There is an once-in-a-lifetime transition underway from volume to value that is creating new investment opportunities in the Japanese equity market. The corporate governance reform and Japanese population dynamics have played a key role in catalyzing this transition to a value-oriented mindset. As an investor, SPARX Asset Management plays an important role in helping companies understand this change, and we observed lately that Japanese companies are becoming more receptive to engagement with investors like us.
When you consider investing in Japanese equities, you cannot ignore the infamous “Lost Two Decades” – the years between Japanese equity market peak in December 1989 (as measured by Nikkei 225 Index) until 2012, when the former Japanese Prime Minister Shinzo Abe set forth his Abenomics stimulus policies. Why did the market struggle for so long, and what did Abenomics change?
The return of shareholders
Shareholders were absent for a staggering 70 years in Japan. From the end of World War II – which saw a transition from shareholder to bank governance – until the implementation of Abenomics, the concept of shareholder value was largely absent. Abenomics, however, opened the door for shareholders to make their way back into Japanese corporate governance sphere. Corporate Governance Reform started in 2013 and since then, the results have been impressive. For example, in the Tokyo Stock Exchange First Section with over 2,100 listed equities, the percentage of the companies with two or more independent directors was 18% in 2013; as of August 14, 2020, that number had dramatically increased to 95.3%. Global investors, as well, are recognizing that Japanese corporate governance is changing for the better.
Why were shareholders absent from the scene for more than 70 years? WWII was the cause for the transition from shareholder to bank governance. It may be surprising to hear that, prior to the war, the private sector was actually the largest single shareholder of corporate Japan. Some company groups, such as Mitsubishi or Mitsui, were very strong at that time. But in order to prepare for the war, the Japanese government implemented a controlled economic model and obtained shares from the private sector. In the aftermath of the war, the public sector became the largest single shareholder in 1947, and the government utilized the financial sector to direct capital into strategic sectors, such as materials plants and heavy industry. This led to financial institutions becoming the largest shareholder by 1989. When the bubble burst, bank shareholdings decreased, and the private sector – such as foreign and individual investors – increased. From that point until Abenomics constituted a transitional period with no single shareholder group having an outsized influence over companies. After this transitional period, the private sector has now come to represent 50% of corporate Japan’s shareholding, and shareholder structure change has come full circle with the private shareholder finally returning as the main actor.
The bank-led governance model worked well under the volume growth era underpinned by population and demand growth. Japan’s population steadily increased for 140 years until 2008. In 1868, when the Meiji Restoration occurred, and the Era of Samurai Warriors ended, the population was around 30 million. It increased fourfold into the first decade of the 21st century. The banks’ business strategy worked well under the volume growth economy as banks simply wanted to increase lending volume without considering the cost of capital. But after population growth peaked, this model ceased to work. A declining and aging population characterized by labor shortage is one of the key social issues in Japan and is forcing the government and corporate management teams to revise their growth strategy going forward. From an annualized population growth of 1% in the period between the 1950s and 1980s, Japan now faces declining population growth of -0.10%.
A declining population marked the beginning of the value growth era and a change in the focus of management and employment styles across Japanese companies. Labor market conditions have also changed from aggressive hiring during the population growth period to over-employment during the lost two decades, and now finally labor shortage. During these periods, the focus of management started with a priority of increasing volume, then to cost-cutting, and now finally to adding value. In Japan, labor mobility has been low due to regulation, so that companies could not downsize in the over-employment regime, forcing many to follow a business diversification or low-price strategy, with cost-cutting. But after 2010 with a wave of baby boomer retirements and a declining youth population, the Japanese market suddenly switched into labor shortage paradigm, and companies have begun seeking value adding strategies.
In that context, what are the questions management should be asking? Under this new paradigm, the quality of governance is key to creating value. Can the management tackle the labor shortage problem by improving productivity? Can they focus the business on its core competence to strengthen corporate brand value, and take advantage of industry consolidation as less productive firms exit their sector? In order to successfully transition to value-added model, a shareholder’s mindset is an absolute necessity.
To address that mindset, it is the sincere desire of SPARX to contribute to the improvement of ESG issues and investing in Japan, and we are using our position as the largest independent asset manager in Japan to engage with companies on that topic. We believe this can impact global ESG improvement and lead to positive strategy returns for our investors. With more capital and advice from global institutional investors, our impact can be very significant, and we appreciate their continued support for our activities.
