On March 13th Fanuc, the world's largest manufacturer of industrial robots, took the market by surprise after announcing that it was moving to increase shareholder returns and intended to set up an investor relations department in an effort to start communicating with shareholders. While it would seem obvious that such a well-established company (after all the second biggest holding in the Nikkei 225 index and Japan's tenth largest company by market capitalization) should have an IR department, this news is exceptional because Fanuc was known for being notoriously indifferent to its shareholders.
Fanuc's change of heart is good news in different respects. First, after the announcement, shareholders like us benefited from a big jump in the stock price, as this decision clearly enhanced the company's investment appeal. Second, and this is certainly more important, if such a reclusive company like Fanuc is announcing such profound changes, this is a clear sign that Corporate Japan is changing and that Japanese companies are willing to step up efforts to reward their shareholders and put their inefficient balance sheets to use.
In order for Japanese companies to be able to enhance their shareholder remuneration policies and boost their earnings capacity, business attitudes have to change and improvements in corporate governance are inevitable. In a recent research report, analysts from the investment bank Nomura pointed out that, "20 years of economic underperformance have resulted in executives having lost their entrepreneurial spirit, talented staff finding limited opportunities to shine, excellent ideas going to waste and companies being unable to make effective use of their financial assets and retained earnings. Improvements in corporate governance are an important mechanism for changing executive mindsets and encouraging them to take proactive decisions that will restore the global competiveness of their companies, thereby facilitating a rise in the longer-tem productivity and profitability of Japanese companies."
Japan is renowned for having weak corporate governance
Many studies show that Japan scores low in terms of corporate governance compared to other G-7 countries. In contrast to these other countries, corporate governance in Japan rarely chimes with shareholder friendliness and many companies are not run in the interest of shareholders.
The notorious cross-shareholdings (when two firms hold each other's shares), as well as parent-child listings (where one company holds a major stake in another listed company), often lead to situations that prevent efficient use of capital and discriminate against minority shareholders. These kinds of alliances make it harder to work with firms outside the circle, leading to general inflexibility in capital allocation. While in an efficient free-market economy, business relations are forged purely on economic considerations, corporate interdependences that are too strong hinder the development of fruitful partnerships. They also lead to discrimination against minority shareholders, as business decisions are often governed by the interests of the parent companies and are not always compatible with the best possible choice in the interest of shareholder value creation.
The composition of Japanese corporate boards is also often problematic. Many boards don't include any independent external members, which can lead to the unhealthy situation where the necessary scrutiny that is supposed to be applied by an independent eye is missing and thus opens the door to corporate malfunctions. The scandal at Olympus for instance that unfolded in 2011, can clearly be attributed to a lack of corporate governance and a board of directors whose members were too close to the company. Independent directors can also help to introduce fresh perspectives and new ideas to a company and encourage the board to take proactive decisions instead of adhering to the status quo. Recent data actually shows that companies that have more external board members also put more emphasis on profitability and generate higher returns.
Relationship between ROE and the number of independent external board members of TOPIX companies
Source: Nomura, based on TSE data
Companies are starting to feel the pressure
Most investors are not willing to accept these shortcomings anymore. In the past, issues of corporate governance in Japan were largely raised by foreign investors, who for years have called for improvements in return on equity (ROE) and higher returns for shareholders. Today, domestic investors are becoming more and more concerned about the problems as well. With the introduction of new tax incentives promoting equity investments for private households and the decisions by big institutional investors like the Government Pension Investment Fund (GPIF) to significantly increase their allocation in domestic equities (see graph),Japanese investors are now far more exposed to the stock market than in the past. They have greater interest in asking their companies to raise profitability and improve shareholder returns and they are backing new government policies that push for improvements in corporate governance.
Asset Allocation of GPIF
Source: Government Pension Investment Fund, Japan
Improvements in corporate governance are indeed one of many objectives of the new government and are animportant part of the structural reforms that form the third arrow of the Abenomics program. The aim is to improve the business environment and trigger a virtuous circle in which companies' higher productivity should lead to wage increases and more sustainable economic growth.
Several important measures to improve corporate governance have already been implemented and promoted:
- The government has issued requests to stock exchanges to take steps that force companies listed on their exchanges to improve corporate governance and profitability. An index of the 400 "best" companies in terms of profitability has been established and now serves as the new benchmark for the GPIF and other large pension funds. The Tokyo Stock Exchange has also issued requirements for listed companies to appoint a least one outside director to their board.
- A new Stewardship Code was introduced for institutional investors in spring 2014, with more than 160 institutions already having subscribed to the code. Its purpose is to promote improvements in corporate governance by calling on shareholders to engage more actively with the companies they invest in, in order to enhance long term investment returns.
- The most important development, however, is the establishment of a new Corporate Governance Code. The code is due to come into effect this June and a first draft has been published. Companies are urged to adopt several principles in fields like equal treatment of shareholders, suitable cooperation with all their stakeholders, appropriate disclosure of information and improving dialogue with shareholders. They are encouraged to improve shareholder value creation, promote diversity among employees and executives and discouraged to adopt antitakeover measures.
With these initiatives and the interests of domestic investors in play, the pressure on Japanese companies to enhance corporate value and improve shareholder returns has increased. Recent developments show that more and more Japanese companies are willing to pay closer attention to shareholders. In 2014, the number of outside directors appointed to corporate boards took a big leap forward and projected total shareholder returns (dividends & share buybacks) are reaching a new record high for the first time in 7 years.
Percentage of TOPIX companies with outside directors
Source: Nomura, based on TSE data
Positive outlook for companies held in BL-Equities Japan
Companies that are highly profitable and generate large amounts of free cash flow are best positioned to improve their shareholder remuneration policy. These are also the kind of companies that are the preferred investment candidates for our Japanese equities fund, BL-Equities Japan. Due to their strong market positions, companies held in the fund have the potential to generate attractive returns and are able to create shareholder value over the long term. The recent initiatives to promote corporate governance should incite them to raise their payouts and improve the remuneration of their shareholders.
Companies like Lawson, one of Japan's biggest convenience store chains, Canon, a world-leading supplier of printers, copiers and digital cameras or Daito Trust Construction, a property company specialising in the construction of houses and apartments for the rental market, already have exemplary shareholder remuneration policies, posting a dividend yield of around 3%. Other companies held in the fund are just starting to improve. Fanuc is certainly the most noteworthy example, as historically it has been famous for not paying any attention at all to its shareholders. However, it is not the only company announcing higher payouts recently. Keyence, for example, a world-leading supplier of sensors for the automation of industrial processes, has decided to triple its dividend, while Sekisui House, one of Japan's biggest house builders, has announced plans to significantly boost its overall return ratio by focusing on share buybacks and higher dividends. Pola Orbis, a cosmetics company specialized in skincare products, returned some of the cash sitting on its balance sheet in the form of a special dividend and has plans to raise its dividend payout ratio above 50%.
Other companies held in the portfolio still have room to improve their shareholder remuneration policies. Among the 55 companies currently held, ¾ have a net cash position on their balance sheets (the amount of cash on their balance sheets is higher than their total debt) , while nine companies have a massive cash position equal to more than 20% of their market capitalization. This should give them ample room to increase their payouts, pay special dividends or buy back shares. Typical examples of companies that could improve their remuneration policies include Nitori Holdings, Japan's leading furniture chain, and Rinnai, a supplier of gas-fired household appliances. These companies are very profitable, generate large amounts of free cash flow, have strong balance sheets and still pay out less than 20% of their earnings in form of dividends.
Quality companies in demand
Improvements in corporate governance and shareholder returns has become a major investment theme on the Japanese stock market and the demand for quality growth stocks has increased continuously in recent months. Investors have been anticipating the rising demand for equities from the big Japanese pension funds, which generally adopt a long term investment approach and thus favour profitable companies that generate strong cash flows. Over the past year, BL-Equities Japan has benefited from this flight to quality and should continue to do so in future.
Performance of BL-Equities Japan vs. MSCI Japan since fund launch
Source: Bloomberg
