Earnings growth in Japan has been comparable with the rest of the world over the last decade. Margins whilst lower have been on an improving trend. The obvious weakness has been the management of balance sheets and general levels of corporate governance. In a word, poor capital allocation.
All experienced investors in Japan are aware of these weaknesses and the prospect of improved governance and capital allocation have been an enticing prospect for decades, but one which has sadly been slow in being realised.
Finally, these reforms offer a real prospect for significant change and a great opportunity for investors.
What has the TSE said?
The TSE is asking all companies whose Price Book Ratio (PBR) is consistently below 1x to explicitly disclose plans to improve including specific targets related to profitability and market valuation. Moreover, companies will be required to update investors on progress against these targets at least once a year. The TSE themselves estimate approximately half of companies listed on the Prime market have an ROE of below 8% and PBR below 1, indicating they may be destroying corporate value.
This represents the headline, but the small print includes encouraging a better understanding of the cost of capital, improved adherence to the corporate governance code, the role of non-exec directors, better dialogue with investors (and explicitly helping overseas investors with English disclosures) and other supportive policies. All in all, this is a major step forward for Japanese governance standards.
And the government is fully supportive. The Kishida Government is aiming for more domestic savings to be invested in the stock market and wants the companies to offer a better prospect for returns. Meanwhile it has been reported that the Financial Services Authority is also looking at similar measure to encourage better results.
The Kishida Government is aiming for more domestic savings to be invested in the stock market and wants the companies to offer a better prospect for returns.
What could happen?
There is no fixed date yet specified, but a prompt response is requested, and given the majority of companies have year-end results, analyst meetings and AGMs coming up over the next 2 months we would expect most companies to have something to say on these matters. In our interpretation this will put enormous peer and social pressure on companies to come up with credible plans and make efforts to achieve them.
Any board who falls into this category sitting over the coming months will surely be thinking about what an appropriate response could be. For those companies sitting on far too much cash and with large amounts of cross shareholdings causing a disappointing return on capital the answer would appear obvious. Restructure the balance sheet and buyback stock. All else held equal, this raises the PBR and return on equity in one simple move and also provides additional buying support.
It is worth noting that the TSE makes explicit comment that they want these measures to extend beyond one-off short-term measures – i.e. buybacks, to sustainably increase profitability through the business operations. However, we suspect buybacks and dividends will play a major role in the first steps to improvement.
Whilst the proposals were still in draft form, we have already seen some pretty dramatic examples. In February Citizen Watch announced a Y40bn buyback, worth 21% of market capitalisation at the time. The shares rose 40% in a few days. Dai Nippon Printing, under activist pressure, announced a plan for a ROE over 10%, PBR above 1 and the largest buyback in company history. The shares rose 15% the following day. NOK Corp announced a buyback of Y67.5bn, accounting for approx. 25% of market cap. Furthermore, they will sell 25% of their cross shareholdings (worth Y110bn against market cap at the time of Y267bn). The shares rose 15%.
These remain isolated cases and as the TSE notes in many cases one off buybacks are insufficient. But it is easy to see how this becomes something which is expected of management teams and pressure builds for improved capital allocation. Naming and shaming is the stick, improved corporate performance the carrot. And we do not think this is a one-off event, companies will increasingly be disclosing these plans on a regular basis with improving returns across the board.
What are we doing?
The Martin Currie Japan Equity strategy is unconstrained and seeks out the best opportunities arising from long term structural changes to Japanese society and economy. In most circumstances this means investing in high quality companies with sustainable growth prospects resulting from those structural changes. Whilst the quality and growth metrics will look different, this is a very significant long term structural change and a great opportunity for investors, and we intend to have exposure to benefit.
We will also engage with all the companies which fall into this bucket to encourage improvement, balance sheet restructuring, greater shareholder returns and good disclosure. These positions will be relatively small as a percentage of the total fund but offer an exciting risk-reward opportunity.
And we are not simply buying low PBR stocks. We are concentrating on companies with seriously underleveraged balance sheets, where cash and cross shareholdings make up a substantial portion of market cap, so they have the ability to improve via balance sheet restructuring. Furthermore, all the companies we are considering are profitable and have business whose returns are reasonable based on the actual capital employed (excluding the excess) and with businesses with strong brands / market positions etc, so the underlying businesses also have long term potential when managed well.
In our view such companies have limited downside risk, whilst the upside from substantial improvements is significant – a skewed risk reward which is hard to ignore.
1Source: Morningstar, 31 March 2023 unless otherwise stated.
Regulatory information and risk warnings
This information is issued and approved by Martin Currie Investment Management Limited (‘MCIM’), authorised and regulated by the Financial Conduct Authority. It does not constitute investment advice. Market and currency movements may cause the capital value of shares, and the income from them, to fall as well as rise and you may get back less than you invested.
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Past performance is not a guide to future returns.
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Risk warnings – Investors should also be aware of the following risk factors which may be applicable to the strategy shown in this document.
- Investing in foreign markets introduces a risk where adverse movements in currency exchange rates could result in a decrease in the value of your investment.
- This strategy may hold a limited number of investments. If one of these investments falls in value this can have a greater impact on the strategy’s value than if it held a larger number of investments.
- Smaller companies may be riskier and their shares may be less liquid than larger companies, meaning that their share price may be more volatile.