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Land of the rising capital returns

Land of the rising capital returns

13-11-2019 | Insight

Japanese companies are gradually getting better at creating value for investors, Robeco’s engagement work has shown.

  • Ronnie Lim
    Ronnie
    Lim
    Senior Investment Specialist at Robeco Hong Kong
  • Michiel  van Esch
    Michiel
    van Esch
    Specialist Governance and Active Ownership

Speed read

  • Investors face insufficient returns on capital and low dividends
  • Engagement work is slowly improving corporate governance
  • New governance code and Abenomics are also raising the bar

In the land of the rising sun, achieving a rising share price is often blocked by a cultural adherence to hoarding money rather than returning it to shareholders. Part of the problem is that the country has lacked the corporate governance standards that protect investors in the West.

In 2015, Robeco’s Active Ownership team began a research project that aimed to improve governance and thereby enhance returns on Japanese investments. These efforts are now bearing fruit, though engagement is continuing with 10 companies and some sticking points remain, says Michiel van Esch, Engagement Specialist and co-author of the project.

The main problems are insufficient returns on capital compared to the West. These are often caused by poor capital allocation practices, such as companies hanging on to unprofitable business segments that should be sold or closed, he says. More general governance problems include low levels of qualified independent directors, a lack of understanding of duality between management and supervision, and poor communication with investors.

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Return on invested capital

“In order to achieve sustainable economic value creation, a company’s return on invested capital (ROIC) should exceed its weighted average cost of capital (WACC),” says Ronnie Lim, Senior Engagement Specialist in the region. “Our analysis concluded that the majority of companies had poor capital management, with 70% of 2,000 TOPIX companies having a five-year negative return on their ROIC when compared with their WACC.”

“Although companies’ dividend payout ratios have risen by 29% over the last five years, their debt-to-equity ratios have declined by 14.4%. Therefore, the growth in returns has barely kept pace with the growth in earnings per share and cashflow.”

“The current dividend payout ratio of 35% is only just above the post-Abenomics average. The lack of progress on this measure helps explain why there has been little reduction in cash on balance sheets, despite large increases in earnings per share and dividends per share.”

Dividends are improving

“More encouragingly, the total payout ratio (including net buybacks) as a proportion of net profits has increased for the TOPIX to 46% in the second quarter of 2019 from 34% in the fourth quarter of 2017. However, this still remains well below Europe (75% for MSCI Europe) and 105% for the largest 500 US companies in the first quarter of 2019.”

Engagement has been conducted with 10 companies that aimed to:

  • Improve communication through higher quality disclosures, providing clear guidance for investors
  • Protect shareholder rights and align a company’s incentives with those of investors
  • Increase the number of independent board members, and
  • Prioritize sustainable value creation by seeking more robust strategies on capital allocation

“Of the five companies where we were effective in our objective of shareholder rights, three of these companies (in industries ranging from automation equipment to sports apparel) have also made improvements in creating shareholder value over the period of engagement,” Lim says.

“Tangible actions that the companies have made include the disposal of low-return investments and consistent share buybacks. These have led to steady increases in their return on equity in three out of five cases, and a flat-to-improved valuation in the price-to-book ratio in four out of five cases.”

Buybacks trend is positive

“The trend of share buybacks is also very positive – in 2018, Japanese companies announced share buybacks of USD 55.6 billion, which exceeded the previous record of 2016 by 4%. The first half alone of 2019 saw announced buybacks totaling USD 53 billion, more than double the level in the first half of 2018.”

“With all other factors being equal, such buybacks reduce the over-capitalized levels of Japanese balance sheets, thus improving their return on equity, ultimately encouraging investors to value those companies more highly.”

But there remains some work in progress, particularly on subjects that are deeply ingrained in Japanese culture, Lim says. “One of the more intractable issues remaining is the slow pace of companies prepared to dispose of unprofitable or low-return assets (including cross-holdings) for reasons attributed to retaining business relationships,” he says.

Governance Code is working

Business practices on the whole have improved since the introduction of the Japanese Corporate Governance Code in 2015, while investors have become more assertive in their roles as owners of the companies, particularly when voting at company meetings. Robeco, in common with other investors, now blocks resolutions that include the reappointment of directors, if progress is not being made.

“Momentum is also gathering amongst investors exercising their fiduciary duty, as we’ve seen an increase in the number of shareholder proposals,” Van Esch says. "These developments are positive, and we are hopeful that the under-valuation of Japanese companies will narrow compared to other developed markets.”

Meanwhile, the ‘three arrows of Abenomics’ introduced by Prime Minister Shinzo Abe in 2012 – monetary easing, fiscal stimulus and structural reforms to combat an aging population – are also kicking in.

Abenomics means reforms

“Abenomics’ ‘three arrows’ represent a bold move to invigorate corporate Japan, and to enhance returns for investors in Japanese companies,” Lim says. “A key requirement for the success of structural reforms includes institutional investors engaging in constructive dialogue with companies to create financial strategies that support sustainable value creation.”

“These strategies are aligned with recommendations by Japanese institutions and include measuring the true cost of debt/equity, setting appropriate hurdle rates for specific categories of businesses and assets, and making realistic assumptions about risks and returns.”

“We have seen progress in disclosures and communication with investors, yet there is still much more work that needs to be done by investors to encourage companies to adopt a discourse of financially ratio nal strategies.”

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