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Japanese equities have been shunned for their low returns on capital. As a result, foreign investors have been selling them over the last three years. One of the aims of Shinzo Abe’s government has been to make Japanese equities more appealing to international investors. A key element was to prompt investors to become more engaged with companies, to improve corporate governance and capital management. Since the launch of the Japanese Stewardship Code in 2014, we have seen modest progress.
There has been mixed progress in corporate governance reform in Japan, including an increase in outside directors, and some modest growth in shareholder returns. Investors - both foreign and domestic - are now far more actively engaged with companies in Japan. Shareholders are also voting more against management, which is a new, positive development in a consensus-driven culture.
The launch of Japan’s Stewardship Code in 2014 and the Corporate Governance Code a year later are part of the government’s push to improve corporate governance. Japan’s Government Pension Investment Fund (GPIF) announced a five-point action plan in February, which included a shift from merely monitoring their external managers to constructive communication. It also linked 10% of its Japanese equities portfolio to ESG indices. As the world’s largest pension fund, GPIF’s actions are influential and are likely to be followed by other asset owners in Japan and the rest of Asia.
Bloomberg data on the 58 Japanese domestic asset managers that disclose data, show a 30% year-on-year increase in asset managers voting against the (re)election of directions since the adoption of the stewardship code in 2014.
An important cultural feature in Japan is that companies are run for the benefit of many stakeholders, with employees and customers often having priority over investors. We have seen that the codes and engagement have increased some corporates’ receptiveness to increase corporate value.
The number of independent or outside directors has also grown substantially, with around 80% of companies having at least two people that satisfy the Tokyo Stock Exchange's definition of an independent outside director. In January 2017, Nikkei 225 companies still had the lowest median proportion of independent directors (26%) and female directors (0%) and the oldest average age (63.2 years) among their developed-market peers, according to Bloomberg data.
As outsiders, minority investors often have no real grasp of the actual dynamics of how boards operate and who holds real power. The chairs of company boards remain dominated by company chairmen or presidents, with few outside directors fulfilling this role. There still appears to be little separation between supervision and the execution of corporate strategy.
Most companies still see corporate governance as merely a compliance issue. Therefore, we believe it is crucial to talk to them about the creation of value, and we often have to educate our investee companies on how we evaluate them as financial investments.
The greater structural issue concerns the pervasive cross-shareholdings, where Japanese companies rely on long-established relationships to protect each other from hostile takeovers. This can be a real barrier for investors to pressure companies to change. Cross-holdings held by non-financial firms at the end of 2016 still accounted for 5.7% of the market’s value, compared with 6.2% in 2002, according to Nomura research. These ‘friendly’ investments depress return on equity (RoE).
For sustainable value creation, a companies’ return on its capital needs to exceed its cost of capital. Our analysis indicates that only 31% of the 2031 companies in the TOPIX Index have a ROIC greater than their WACC. In other words, fewer than one-third of Japanese listed companies created value for shareholders over a five-year period.
The majority of listed companies actually destroy shareholder value. Our meetings with companies this year revealed that several of them failed to appreciate the value of generating free cash flow, and continued making new investments with little regard for whether the returns were adequate. We find that corporate managers consider low-yielding cross-holdings a business necessity and equate high cash holdings with prudence.
Still, shareholder support for the Board is declining, and CEOs are increasingly sensitive to this. In the year following low voting support, companies appear to take action that shareholders appreciate. For instance, in April of this year, CLSA found that of the 14 companies that faced a decline in the CEO support rate to below 85% at the 2016 Annual General Meeting of Shareholders, 77% outperformed the TOPIX the following year.
Since the introduction of the Japanese Stewardship Code, investors are far more actively engaged with companies in Japan. For Japanese equities to outperform, a sustained improvement in capital management and shareholder returns is required. We continue to engage with Japanese companies on this topic.