By Gerard Cawley and Chris Smith, managers of the Polar Capital Japan Value Fund
Japan is changing. Its corporate governance is improving. It has been for some time yet investors we speak to are often surprised when we highlight the progress made over the past decade and its impact on investor returns. We often hear that the progress is slow and, while we have sympathy with such views, we would argue that the benefits from such changes are accelerating and when you combine this with the vast ocean of value locked away in Japanese companies, the opportunity to investors going forward remains significant.
The historical criticism of Japanese companies has been fair. It was a market that on a widescale basis highlighted the agency risks associated with being a shareholder. Management teams, often with little skin in the game, prioritised the social gratification that came with running large, listed businesses over their shareholders’ desires for efficiency. As a result, we saw companies racing to expand their top line, often through poorly thought-out M&A, while paying little attention to profitability.
There have, of course, been attempts to change this. On multiple occasions over the years, we have seen foreign investors come to Japan in their attempt to change this before retreating with their tail firmly between their legs. The most notable bout of excitement came with former Prime Minister Junichiro Koizumi (2001-06). He was a maverick, certainly by Japanese standards, and enticed the international investor back to the land of the rising sun with his promises of change and untapped reward. Alas, it again ended in disappointment.
Despite the many setbacks, Japan’s central desire to change did not recede but, clearly, a new method of attack was needed. It was Shinzo Abe, who was so tragically assassinated last month, who decided to lead the fight. The solution was simple – if shareholders keep rejecting change, the shareholders must change. The problem children within the shareholder structure, supportive cross-shareholders (suppliers and customers) and friendly domestic intuitions, were to make way for a more aggressive and interactive shareholder. The tools to achieve this came in the shape of the Corporate Governance Code and Stewardship Code.
In reality, both came in the form of a series of small, incremental changes that cumulatively add up to a significant change in direction. The changes were modest to start and even resisted within some facets of corporate Japan. The past few years have, however, been instrumental and we continue to see an acceleration in corporate reform. We have moved from management teams that would refuse to speak to international investors now approaching us – sometimes even for advice – which is a huge change from them not being at all interested in what we, as an overseas investor, had to say. Although the asset allocators have been slightly slower to recognise this change, the private equity market started raising capital some years ago to take advantage of this opportunity and we changed the mandate of the Polar Capital Japan Value Fund to target the same.
We are now almost 10 years past the inception of Abenomics. The Japanese equity market has made an annualised return of over 12% (in yen terms) during this period which, while not as strong as in the US, is a very credible return and better than most other developed markets.
In marathon terms, this change process has just passed the halfway point. It has not been as fast as any of us had hoped but it has continuously moved forwards. The next five years are about reaching the finishing line, along the way targeting those areas of corporate governance that still need to be cleaned up. Japan still has too many cross-shareholdings and poor capital allocation; board structures have improved but not to the extent they could and we believe there is still plenty more value to be unlocked in this opportunity.
As with the past decade, we are expecting to see slow, steady progress. A revised corporate governance code is already underway and proxy advisers are being more aggressive with company managements who continue to hold cross-shareholdings. In April, there was a much-needed restructure of the Tokyo Stock Exchange (TSE) to help it back to being the world leader it once was, with the introduction of the TSE Prime, Standard and Growth markets. This impacted 45% of the constituents in the TSE first section with around 350 companies evicted and 600 needing to change to remain. It is yet another good example of a small change that will eventually lead to a considerably larger change.
Change brings with it opportunity, and that is the message to leave you with. Japan is going through a process of change that has generated good returns for investors and we believe it will continue to do so. After two decades in the wilderness, we feel Japan should once again get a seat at the asset allocation table.