Governance Reform Key For Japan Equities

Governance Reform Key For Japan Equities

Japanese companies are increasingly adopting governance practices geared toward enhancing shareholder value and aligning operations with global standards.


Key Takeaways
  • Japan’s economic revitalization is an ongoing process with improving corporate governance at the heart, providing the potential for years of beneficial structural reforms.
  • Implementation and revisions to the Corporate Governance and Stewardship Codes have caused Japanese companies to adopt more practices geared toward enhancing shareholder value and bringing corporate operations more in line with global standards.
  • We view increasing board independence, more transparent shareholder communications and adoption of incentive-based remuneration as key areas of improvement for Japanese companies in the near term.

The bold economic policies and strategies enacted in Japan starting in 2012 were in direct response to the years of turmoil following the global financial crisis. Economically, Japan was experiencing a contracting GDP, falling exports, deflation and rising debts. Politically, the country was rudderless and burning through a revolving door of five prime ministers in five years, who often promoted inept or poorly timed polices. Shinzo Abe rose to power after the general election in 2012, advocating for bold policy transformations around economic reflation, government stimulus and structural market reforms. Ultimately, this became known as Abenomics, centered in his “three arrows” approach of monetary easing, fiscal stimulus and structural reforms designed to address decades of weakness and underperformance of the Japanese economy and capital markets. Abenomics was meant to transform Japan from a laggard to a leader. Each of the three arrows is significant and important on its own, and collectively they would become the backbone of revitalization.

While Japan remains challenged in generating significant inflation and economic growth, the measures have resulted in improved personal consumption and employment, especially among women who have become a critical part of the workforce as Japan’s population ages. More important to us as active equity managers has been the structural reforms component – the third arrow – which is targeted toward improving corporate governance and structurally enhancing the competitiveness of Japanese companies with their global peers. While progress has been slow, we believe the competitiveness of Japanese companies, as measured by return on equity (ROE) and shareholder returns, is improving (Exhibit 1).

Exhibit 1: Structural Reforms Have Led Return on Equity to Double

Source: FactSet, as of 10/31/19. LTM - Last Twelve Months. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

In 2013, Abe’s first cabinet outlined principles for reform in key areas of governance to foster improvement over time. Reform followed a two-pronged approach of constructive engagement between investors and corporations, building a virtuous circle of asset owners and asset managers with Japanese corporations, management teams and boards of directors. The principles for the asset owners became Japan’s Stewardship Code in 2014, and the principles for corporations became Japan’s Corporate Governance Code in 2015. Each of these codes have continued to be modified and improved.

Asset owners, which include Japanese institutional investors, are expected to drive implementation of the Stewardship Code, with the broad goal of promoting sustainable growth among the companies in which they invest through constructive engagement. As with governance, the goal is to drive Japanese asset owners and asset managers to adopt practices more in line with active shareholder standards. A core tenet of the code is transparency in investment policies and regular reporting of proxy voting and progress in other areas related to the performance of portfolio companies.

The Governance Code is intended to provide growth-oriented governance with structure, by promoting timely, transparent and decisive decision-making that fulfills companies’ accountability to shareholders and stakeholders. Its success relies on ongoing dialogue with shareholders, information disclosure and transparency, active participation of a company’s board of directors in serving shareholders as well as appropriate cooperation with a company’s other stakeholders.

Shareholder Engagement Leading to Governance Improvements

Shareholder engagement has been growing sharply since the launch of the Stewardship Code, especially the use of shareholder proposals. Although the majority of proposals do not pass, a clear trend exists for the number of proposals being put forward as well as in the number of votes in their favor. Specific areas showing growing support of shareholders include disclosures of capital cost, management incentive compensation, anti-takeover defenses, dismissal of directors or auditors and the unwinding of cross shareholdings. This trend is one we have every reason to believe will continue, driven in part by the more actively and engaged shareholder base, as well as the positive returns companies can achieve from positive policy changes.

The Stewardship Code clearly encourages greater input from shareholders to management teams, and activist investors existed long before these codes were put into place. However, in the current environment, we believe management teams are under increased pressure to respond to shareholders including activists.

As we enter 2020, we believe there are several key areas where Japanese public companies can show near-term corporate governance improvement. One is to increase penetration of independent board members on committees (Exhibit 2), as well as functioning of these independent board members with independence criteria. Another is more accessible shareholder meetings, with further improvement in access to early digital disclosures in English weeks prior to general shareholder meetings to support more informed shareholder voting.

Exhibit 2: Nearly All Japanese Companies Have Appointed Independent Directors

Two or More Independent Directors - Tokyo Stock Exchange-Listed Companies

Source: Japan Exchange Group, as of 7/12/19. LHS = Left Hand Scale. RHS = Right Hand Scale. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

One of the areas with greatest potential for change and impact on shareholder returns is greater adoption of comprehensive incentive-based remuneration. Japanese management compensation is overwhelming fixed and not directly aligned with shareholder interests. When Japanese management teams do have some variable compensation, it is most commonly only tied to key performance indicators (KPIs) around profitability targets and not shareholder returns. We expect greater use of variable compensation tied to shareholder interest will bring Japanese management teams closer to their global peers and deliver higher returns to shareholders. When executive compensation is tied to KPIs around both profitability and total shareholder returns (TSR), this increases the likelihood of more management teams delivering on TSR.

As Japanese companies commit to further governance improvements, they should continue to close the performance gap with their global peers and make Japanese equities more attractive. We will continue to engage with leading Japanese companies, sharing best practices on corporate governance and related shareholder friendly approaches, encouraging greater disclosures and helping set progress benchmarks.


Definitions:

Deflation refers to a persistent decrease in the level of consumer prices or a persistent increase in the purchasing power of money

Gross Domestic Product ("GDP") is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time.

The MSCI Japan Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of Japan.

Return on Equity (ROE) is the amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested. ROE is expressed as a percentage and calculated as: Return on Equity = Net Income/Shareholder's Equity.

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