Written by Michael Kretschmer, Senior Portfolio Manager Small Cap Strategies at Van Lanschot Kempen
Despite the Japanese stock market recently breaking long-standing record highs this year, we believe there is more in store for Japanese equities, in particular for selected small-cap investments.
The recent surge in equity markets has been driven by earnings growth and significant corporate governance reform. In our view, the largest impact of these ongoing reforms is still to be fully realised.
Plethora of Japanese small caps overlooked by global investors.
Japan has more listed companies than the United States, including a vast small-cap universe with attractive investment targets. Most are overlooked by global investors who pay little attention to the long tail of these under-researched investment opportunities. With more than 3700 companies listed on the Tokyo stock exchange, less than half are followed by institutional analysts.
Still, over the past decade, the Japanese equity market has experienced a strong revival, propelled by low starting valuations, improving profitability and a surge in shareholder returns. In our view, this has been largely driven by improving corporate governance, gradually introduced by the Japanese regulator since 2012.
This has created a unique set of opportunities with companies now more open to advice from specialised investors who are willing to share their global expertise and best practice to improve shareholder value. While this already has had positive outcomes, the full potential is yet to be achieved.
Why Japan’s corporate governance needed to change
Japan’s population is aging and its workforce declining rapidly. Therefore, for Japan it is a matter of national security to increase its capital and human resource productivity. Without drastic reforms it would be a challenge to maintain current living standards.
Historically, Japanese corporate governance has been characterised by a focus on stakeholder interests, including employees, customers, and society at large. Although this approach nurtured stability and harmony within organisations, it often resulted in opaque decision-making processes and a lack of accountability to shareholders.
In addition, due to its cultural and language barriers, Japan’s corporate board rooms are partly isolated from the rest of the world. Additionally, Japan does not have a well-developed Private Equity or Venture Capital infrastructure, and until recently, most companies we engaged with would not understand the concept of return-on-invested-capital.
Acknowledging the situation and to enhance corporate governance standards, Japan regulators and policymakers have set out on a journey of much needed reform, initiated by the late Prime Minister Abe in 2012. The introduction of the voluntary Corporate Governance Code by the Financial Services Agency in 2015 aimed to promote transparency, accountability, and shareholder engagement among listed companies.
More regulations and guidelines have been introduced in later years. For example, in January this year the Tokyo Stock Exchange began issuing a list of underperforming companies which they now distribute monthly with the aim of enforcing compliance to improve capital allocation.
Engaged shareholders can act as a catalyst to further accelerate change.
Supported by Japan’s reform agenda investors are increasingly reinforcing what companies have been told by Japanese regulatory bodies and provide suggestions on how it can be achieved.
To enhance shareholder returns, investor engagement priorities with companies are focusing on themes such as independent and diverse board composition, greater transparency around executive incentivisation and renumeration, improved reporting and communicating, and more comprehensive capital allocation policies, including a meaningful and sustainable improvement in ROE.
Japan is known to be a traditional society and with that, Japanese corporates take time to change. While this has frustrated global investors, the steady shift towards transparency and accountability has now hit an inflection point. The number and amount of share buybacks has drastically increased and with it, valuations expanded. Furthermore, board members increasingly recognise that their actions have a positive impact on the company’s share price and that awareness can become a self-sustaining process.
Japanese small caps hold further valuation upside
In Japan we still see considerable valuation upside as further governance enhancements are implemented. For instance, quality companies in Japan tend to be overcapitalised, with significant cash on hand and cross shareholdings. Investor engagement work which advocates for higher dividend payout ratios and share buybacks to effectively deploy excess capital can enhance shareholder returns.
The corporate governance revolution also marks a significant milestone in the country’s economic evolution. Japan’s revival extends beyond its equity market: the country has seen a boom in tourism, an increased popularity of Japanese consumer products and a ubiquitous presence of its design and manga. Japanese brands have become synonymous with quality, engineering excellence, customer satisfaction and durability.
With Japan embracing a new era of transparency and accountability, investors have the opportunity to participate in a market that is becoming increasingly aligned with global standards.
By understanding and navigating these changes, we can capitalise on the potential long-term re-rating and value creation offered by Japan’s revitalised corporate governance landscape.
