes has remained disappointingly high through the June and explain them in terms of their fiduciary duty. 2018 AGM season. The Ito Review Required companies to improve their corporate value by The Ito Review has contributed to a change in setting clear performance metrics. Each company should management behavior, and the structural improvement aim to generate a minimum 8% ROE. in capital efficiency. However, ROE targets are often not well integrated with company key performance indicators. The Corporate Governance Code Instructs all publicly traded companies to follow The most impactful of the initiatives, the Corporate “fundamental principles for effective corporate Governance Code has contributed to the structural governance.” Companies must explain their “policies decline in cross shareholdings. However, adherence regarding the reduction of cross shareholdings” and is often superficial and the pace of change varies justify them in relation to “the company’s cost of substantially by company. capital.” Information and opinions are subject to change. Key Issues Remain Exhibit 4 We believe Japanese corporations have made significant strides in Reducing Stable Shareholders Could Help Profitability corporate governance, thanks to these policy reforms but some key (%) ROE [LHS] Price-to-Book [RHS] (X) issues remain. 12 2.5 Stable shareholders 10 2.0 Stable shareholders generally prioritize business relationships 8 1.5 over financial returns. They can include cross shareholders, most banks and insurance companies, individuals, and the government. 6 1.0 Bottom 20 20–40 40–60 60–80 Top 20 These investors have historically lacked the incentive to hold Quintile management accountable for profitability and capital efficiency. As of 5 April 2018 Companies with a higher percentage of stable shareholders tend to TOPIX 500 companies (ex-financials) are broken down by quintile based on the weighting of strategic shareholdings versus total assets; median values for each have lower profitability and lower valuations (Exhibit 4). group's ROE and price to book. Data are as of the end of fiscal year 2016. Source: MUMSS, Astra Manager We believe that the prevalence of stable shareholders is declining. While it is difficult to measure the extent of stable shareholdings in the Japan market, due to classification and data availability issues, Exhibit 5 it is clear that cross shareholdings (a key component of stable Cross Shareholding Has Been Declining shareholders) have declined significantly since the 1980s. (%) 25 The decline accelerated from the late 1990s as Japanese banks Broadly Based on Cross shareholding Ratio Cross shareholding Ratio restructured their balance sheets by writing off bad assets that 20 were a legacy of the bubble era. Nomura estimates that cross shareholdings have fallen to represent just 15% of the market 15 (Exhibit 5). However, this figure underestimates the continuing 10 extent of the stable shareholders problem, which one analyst 5 estimates to represent 47% of all shares in the TOPIX 500 2006 2008 2010 2012 2014 2016 2018e 2020e companies.3 We believe the decline in stable shareholdings is likely As of 10 August 2018 to persist and encouraging this trend remains a focus of our team's The cross shareholding ratio represents the holdings of shares in other listed companies by listed banks and nonfinancial companies. The broadly based cross engagement activities. shareholding ratio includes the holdings of insurers (life and nonlife). Source: Nomura 4 Board structure situation, the more proactive stance of the Japanese government, Japanese boards have become more diverse and independent, in and valuations that are below global peers. line with the government’s policy goals. Between 2011 and 2018, Capital efficiency and shareholder returns the number of companies listed on the Tokyo Stock Exchange with at least two independent directors rose from 15% to 92%.4 Management focus on profitability has improved and the results The number of female and foreign board members also increased are starting to show. Net profit margins for Japanese companies over the period, but remain well below US and European levels.5 are at historically high levels and have narrowed the gap with their developed markets peers (Exhibit 6). Rising profit margins have However, independent directors in many cases lack the ability boosted both ROE and free cash flow for Japanese companies to and motivation to provide real oversight to management teams. all-time highs. Higher profit levels and dividend payouts have