Jeff Atherton, Head of Japanese Equities at Man GLG, explains how a corporate governance revolution is changing the landscape for Japanese equity investors.
The Japanese equity market is at its highest level since around June 1990. It has been a long road for investors loyal to the region during this period, with a number of false starts and much stagnation, but after 30 years the market appears to be on a new path in part driven by changes in the attitudes of Japanese businesses.
Japan is still seen as a cyclical market, much like South Korea, which sees inflows from global investors when some of the seemingly more attractive areas of the global equity market – such as the US tech stocks – fall out of favour. This cycle has presented opportunities for active value investors over time, but in our view the real story in Japan is no longer about being a global cyclical, it is really about the corporate governance revolution we are seeing at the moment.
Revolution in corporate governance
The evolution of the corporate governance scene emerged around seven years ago as part of Abenomics, but it has taken until the past couple of years to really take off. It is no exaggeration to say that there has been more change in Japan in the past two years than during the entire period since the highs of 1990. This evolution has pushed businesses outside of their comfort zones and created practices more akin to companies in Western markets. Companies now find themselves under intense pressure to raise return on equity and to do a lot more for shareholders.
Previously, Japanese companies typically viewed the shareholder as only one of a number of interested parties, but going forward we see companies doing more Anglo-Saxon-type capitalist measures to get the share price up, such as share buybacks or dividend payments. The adoption of a new Stewardship Code in Japan in 2014, closely followed by the Corporate Governance Code in 2015, has led to an unintended consequence: the paradox of the 8% return-on-equity (‘ROE’) target. Since 2016, corporates have been encouraged to aim for an 8% ROE ratio, while shareholders have been encouraged to vote against the reinstatement of boards which fail to reach this target three years in a row. This has resulted in a wildly bifurcated environment – in all other regions, the price-to-book (P/B) ratio moves in a linear fashion with ROE: as ROE increases, so does the multiple. In Japan, businesses which achieve the exalted 8% figure enjoy a disproportionate PB premium; those which don’t have their multiple crushed.
The pressure to lift financial performance, especially ROE, is now intense and activist investors are increasing their presence as a result. Hostile bids are starting to be seen in Japan for the first time. CVC Capital Partners attempted to take Toshiba private earlier this year, and we are increasingly seeing activists targeting other opportunities. While this type of action is seen as a regular occurrence in the UK or US markets, it is all very interesting and ground-breaking in Japan. We are yet to see how far this new trend will go, or whether the country and authorities will be comfortable in letting it get to full-blooded capitalism, but we believe it is going in a positive direction.
Reformed landscape provides appealing opportunities
From a market perspective, this has been a powerful driver of the stronger returns we have seen recently. It has happened without foreign investors really taking too much notice – investors have largely been selling Japanese equities since 2015, so there remains a lot of underinvested positions in the region in our view. But for the market and the Japanese corporate landscape, we think there are lots of reasons to be positive, it is a bottom-up corporate improvement story, which is set to revolutionise the landscape, both for corporates in their overall profitability and the efficiency of their businesses, and also for investors exploring opportunities in the region which has long been undervalued.
Possibly as consequence, the corporate sector continues to enjoy strong profit momentum. Sales and profits in the latest quarter were 6% and 17% ahead, respectively, of the levels of the same quarter in 2019 (2020’s figures were hit by Covid-19) and profit margins pushing towards all-time highs. Dividend payments are rising and share buybacks resuming as life returns to normal for most companies.
Historically Japan has rewarded value investors over growth. One of the reasons this has worked in Japan is that there has been no fiduciary duty to maximise shareholder value. Traditionally, companies that do well quite often take their foot off the gas, whereas those in trouble can generally find an extra level to go to which they don’t pursue at other times. This means a long history of companies going down and back up on a cyclical basis. The irony in our view is that achieving the hallowed 8% ROE is not even that hard for companies to achieve. Management teams have a number of levers to improve ROE – such as negotiations with suppliers, share buybacks and reducing unnecessary expenditure such as travel costs – but have traditionally shrunk from pulling them. The pandemic has provided opportunity to move the pendulum back towards a healthy centre ground.
We believe this ought to benefit that segment of the market where returns are lowest and most easily improved through self-help, which are typically value stocks, and provide a medium-to long-term driver of value outperformance.
Patience has been a virtue, but rapid change has emerged
In investing, patience can be a virtue. This is especially true for Japanese equity investors, who could have been forgiven for giving up during the 30-year period since the previous market high. Ever since the collapse of the Japanese property bubble in the early 1990s, investors have been slow to enter and quick to exit Japanese equity positions. However, as the evolution of the governance landscape continues to evolve rapidly and significantly over the next few years, global equity investors may find a corporate landscape more willing to maximise outcomes for shareholders than ever before.
 Source: Bloomberg data of aggregate Topix Operating and Net Profit Margins as on 17 September 2021. ‘Corporate sector’ relates to the sum of constituent companies within the Topix index
 Value stocks outperformed Growth stocks between 1980-2009, according to Russell/Nomura Japan Equity Indexes.