For too long, poor corporate governance has held Japan back in the global race. But with shareholders beginning to speak up, and companies starting to listen, this could be set to change.
As recently as 2013 nearly 600 of the 1400 largest listed companies in Japan had no outside directors at all. Not only does this compare unfavourably to other large developed markets, but even less established markets like South Korea, China and India are all way ahead of Japan in this regard. Even where outside directors were present they were often far from independent and frequently tame: unable or unwilling to hold management to account. For minority shareholders – those with no direct board representation of their own – this is a huge problem, allowing management to behave with little consideration for their best interests.
The detachment of management from shareholders in Japan has been exacerbated by the timing of AGMs: in 1995 some 96% of all AGMs were held on the same day (it is now just 32%) . The reason for this was to combat sokaia – racketeers specialising in the extortion of companies by the threat of public humiliation at AGMs. The immediate effect, however, was to drive a further wedge between management and shareholders. The association made between tough questioning by shareholders and some degree of impropriety lingers in too many boardrooms.
Management compensation has been a further stumbling block. The chart below shows not only how poorly Japanese executives are paid, but also how little of their compensation depends upon their performance. This has led to a management class with few incentives to do better. It has also meant that Japanese companies have typically been unable or unwilling to hire the best foreign managers for top jobs.
Company managements aren’t entirely to blame, however. For too long too many shareholders have been accepting of poor management behaviour, automatically voting in line with management or not voting at all. One of the key reasons behind this is that many shareholders are not investors at all but rather hold shares for ‘commercial’ reasons.
Japanese management teams have been too cautious to pay out a fair share of the profits their companies make and too keen to hoard cash as figures 2 and 3 show
This timidity, combined with a general disinterest in profit maximisation has led to sub-par returns for Japanese businesses versus their global peers. Over the last twenty years return on equity has averaged just 4.7% for Japan against 13.4% for the US, 10.1% for the UK and 8.8% for Germany.
What is changing?
Happily for equity investors there are signs of meaningful change in the way Japanese companies are run. Perhaps the only, and certainly the most, successful policy amongst PM Abe’s Third Arrow of structural reform has been to improve corporate governance. The key institutional changes are the implementation of the Stewardship (2014) and Corporate Governance Codes (2015). The Stewardship Code is designed to encourage engagement between institutional investors and company management whilst the Corporate Governance Code aims to encourage better management behaviour principally through the suggestion of greater outside influence in the board room.
Both codes operate on a “comply or explain” basis, meaning they are entirely voluntary, but adoption so far has been encouraging. The giant government pension fund (GPIF) has been instrumental in improving stewardship amongst investors. The Fund’s annual stewardship survey reported that 60% of respondent companies recognised an appreciable change in investors’ engagement following the introduction of the Stewardship Code.
Meanwhile the Corporate Governance Code has had a measurable impact upon companies’ board structures. As figures 4 and 5 show that both the prevalence of outside directors and the adoption of legal committees have increased markedly.
Management behaviour appears to be changing too. From its low base overall return on equity is on the rise, though this is entirely a function of better profitability with bloated balance sheets continuing to drag. More positive is the observed explosion in proposed distributions – both through dividends and share buybacks – to shareholders (see below).
For corporate Japan the work has only just begun. Shareholders are beginning to see the fruits of the most obvious and easily quantifiable of these improvements, but the market has a long way to go. It is important that government continues the pace of reform, that companies embrace the challenge to change and shareholders fully use their ability to influence management behaviour. If this happens – and we think it will – then the terms for equity investors in the Japanese market should change for the better, for good.
Mitesh Patel - assistant fund manager on the Jupiter Japan Select Fund - Jupiter Asset Management