On the face of it, the picture in Japan is still not rosy. The main Japanese stock market index, the Nikkei, reached a high of around 38 600 in December 1989 before embarking on a 13-year painful slide down to 7 600 in April 2003, losing over 80 percent of its value. Today, at 21 300, the Nikkei index is still trading 44 percent below its peak.
To put things into context, it is important to remember that after World War II, Japanese companies sought to secure their workforces by introducing life-time employment with pay deals that promised ever-increasing wages and promotions until retirement. While this may have achieved its goal in the short term, combined with a rapidly aging population, it proved to be lethal for the long-term health of corporates.
Abe and the three arrows
Following the stock market crash of 2003, the Nikkei index hovered around 10 000 until December 2012 and the election of Prime Minister Shinzo Abe. Abe introduced reforms popularly known as “Three Arrows”. These were namely fiscal policy, monetary policy and structural reform, or “revitalisation”. While the first two arrows have brought about economic stability, the third has yet to make a major impact. Nevertheless, the third arrow is the most powerful as it sets out to fundamentally change corporate Japan.
Risk aversion
The Japanese are risk averse by nature; they save in cash or bonds with little or negative interest and companies are no different. We learnt that this risk aversion is born of a wish to guard against potential external shocks – whether economic, geopolitical or climate-related – as well as against internal misconduct, which could have costly consequences. The corporates’ cash hoarding has resulted in so-called “net-net” companies; companies whose stock exchange valuation is exceeded by that of its cash holdings and holdings in other listed and unlisted companies. Missed corporate opportunities and inefficient capital allocation have led to countless value traps in the past, disappointing global investors for long periods of time.
What makes it different this time? As we see it, a fundamental difference now is that demand for change is coming from the government itself, whose reforms are dependent on the actions of corporates in order to revitalise the economy.
A delicate balance
The third arrow depends on cultural change and this is not as quickly resolved as ordering a new highway or lowering interest rates. Changing culture takes time. While there is a sense of urgency, this needs to be balanced with a need to respect honourable elders which lies at the heart of Japanese society; it is a delicate challenge.
The government has introduced some minor labour reforms in terms of part-time work and short-term employment as well as supported a new Stewardship Code for investors and Corporate Governance Code for corporates. The latter is having a measurable impact already and the general principles can be summarised as follows:
- Securing the rights and equal treatment of shareholders
- Ensuring appropriate information disclosure and transparency
- Engaging in constructive dialogue with shareholders
- Understanding the responsibilities of the board of directors in terms of setting the strategy, supporting appropriate risk taking and carrying out effective oversight
Cautious optimism
So what kind of changes do we see taking place in corporate Japan? There is a noticeable increase in the hiring of more independent directors with relevant competencies, the training of directors (research shows that Japanese board members have frighteningly little understanding of basic financial concepts) and the hiring of investor relation professionals to improve dialogue with investors. The hope is that with the larger corporations in the lead, the principles will gain traction and create a watershed moment across corporate Japan.
While we are optimistic, we recognise that fundamental principles of corporate governance, such as the equal treatment of shareholders, alignment between management and shareholders and effective dialogue with investors, continues to be absent from many listed companies.
Opportunities for active value investors
However, the tide is turning and revealing a number of opportunities. With the sheer number of “net-net” and close to “net-net” companies with significant potential for self-help, Japan is a Mecca for true value investors like SKAGEN. Change cannot happen without engagement from the investor community though, which is why active investors such as ourselves have an important role to play, through dialogue with companies and networks as well as demands for change.
As unconstrained and active investors, we also have the advantage of being able to pick the most attractive opportunities present in the market, amidst an unfolding (r)evolution of improved corporate governance, to the benefit of our unit holders.