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” e ent e m n es e e s e ee Inte est e n e t industrial and financial business conglomerates re-emerged as 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, 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— provided not only financing, but also comprehensive financial and business advice. Faced with the turmoil of labor disputes in the 1950s, Japan’s bureaucrats and politicians worked with the main e n 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. Things began to change after the bursting of Japan’s massive stock and real estate bubble in 1990. The subsequent decline in asset prices caused a solvency crisis for the overly leveraged banks, which led to a credit crunch and period of economic contraction in the mid- to late-1990s. As a result, banks increasingly abandoned their roles of lender and advisor. Corporations viewed this withdrawal as a “betrayal” and responded by reducing debt and accumulating cash in order to distance themselves from the banks.2 e n
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 e t (Exhibit 1).
Second, these bloated balance sheets have depressed capital effi- ciency. The average Japanese company’s return on equity (ROE) In enm t e n is 10.5%, well below US and European companies’ ROEs of 18% n and 14%, respectively (Exhibit 2). Third, as a result of Japanese st n e corporations’ lower capital efficiency, their valuations are lower e m n than their developed markets peers (Exhibit 3). It n e n n e We believe Japanese companies have the ability to increase their n corporate value through improved capital allocation and share- 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 e t issues remain.
Stable shareholders Stable shareholders generally prioritize business relationships over financial returns. They can include cross shareholders, most banks and insurance companies, individuals, and the government. tt m These investors have historically lacked the incentive to hold nt e 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. The decline accelerated from the late 1990s as Japanese banks se n ss s e n t ss s e n t restructured their balance sheets by writing off bad assets that were a legacy of the bubble era. Nomura estimates that cross shareholdings have fallen to represent just 15% of the market
(Exhibit 5). However, this figure underestimates the continuing extent of the stable shareholders problem, which one analyst estimates to represent 47% of all shares in the TOPIX 500 e e 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 also To empower Japanese boards, we believe more senior business driven an uptrend in shareholder returns over the past 10 years, executives need to join the boards of other companies. A good despite a decline in share buybacks during the past two fiscal years example is Nidec’s (a Japanese manufacturer of electric motors) (Exhibit 7). talented CEO Shigenobu Nagamori who serves on SoftBank’s board (a global telecommunications and technology investment However, Japanese balance sheets have disappointingly become company). Unfortunately, the majority of external directors are even more bloated, as these increasing distributions have not kept still academics, lawyers, and bankers, who may not have the ability up with increased free-cash-flow generation. The pace of Japanese or experience to evaluate critical issues such as corporate strategy corporate cash accumulation has increased since the late 1990s, in and capital allocation. striking contrast to the US corporate re-leveraging (Exhibit 8). Proxy voting Exhibit 6 Shareholders are increasingly exercising their proxy voting rights Japan Has Narrowed the Profit Margin Gap and there has been an encouraging trend to eliminate “poison Trailing Net Profit Margin (%) Japan USA Europe pill” provisions (a company’s defense measure to make itself 12 unattractive in order to avoid an unwelcomed takeover). 8 CEOs of underperforming companies have come under more 4 pressure. Companies with low CEO approval rates in 2015 increased their ROE during the following fiscal year by much more 0 than those with high CEO approval rates.6 -4 2002 2004 2006 2008 2010 2012 2014 2016 2018 We are also encouraged to see many recent examples of shareholder As of 30 July 2018 activism in Japan. The number of “hostile” activist campaigns Source: Bloomberg doubled between 2015 and 2017.7 While most activist campaigns in the 2000s failed, the more recent round has been successful: • In 2016, the Seven & i CEO resigned as the company’s board of Exhibit 7 directors supported shareholders, including Third Point (a US Japanese Corporate Shareholder Returns Are Increasing investment advisor) that opposed the CEO’s plans. v en s t t t • In 2017, a Japanese individual carried out a successful hostile takeover of computer chip trader Solekia, despite the opposition from cross shareholder Fujitsu. • In 2017, Hong Kong–based Oasis Asset Management achieved some success by using shareholder proposals to achieve improved terms for minority shareholders in listed subsidiaries of Panasonic and Toshiba. Buyouts As of 25 July 2018 Private equity-led buyouts of listed Japanese companies have also Note: Total Payout ratio represents the total of buybacks and dividends as a percentage of net income. surged during the past two years. US-based firms including KKR Forecasts and estimates do not represent a promise or gurantee of future results and and Bain have been most active, taking several mid-sized Japanese are subject to change. firms private with implied government support. We think that Source: Goldman Sachs these firms are taking advantage of the improved governance 5
Long-term structural change appears to be under-appreciated Exhibit 8 Japanese Corporate Cash Accumulation Continues by the market in Japan. Top-down policy initiatives as well as bottom-up elements have combined to reduce the influence of e n et e t t t n e stable shareholders, improved board structure effectiveness, and empowered new investors to improve their level of engagement with Japanese companies.
Change will continue to be gradual and we believe investors need to work harder to recognize actual and potential changes that are not reflected in market valuations. Our team has been investing in Japan since the 1980s, and we see evidence of the change through the
As of 30 July 2018 dynamics of our company meetings. Management teams that had Source: FactSet, MSCI felt protected by stable shareholders are increasingly feeling more pressure, and as a result are coming up with medium-term plans to raise their profitability. They are taking previously unthinkable, but Is This Time Really Different? highly sensible, measures to improve business strategy. Japan’s business environment appears to be changing for the better. In addition, our discussions with management are increasingly While meaningful improvement is taking place in Japan we don’t two-way, with companies expressing increased interest in our ideas believe governance is becoming, or should become, more like that in and suggestions. the West. In the same sense, there is no “optimal” capital structure for all companies as it depends on the specifics of the business and We expect this process to continue, which should support a re-rating management's long-term strategy. Investors in Japan can now of market valuations, similar to the experience in the United States engage in frank discussions with company executives and boards to in the 1980s and Europe in the 1990s. We believe this should improve corporate value for shareholders and other stakeholders. support strong investment returns for the Japan market overall, and particularly for those active investors who can identify change at the bottom-up level. 6
Case Study: Hitachi
Hitachi is a prime example of how improved corporate governance can lead to superior shareholder returns. 2008 Hitachi falls on hard times in the aftermath of the global financial crisis. It reports a record 787 billion yen net loss for the fiscal year, amid falling demand globally for the firm’s products. The loss had eroded the firm’s equity capital base, as it faced criticism from its shareholders. 2009 The board asked the highly regarded Takashi Kawamura to engage in an urgent restructuring of the company. Because Kawamura had previously been ousted as a director at Hitachi, he was able to engage in an unprecedented restructuring and build a “western style” board of directors. 2010 Kawamura picks Hiroaki Nakanishi as President. They embark on a mission to restore Hitachi to sustainable profitability and improved corporate value. A key part of this was changing the corporate mindset to allow for needed business transformation. To support this, they sought to create a board structure that would not simply rubber stamp management decisions, but rather would serve as an independent check on the new strategy and its execution. 2010 to 2012 Top management engages openly with both domestic and overseas shareholders, who brought perspectives on how overseas peers (including GE, IBM, and Siemens) had succeeded in business restructurings. 2013 Nakanishi introduces an ambitious new mid-term plan with clear key performance indicators, commitment to disposal of non-core businesses, and aim to improve working capital management. 2014 Toshiaki Higashihara takes over as President. Organizational reform continues, giving more responsibility to international executives. The number of non-Japanese non-executive directors rises to four, while the total number of board members falls to twelve. 2016 A new mid-term plan was initiated. It included the commitment to further steady improvement in margins, more explicit free cash flow targeting, streamlining of the organizational chart, and attention to return on capital, with further disposals of non-core businesses. 2017 and 2018 Corporate focus improves, with deconsolidations of publicly listed Hitachi subsidiaries, including Transport, Capital, and Koki.
Results
The Majority of Hitachi’s Board Members Are Company Outsiders The majority of Hitachi’s board members are company outsiders, with solid representation from foreigners and women. Most importantly, the board functions well in terms of meaningful oversight. We recently met Hitachi’s President Toshiaki Higashihara to discuss the company’s long-term corporate strategy. Regarding the firm’s UK nuclear power business, Higashihara explained the intensive engagement he had with his board regarding the decision.
t t t e t ts e e t e n e t em e e t
As of June 2018 Source: Hitachi Integrated Report 2017
Hitachi Has Outperformed Its Peers and the Japanese Equity Hitachi Has Outpaced Its Peers in the Earnings Race Market
Hitachi has indeed improved its corporate value. The company has stable Following its corporate governance improvements, Hitachi has positive earnings and structurally improving operating margins. outperformed its peers and the market. s et In me s n t s I e t n n e In e t et In me t n
As of March 2018 As of 13 September 2018 Source: MSCI Source: Bloomberg 7
This content represents the views of the author(s), and its conclusions may vary from those held elsewhere within Lazard Asset Management. Lazard is committed to giving our investment professionals the autonomy to develop their own investment views, which are informed by a robust exchange of ideas throughout the firm.
Notes 1 Zaibatsu refers to industrial and financial business conglomerates prior to World War II whose influence and size allowed them to control important areas of the Japanese economy. 2 Source: Codrington Japan, 2018. 3 As of June 2018. Source: Jefferies 4 As of 13 July 2108. Source: Japan Exchange Group 5 Source: Spencer Stuart 6 Source: MUFG 7 Source: IR Japan
Important Information Published on 23 October 2018. This document reflects the views of Lazard Asset Management LLC or its affiliates (“Lazard”) based upon information believed to be reliable as of 16 February 2018. There is no guarantee that any forecast or opinion will be realized. This document is provided by Lazard Asset Management LLC or its affiliates (“Lazard”) for informational purposes only. Nothing herein constitutes invest- ment advice or a recommendation relating to any security, commodity, derivative, investment management service or investment product. Investments in securities, derivatives and commodities involve risk, will fluctuate in price, and may result in losses. Certain assets held in Lazard’s investment portfolios, in particular alternative investment portfolios, can involve high degrees of risk and volatility when compared to other assets. Similarly, certain assets held in Lazard’s investment portfolios may trade in less liquid or efficient markets, which can affect investment performance. Past performance does not guarantee future results. The views expressed herein are subject to change, and may differ from the views of other Lazard investment professionals. This document is intended only for persons residing in jurisdictions where its distribution or availability is consistent with local laws and Lazard’s local regulatory authorizations. Please visit www.lazardassetmanagement.com/globaldisclosure for the specific Lazard entities that have issued this document and the scope of their authorized activities. Certain information included herein is derived by Lazard in part from an MSCI index or indices (the “Index Data”). However, MSCI has not reviewed this product or report, and does not endorse or express any opinion regarding this product or report or any analysis or other information contained herein or the author or source of any such information or analysis. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any Index Data or data derived therefrom. LR30096