Investing in Japanese equities can be frustrating because the managements of many Japanese companies don’t seem to care about their shareholders. They do not bother communicating to their shareholders about the current business environment or what they see for the company ahead. It is all in the culture. As our Japanese analyst noted, the top management of a Japanese company have usually worked at the same company all their lives and have slowly risen through the ranks to the top by strictly following the rules. They are not entrepreneurs. When such a person becomes a President of a company, his/her main objective is not to do anything stupid to endanger the existence of the company (avoid shame) and to strengthen the company the best they can so that they can pass it on to the next generation in good condition. The shareholders of the company or the stock price are not their priorities. They have an interest in preserving a long-term corporate value. If this includes conservative management, piling up capital for a rainy day, and various other poor capital allocation decisions that annoy investors, so be it. This description certainly seems accurate from our experience.
Changes in culture could help
Japanese companies have notoriously low returns on capital, there’s a lifetime employment system with people working at the same job all their lives, and protectionist cross-shareholdings are widespread. Nikkei 225 companies have the lowest median proportion of independent directors (26%) and female directors (0%) and the oldest average age (63.2 years) among developed-market peers. So the boards of directors are packed with yes-men who just want to serve out their term quietly and not cause any trouble. That’s partly the reason why we had such big Japanese corporate implosions recently like Olympus and Toshiba. Nobody questioned the CEOs decisions.
Partly because of low returns on equity, the Nikkei 225 index is still nearly one-half of its 1989 peak, although currently the index hovers close to its 2-year high. Japanese companies’ ROE stands at around 7-8% while the global standard is above 15%. In a recent interview Seth Fischer, who is the founder of Hong Kong-based hedge fund Oasis Management which invests in Japan, said “With better governance, I believe comes increased margins, much more efficient use of balance sheets, which would dramatically increase ROEs (return on equity), which would, I believe, more than double the Nikkei over the next three to five years”. Potential changes in culture could unleash a sea change in valuation of Japanese equities.
Corporate governance reform
There has already been some improvement in recent years. The corporate governance reform is being pushed from above – by the government. The reform – pushing companies to increase outside board members and encouraging more dialogue between shareholders and company management – has been a key part of Japanese Prime Minister Shinzo Abe’s drive to revive the economy, along with monetary and fiscal stimulus. This is Abe’s third arrow. The government also encourages investors to be more forceful in prodding companies to increase returns. There has been an increase in activist campaigns and acquisitions in Japan. There has also been a pickup in share buybacks by companies. Considering that shares of many Japanese companies trade at or below book value, share buybacks are an attractive and underutilized way to deploy cash that many corporations prefer to simply hoard. Shareholder proposals and votes signalling disapproval of management or of external directors are becoming more common. The Tokyo Stock Exchange, too, is pushing for better governance by introducing new corporate governance rules for public companies and has launched a JPX-Nikkei index of 400 companies, chosen for their higher returns on equity and strong governance. These are all only baby steps but in the right direction.
How Japanese sending down the stocks
One aspect of Japanese corporate culture which we have found especially troubling, and which isn’t talked about at all, is the way management issues earnings guidance for the present year. True to their nature of being ultra- conservative stewards of a company for future generations, the management does not try to issue an accurate earnings guidance. Instead they issue a low-ball number that they can definitely beat (avoid shame). This behavior is true everywhere but in Japan takes on an extreme nature, almost as though they are providing a worst case scenario. We discover and research these companies thinking they are a good investment and the company indeed does very well operationally, but then at the end of the fiscal year they give an awful forecast for next year sending the stock down instead of up on recent good results. And then they carry that awful forecast for a long time, the stock goes nowhere and what should have been a good investment languishes with no gain and all credibility of the company is lost Again and again, year after year they do this, and finally as a shareholder we cannot take it anymore. In many cases we had failed to make any money for our investors when the company has actually been very successful, but not its stock price. One would imagine that the market would see through these biased forecasts, but in practice we have found that instead it places a cloud over the company’s prospects and management credibility that impacts valuation.
The change in corporate mind-sets will take time, but government officials acknowledge the problem and are taking steps to address it. So foreign investors have to be patient and communicate with the government. Although at a very slow pace, things are moving in the right direction in corporate Japan.
By Vaidotas Petrauskas, ZPR Global Equity Fund