Chancellor: the tortoise of Japan will overtake the American hare
LONDON (Reuters Breakingviews) – You could say that Japan invented stakeholder capitalism. Its companies have long proclaimed allegiance to the “five joys” – namely employees, customers, suppliers, society and finally shareholders. The relatively low returns of Japanese stocks over the past several decades have largely been the result of this contemptuous attitude towards stock owners. In contrast, US companies put the interests of shareholders first and generate much higher returns. Now that the United States is leaning towards a form of actor capitalism, Japan is moving in the opposite direction.
After Japan’s economic bubble collapsed in the early 1990s, many industries suffered from chronic excess capacity. A key problem was that the country lacked a market for corporate control. Foreign activist investors, such as New York-based hedge fund Steel Partners, which in 2007 attempted to take over brewer Sapporo, have been pushed back. After Steel’s beer putsch, many Japanese companies adopted “poison pills” to protect themselves from pesky shareholders.
Activists weren’t the only investors to be disappointed. Followers of Benjamin Graham’s value investing approach, who bought Japanese stocks at conspicuously cheap valuations, found there was no way to unlock that value. The nadir came 10 years ago, when Michael Woodford, the UK chief executive of optics company Olympus, was ousted by a unanimous board vote after uncovering massive fraud at the company. To many foreigners, the Olympus scandal was all that was wrong with Japan Inc.
Endemic governance problems, however, have overshadowed certain strengths of Japanese capitalism. In search of shareholder value, many Western companies have relocated their production to regions with low labor costs, notably China. These so-called “platform companies” have generated wonderful returns for shareholders and have contributed to those returns with financial engineering. But, in the process, they lost their manufacturing know-how and got into too much debt. In contrast, Japanese companies have largely repaid their debts and retained their basic manufacturing skills.
Now that the West has lost confidence in China as a manufacturing base, Japan is starting to look more attractive. “What’s bad for China is good for Japan, especially for small Japanese companies that were reluctant to move their operations to the People’s Republic,” says Alexander Kinmont of Milestone Asset Management. Not only is Japan still making things, but it also has a lot of cutting-edge technologies, including solid-state batteries and hydrogen fuel cells, he says. Toyota Motor, for example, has more electric vehicle patents in the United States than Tesla.
Their deep commitment to investing gives Japanese companies a certain resilience. While the mighty Kodak has never recovered from the advent of digital cameras, Japan’s Fujifilm has successfully reinvented itself as a supplier of medical electronics. Even Olympus has recovered from its disgrace. After the scandal, the company abandoned its loss-making cameras business https://www.breakingviews.com/considered-view/camera-sale-puts-olympus-value-into-clearer-view to focus on surgical equipment at high margin, and its shares have grown more than 25% per year over the past decade.
The fact that many Japanese companies have advanced technology is nothing new. What is new is that Japanese industry is becoming more shareholder friendly, a change that is strongly supported by the authorities. In 2014, the Tokyo Stock Exchange passed a management code that requires fund managers to put clients’ interests first. An immediate consequence was that most Japanese companies got rid of their poison pills. The following year, Japan introduced a new corporate governance rulebook that draws heavily on the UK’s shareholder-friendly code of governance.
Around the same time, the government’s huge pension investment fund concluded that it could never honor its obligations by investing in low-yielding Japanese government bonds. The fund therefore started investing in equities and now owns around 8% of the Japanese stock market. Toby Rhodes of Kaname Capital observes that GPIF employs fund managers to vote its stocks to improve shareholder returns. “Thanks to the intervention of the pension fund,” he says, “people are starting to think about the cost of equity in Japan for the first time. A quiet revolution is taking place.
The signs of change are plentiful. Cross-shareholdings continue to be unwound. Dai-ichi Life and Sumitomo Mitsui Financial used the proceeds from the sale of these holdings to buy back their shares. Auto parts maker Denso is also buying up shares. Japanese companies return more of their profits to owners. Some companies go into debt to increase their returns. Retailer Seven & i, which owns the 7-Eleven business, used loans and leases to finance its recent $ 21 billion acquisition of US convenience store chain Speedway.
Corporate activists are more welcome than in the days of Steel Partners. The industrial conglomerate Toshiba is fighting against hedge funds. In September, Elliott Management, the New York-based activist, said it had taken a significant stake in the company. There are even rumors in the market that Toshiba may be going private. Earlier this summer, maverick investor and former government bureaucrat Yoshiaki Murakami completed Japan’s first hostile bid when he took control of the Japan Asia Group. Slowly but surely, a market for corporate control is emerging.
Returns on equity have increased as management realizes that capital does have a cost. So far, all the gains have come from higher profit margins, after companies have cut costs and extracted other efficiency gains. This is the difficult part. But the return on equity can be more easily increased by taking on low-cost debt or by ceding unprofitable operations. There is a lot of room for improvement. While Japan’s steel and cement industries have consolidated, several other sectors, including beer, food and pharmaceuticals, have yet to take the plunge.
American shareholder versus Japanese shareholder capitalism resembles the legendary race between the hare and the tortoise. American companies have been leading this race for decades. However, as they begin to embrace many elements of stakeholder capitalism, they risk slowing down at a tortoise pace. Japanese companies, meanwhile, want to become more hares. None of this is discounted by the stock market. US stocks are currently trading at much higher valuations than their Japanese counterparts. Some parts of the Japanese stock market, especially the value of small caps, are downright cheap. Bet on the turtle.
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(Edited by Rob Cox and Katrina Hamlin)
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