Ahead of the Curve: Japan’s best is yet to come
A genuine change in corporate governance culture at Japanese companies will underpin good economic fundamentals, believes Richard Kaye
Japan has been outstanding in terms of earnings growth and earnings revisions over the past two years and the fundamentals look compelling for the future. In 2015, the Nikkei passed 20,000 points for the first time in 15 years. However, there is concern that this growth might not be sustainable bacause of poor domestic corporate governance.
The criticism of Japanese governance is based on three factors. These are that: companies often have low return on equity (RoE) and dividend pay-out ratios; the high tax threshold causes them to be less profitable; and Japanese corporations are run for their stakeholders, not their shareholders. Each of these arguments can be turned on its head.
Historically, Japanese companies have had low RoEs and dividends when compared with other large equity markets. This has been due to a higher corporate tax rate, fiscal incentives to invest rather than pay dividends, and much less financial leverage.
However, there are signs of improvement. Dividends paid by Japanese corporations have increased from ¥9trn (€65.2bn) to ¥23trn over the past 10 years, which is a compound annual growth rate of 10%. As of today, the dividend yield for Japan is at 1.7% versus 1.9% for the US.
Prime Minister Shinzo Abe is pushing for reforms and his ‘third arrow’ may be most beneficial to domestic companies, with a focus on microeconomics and corporate governance.
In Japan, the average corporate tax rate stands at 35% of pre-tax profits versus 24% for the US, 20% for Europe and 23% for emerging markets, excluding financials. Abe’s plan to cut corporation tax to 25% by 2017, could become a long-term stimulus for Japanese equities.
Corporate tax reform would include the reduction – or even abolition – of capital gains tax levied on cross-shareholdings. This happened in Germany at the beginning of this century.
In the old German ‘Hausbank’ model, banks frequently held stakes in corporates they lent to. The abolition of capital gains tax under the Schröder government led banks to sell down these stakes and free supervisory boards, driving corporate governance from shareholder instead of debt interests.
A similar process could lead to a reduction in cross-shareholdings in ‘keiretsu groups’ in Japan, such as Mitsui, Mitsubishi or Toyota. Accounting for these groups dilutes RoE, as subsidiaries are recognised without any consideration of their debt. They also alienate foreign investors as they represent a ring fence of compliant shareholders that fosters complacency.
The new Corporate Governance Code (CGC) of June 2015, obliges companies to disclose their policy on cross-shareholding structures. This is a good beginning.
Japan is known for its philosophy of ‘Wa’, meaning the search for harmony in society. As a result, companies are run for their stakeholders, comprising employees and suppliers. This explains why profitability targets, or payout ratios, are not the prime objectives of running a business in Japan. This is now changing with the CGC aiming to improve RoE over time. The CGC obliges the board each year to examine the economic rationale and future outlook for any existing shareholdings. It also requires at least two independent directors to “significantly enhance the possibility that their presence will be fully leveraged”.
The CGC also requires institutional investors to engage with companies to enhance long-term returns and to act as responsible investors. Its principal objective is to enhance the dialogue between companies and shareholders by homing in on the investors’ role within corporate governance. After a wide consultation with its clients, for example, ISS (the global leader in proxy voting) has recommended voting against the renewal of directors of companies with RoE below 5% for five years or more.
On a recent trip to Japan, we met 20 companies at top management level as well as industry experts and politicians, to discuss governance and ESG issues. Many companies are just starting to embrace the idea of corporate governance, and we genuinely believe that this time it is different. Change is happening – 1,300 companies in the Nikkei now have at least one independent or outside director, up from 844 last year.
Cultural differences will continue to exist, but growing a company requires capital returns, which shouldn’t be a question of culture. Japan doesn’t need to follow the Anglo-Saxon way, but it has to improve governance to succeed.
Richard Kaye is portfolio manager for the Comgest Growth Japan fund