The Heisei era began with the jarring transition from the post-war growth period to the bursting of the asset price bubble in the early 90s.
The country has endured a prolonged period of economic stagnation along with the more acute shocks of the Great Hanshin Earthquake (Kobe) of 1995, the Global Financial Crisis in 2008, and the Great East Japan Earthquake and tsunami in 2011.
In spite of the surrounding turmoil, success as a portfolio manager still means being able to identify investment opportunities and beat the markets consistently over the long term.
Compared to 30 years ago, portfolio managers are today flooded with information, while facing a shifting regulatory framework and a chorus of experts constantly informing them of the `right way` to invest.
My ‘right way’ to invest is to thoroughly understand the dynamics that drive the Japanese market and its companies through painstaking fundamental research. There are no short cuts.
We believe equity markets can only be described as partially efficient over the long run, with inefficiencies in the short term that active investment managers are able to exploit.
Japanese companies' focus on profits
Prevailing opinion about the role of corporations has progressed since the 1970s when the late Nobel Laureate Milton Friedman stated that a publicly traded company’s only social responsibility is to increase profits and maximise shareholder value.
In Western markets, there has been a transformation in collective attitudes towards capitalism and the responsibilities of publicly traded companies.
The global financial crisis in 2008 was a watershed moment, and the coronavirus pandemic could be another one. Maximising profits at all costs is no longer enough.
Compared to 30 years ago, portfolio managers are today flooded with information, while facing a shifting regulatory framework and a chorus of experts constantly informing them of the `right way` to invest. Japan has been an outlier, where corporate governance has historically revolved around banks.
Japanese corporations typically had fewer sources of financing outside of the banking system, and so it was common to build long-term relationships with their main banks. Corporations were more dependent on bank financing, leaving many to focus on the priorities of their lenders rather than their shareholders.
Alongside this dependence on bank financing, a unique system of cross- shareholdings also evolved in Japan, whereby interlocking share ownership between Japanese companies effectively blocked hostile takeovers.
Cross shareholding had become a longstanding practice and allowed companies to ignore outside shareholders’ interests.
The end result was a lack of transparency and accountability from Japanese companies.
In Western markets, there has been a transformation in collective attitudes towards capitalism and the responsibilities of publicly traded companies.With Japan’s closer integration into global capital markets since the “Big Bang” financial liberalisation reforms began in 1996, the influence of banks has waned over the decades.
In 2018, revisions to the corporate governance code were introduced to challenge these cross-shareholding relationships; they required companies to provide justification for holding shares and offer plans for the unwinding of their holdings.
In many cases, senior executives in Japan have only recently started to appreciate the importance of shareholders.
Driven by the corporate governance code and the growing stake in Japanese companies held by international investors, there has been a huge shift in the mind-set of chief executives.
They are now increasingly under pressure to produce returns and are accountable to outside shareholders.
From my perspective, Japanese companies only started to shift their focus to profit maximisation following the collapse of Lehman Brothers in 2008.
Typically, they had chased revenue and market share growth.
Abenomics was also a catalyst for corporate governance reforms, and these are likely to be part of its enduring legacy. Return on equity levels have started to increase, and are now comparable with those of western equity markets.
Two major changes have supported these developments, particularly in the manufacturing industry:
1. Shift in Cost Structures
In the manufacturing industry, the systematic hiring of high school graduates as permanent employees was superseded by the hiring of temporary and contract workers.
With temporary workers comprising an increasing share of a more flexible workforce, the cost of labour shifted from a fixed cost to a variable cost. This enabled companies to adjust and lower their cost base.
2. Rise of China
Thirty years of rapid economic development has generated a huge increase in demand from neighbouring Asian countries.
Japanese listed companies have flourished, boosting profits from the growth of neighbouring Asian countries - by 180 percent since the late 1990s - while Japan's nominal gross domestic product increased by a mere 4 per cent during the same period.
Exports of plant and equipment have grown, and consumer goods manufacturers have also benefitted from the emergence of a new middle class in the developing economies of Asia. Offshoring of production has been another consequence of the rapid economic development of Japan’s closest neighbours.
Besides focusing on increasing returns, companies have also strengthened their investor relations.
If a company’s willingness to hold meetings with investors is a barometer of how “shareholder- friendly” it is, then we have definitely experienced a warming of corporate attitudes to institutional investors and a greater willingness to engage.
The role of corporations and stakeholders
To a certain extent, I agree with Milton Friedman`s view on the role of corporations. A corporation can only sustain itself in the long run by remaining profitable and by satisfying its stakeholders.
The key difference is that I also believe companies have a wider role and must operate as part of broader society. Their ability to add value goes beyond making money for their shareholders.
A sustainable company should be profitable by selling goods and services that are relevant to consumers, thereby benefitting society.
Japanese listed companies have flourished, boosting profits from the growth of neighbouring Asian countries.Likewise, there are companies that do little to mitigate their negative externalities, and there are firms that engage in business practices that are socially or environmentally harmful. This is not a sustainable way to manage a company, and these are the companies we tend to avoid.
Employees as key stakeholders
Employees are long term internal stakeholders that are deeply vested in the sustainable success of the companies they work for.
They share a common concern with their employers and as internal stakeholders, are critical to the long-term success of their companies.
After all, a job can be more than just earning a living, for many it also provides a sense of belonging and purpose.
On the other hand, although we do invest for the long term, the fact is that shareholders are generally able to enter or exit positions relatively easily, in contrast to the longer-term commitment of employees of the companies we invest in.
Employees are key internal stakeholders, and I believe that a company with committed employees that are appreciated and take pride in what they do at work, will eventually lead to top line growth and profitability.
Employee satisfaction is therefore just one of several non-financial metrics that can determine a company’s investment performance over time.
ESG perspectives from Japan
Japan is often said to be behind the rest of the developed world in ESG practices. However, the reality is more nuanced, and so it is worth examining the historical context.
ESG as a concept took some time to gain traction in Japan, and has taken a slightly different trajectory.
The focus on corporate governance has been promoted by a strong official push from the Abe government.
The Stewardship Code and Corporate Governance Code introduced in 2014 and 2015 respectively are having a material impact on attitudes of Japanese corporate management. However, efforts remain underappreciated in many other areas, particularly with regard to the environment.
A new generation of leaders
Governance is crucial to the sustainability of a company and can determine corporate environmental and social behaviour too.
Over the course of my career, I have met senior executives who were unwilling to take account of the interests of shareholders, and some that even lacked basic understanding of the financial markets.
There has been a major push to improve corporate governance in recent years, and a new generation of energetic, result-oriented leaders has entered Japan’s boardrooms. I am more convinced that corporate Japan is no longer being run by those who shun their shareholders.
There is some hard evidence to support this given the rising number of M&A deals we have seen over recent years, and the trend towards the consolidation or disposal of listed subsidiaries.
Parent-subsidiary listings and cross-shareholdings have diminished as these improvements in governance have taken hold.
Japan is often said to be behind the rest of the developed world in ESG practices, however, the reality is more nuanced.In terms of corporate governance reforms, putting committees in place and taking steps to improve diversity of the board are extremely important, but ultimately, the effectiveness of governance measures should only be judged by their results.
From my perspective, a way to confirm the effectiveness of a board is, quite simply, whether or not the board is able to fire its chief executive.
I frequently meet with the top management of companies with the aim of understanding their businesses and corporate strategy.
And they are increasingly coming to me and my colleagues to seek advice on promoting positive corporate behaviour that benefits both the company and its shareholders. I expect this trend to accelerate going forwards.
The true meaning of governance
In Japan, governance is still the main focus of ESG, and from my experience of engaging with Japanese companies, past performance does serve as a guide to future performance.
I steer clear of companies with weak management teams and poor corporate governance.
I have made mistakes early in my career of taking a contrarian view on companies that have been involved in corporate scandals, believing they had repented, reorganised and would recover in the long run. If there is one thing I have learned the hard way,
it is that corporate culture does not change overnight.
Masaaki Tezuka is chief portfolio manager at Japan Active Core Strategy
