Barbarians At The Gate – Positive Signs For Third Arrow Progress In Japan by Robert McConnaughey, ColumbiaManagement
- Improved corporate governance, especially as it relates to capital allocation, is a key component to third arrow efforts for Abenomics.
- To create urgency among corporate managements towards reform, we believe the Japanese government should move to gradually but consistently improve shareholder rights.
- The convergence of forces to catalyze more shareholder-friendly corporate behavior is quite encouraging for prospective Japanese equity investors.
Last September, I highlighted the potential in Japan for significant forward progress in the success of Abenomics. However, I also expressed caution about the pace of reforms and the lack of a sense of urgency from corporate managements. More recently, my optimism on Japanese equities has grown, based on some encouraging signs regarding reform progress, especially at the corporate level.
Improved corporate governance, especially as it relates to capital allocation, is a key component to third arrow efforts for Abenomics and one which I feel would be most impactful. I have long argued that an effective way to create urgency among corporate managements towards reform would be an explicit policy move to gradually but consistently improve shareholder rights (i.e., strip away protection from activist shareholders). Therefore, I took special note of the news that Third Point, a high profile U.S. activist hedge fund, has recently taken a large stake in Fanuc, perhaps the worlds’ leading robotics company, and is advocating for change there. Fanuc is generally an excellent company with impressive margins, high market share and exciting growth prospects. However, it has a tremendously conservative balance sheet with a huge cash hoard; it also shows very little concern in most regards for external shareholders. As a result, the company’s stock trades at a far less lofty valuation than one might expect for such a well-positioned growth company. Time will tell whether Third Point is successful in their efforts, but might such shareholder pressure be only the tip of the iceberg? Activists, particularly Western players, have a notably undistinguished track record of taking runs at Japanese companies, but the stars are aligned a little differently these days. There are no shortage of targets in Japan with very cash-rich balance sheets and ROE’s that appear less than optimized. Given how generally picked over the rest of the developed world is for easy balance sheet restructuring plays and how much money is sloshing around looking for returns, one has to believe that there are plenty of deep-pocketed firms out there doing the work on what is possible in Japan.
It is not just activist investors exerting pressure. More than 30% of Japanese listed shares are owned by foreign investors, and they have their influence as well. One force for change in that cohort is the guidance of proxy research firms. One of the largest such firms, Institutional Shareholder Services (ISS), changed their Japanese proxy voting guidelines for 2015. They now recommend voting against the election of directors if a company has an average ROE of less than 5% over the preceding five years. Of the companies matching the criteria to be subject to ISS guidelines (market cap over 50 billion yen, foreign shareholder ratio over 10%, positive net cash), around 30% have already announced share buybacks or dividend hikes. Related, Japanese M&A activity has picked up notably as well. These deals have included a notable level of acquisitions outside of Japan and given current cash levels and extremely low financing costs, virtually any such deals are accretive to earnings and overall ROE levels. For example, venerable camera maker Canon made a cash bid to purchase Sweden’s Axis Communications AB this month for 23.6 billion krona ($2.8 billion). Canon has no current debt and had 845 billion yen ($7.1 billion) in cash and near-cash items at the end of last year.
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The tailwinds for reform are not solely driven by independent shareholders. The government is working to encourage improved corporate governance and is using governance criteria as a growing part of its decision process for allocating its massive pension assets to equities. Given the scale and influence of these assets, that creates a powerful additional incentive to change. On June 1, a new corporate governance code will come into effect requiring, among other things, that listed companies have at least two outside directors on their board. There is likely to be little that seems radical in this new code, but it is positive on the margin, and we hope it only marks the beginning of government action. Beyond the code, there is also growing reason for hope that the government will also begin to implement reforms which would allow for a more meritocratic labor system, including the ability to more easily fire underperforming employees. These labor practice changes are likely to be gradual, but are critical for Japan to significantly improve competitiveness in the global economy. Finally, sometimes timing is everything. The government has caught an extremely lucky break with the decline in oil prices. Japan is a very large importer of oil, particularly with its nuclear reactor fleet off-line. Risks to consumer spending brought on by last year’s rise in consumption tax from 5% to 8% were largely offset by the plunge in oil prices, a turn of events that was remarkably fortuitous. The tax goes a long way to shrinking the huge Japanese fiscal deficit and was able to be implemented with far less spending drag than seen in prior similar tax hikes.
Japan’s economic recovery still faces daunting longer term challenges, most notably a terrible demographic outlook and a massive government debt load. However, for the intermediate term, prospects appear to be brightening. While I have been skeptical about the pace and sustainability of reforms in Japan, the convergence of forces to catalyze more shareholder-friendly corporate behavior is quite encouraging for prospective Japanese equity investors.
*The third arrow of Abenomics refers to structural reforms that aim to position Japan’s economy to compete in the 21st century.