No Excuses - Japanese Boards Have to Face New Reality Post Covid
Investors globally, whilst being quarantined in their home offices, are trying to assess the ramification of the Covid-19 induced economic collapse. The extent of the global economic impact is unprecedented and so is the policy response.
Japan takes the lead and a whopping 20+% of GDP will be spent to stimulate the economy, although, it seems, the Japanese economy is least impacted compared to most other major developed nations. By many measures, Japan, mainly due to its cultural and behavioral particularities, was less affected by Covid-19. Fatalities (0.6 per 100.000 capita with little deviation from ‘normal’ mortality patterns) are a fraction of those compared to most other countries.
Fiscal policy is at full throttle, because this healthcare crisis is the perfect ‘excuse’ to max out the fiscal option. At the same time, monetary policy is aimed at underwriting credit risk and the Bank of Japan committed to even more ETF buying if necessary. Almost all companies we talked to provided the same reply: “This is not 2008, we have plenty of access to credit.”
Whilst the world is still in shock-and-awe and risk assets are trying to price the recovery in whatever form and (U-, V-, L-) shape. However, the most powerful investment theme in Japan, the structurally most appealing and intrinsically most rewarding transformation, is gathering steam. Because of the Covid-19 crisis, people’s behavior had to change, their relationship with co-workers, supervisors and work in general has changed. These are big shifts for the traditional Japanese salaryman mentality, and in the coming months these interactions will settle at a new normal. Hopefully, a better, more efficient new normal. This crisis is a great opportunity for Japanese managers and leaders to avoid a return to ‘business-as-usual’.
In order to make sure, old routines will not return, as bad habits never die, an external force is indispensable. So why not send the board a memo reconfirming what needs to be done anyway and the requesting shareholders can be used as an excuse to push through much needed reform.
Simply said, the activists are back and more determined than ever. After a brief pause to provide some breathing space during the Covid-19 crisis, the boards get swamped with letters again.
In my opinion, listed companies in Japan are among the best risk/reward investment opportunities globally. For one, assets are extremely cheap, which is not a bad starting point, most companies trade below book value and indeed Japanese companies still have something called a tangible book value.
50+% of Topix companies are net cash and we find many opportunities with cash-to-market cap ratios at 30–40%. These are not cash positions for a rainy day or an apocalyptic crisis; this gigantic cash hoardings are there to protect management boards.
The Japanese Stewardship code was introduced in 2014 and earlier this year the second revision was published by the FSA. The intentions are clear and undisbutable; give the shareholders more responsibility to help overhaul the entire framework how listed Japan Inc. is been governed.
It is a gradual process, but in my opinion, we are at an inflection point that will swiftly change the balance of power. As shown below, the number of independent non-executive directors has been increasing. In many cases, the independence is questionable, and board diversity in terms of gender, nationality, age is still appalling, but for investors the incremental change into critical mass leads to great re-pricing opportunities.
We focus on board structure to introduce compensation and nomination committees. A tedious process, but an obviously important step. Once those committees are institutionalized, investors can provide the right incentive structure to leaders selected through a controlled search process rather than through rank and age.
Pay is low and, as shown on above, incentive structures are not aligned with those of shareholders. Low base salary in combination with limited performance based compensation are ingredients for a risk-averse, defensive leadership approach.
However, poison pills are declining and allegiant, friendly cross-shareholdings are on the decline. The ‘regulatory’ pressure is high to unwind investments in other listed companies for relationship purposes.
There is so much more work to be done. However, in many cases boards are just waiting for the letters to come in. Why? Because the boards know, they have to change anyway. The writing is on the wall, in capital letters neon signs. ISS and Glass Lewis made it clear in their respective policies that the no-confidence votes will be pouring in. Thus, the outside view from a foreign investors can be a convenient catalyst to embrace the Corporate Governance Code and implement the necessary, which eventually will lead to tremendously better run companies.
The current wave of parent-subsidiary transactions are just the starting point. Those listed subsidiaries are too obviously conflicted situations, that they need to be addressed ‘first’. However, Japan has 3500 listed companies with a GDP of $5trn , the United States has 2700 whilst their GDP is $20trn. Global Private Equity firms have already built significant presence in Japan as they recognize the opportunity and have deployed most resources outside the US in Japan. They are actively sourcing deals and happy to act as white knights to help beleaguered Japanese boards. However, it is not only shareholders demanding their ‘fair-share’ that creates opportunities. The cost of being listed is vastly increasing. For many companies there is simply no reason for being listed. Often cited reasons are the fact to attract human capital, for bank and client relationships and occasionally it is simply seen as a status symbol. The cost of staying listed will drastically increase as both regulatory requirements and shareholders demands will rise significantly. Japanese corporations will need to improve their capital allocation and have clear shareholder return policies. Management Boards will be held accountable for that and if they do not deliver, they will face the embarrassment of having a low approval rating at the annual AGM season. That is why structural change is inevitable.