Japan entering a new era of corporate engagement
Country's corporate culture is seeing signs of positive change with the launch of a Corporate Governance Code and an increase in ESG practices
Since Japan’s Prime Minister Shinzo Abe was first elected six years ago, his administration’s economic policy program known as “Abenomics” may not have achieved as much as many had hoped for, but its corporate governance reform has delivered tangible results.
While Japanese companies have garnered international recognition for their highly efficient manufacturing processes and innovative electronics, historically, they have been less concerned about governance or shareholder returns. But that is changing and the long-term implications for shareholders could be significant.
Government initiatives such as a Corporate Governance Code and a Stewardship Code (for investors), as well as the promotion of Environmental, Social, and Governance (ESG) practices, diversity and financial disclosure, have all begun to have an impact on the country’s corporate culture. Companies have gradually, but noticeably, responded to the reforms, bringing significant benefits for shareholders.
Poor governance leads to low productivity and return on equity
While many factors have played a role in Japan’s economic sluggishness since the late 1980s, poor corporate governance, particularly on the boards of public companies, has certainly contributed. Shareholder returns were not prioritized in Japanese corporate culture, as compliant boards effectively insulated management teams from outside influence, while shareholders rarely challenged the status quo.
There were often few, if any, independent directors. Complex cross-shareholdings, in which two or more companies hold substantial portions of each other’s stock, diluted outside shareholder influence and negatively impacted returns. As a result, return on equity (ROE) and shareholder yield for publicly-traded Japanese companies lagged behind other regions. Furthermore, mergers were relatively rare. These factors, combined with the impact of an aging population, led to low productivity growth in the Japanese economy.
The introduction of a Stewardship Code in 2014 followed by a Corporate Governance Code in 2015 have together helped to influence corporate behavior through institutional investor engagement and internal reform.
The Stewardship Code, adopted by more than 230 institutional investors as of December 31, 2018, encourages an active dialogue with companies on corporate strategy and transparency with respect to voting activities.
The Governance Code, which was revised in 2018, has encouraged companies to nominate a minimum of two outside directors, increase ROE targets, reduce cross-shareholdings and better and more transparently allocate company resources. This in turn has helped to increase shareholder returns.
While compliance with the codes is voluntary, companies and investors that do not follow the guidelines are required to explain why. This “comply or explain” policy provides a form of corporate peer pressure that appears to be effective in encouraging reform. The numbers of engagements between executives and their shareholders have increased.
By 2018, the percentage of companies with at least two outside directors had surged to 91% from just 22% four years earlier. The level of share buybacks in 2019 is on track to exceed any year in more than a decade, while the use of anti-takeover measures and cross-shareholdings has fallen.
Furthermore, ROE figures for Japanese listed companies have gone a long way toward closing the gap that existed with other regions when Abe came to power. As of March 2019, the ROE for the MSCI Japan Index was 9.4%, compared to 5.8% at the end of 2012. Although still below the MSCI World at 12.9%, Japan is catching up with other markets.
“Womenomics” chimes with Fearless Girl campaign
Japan has also made strides with respect to gender diversity. Dubbed “womenomics,” the Abe administration has implemented several policies designed to promote wage equality, raise female labor participation rates and increase the number of women in leadership roles.
This particularly resonates with State Street Global Advisors, as we have initiated our own “Fearless Girl” campaign to raise awareness about the importance of gender diversity and promoting women to corporate leadership positions.
As Abe referenced at the World Economic Forum in February 2019, female prime-age labor force participation in Japan increased 5 percentage points from 2012 to 2017. At 77.5%, it now exceeds that of the US where female prime-age labor force participation is 75%. This success is in part due to initiatives such as increasing the availability of infant care.
While progress has not been as rapid in important areas such as mitigating the overrepresentation of women in part-time positions and the underrepresentation of women in management positions, we recognize that raising awareness and initiating a conversation about gender diversity is a crucial first step. As the well-publicized term “womenomics” advocates, policies have successfully brought the gender diversity dialogue into the mainstream in Japan.
The big question around any initiative of this kind is whether companies are simply doing the minimum to appear compliant or are truly making substantive changes. Thus, it is helpful to have people on the ground meeting with company managements and asking the tough questions. Our Fundamental Equity and Asset Stewardship teams do just that, and together they constructively engage with companies on the path towards continued reform.
Following the introduction of the Japanese Stewardship and Corporate Governance codes, we have observed an increase in the frequency and quality of our engagement with Japanese issuers, a positive trend that puts the region more in line with other developed markets and should help enhance long-term value for our clients.
In 2018, we expanded our Fearless Girl campaign to Japan in order to increase the level of gender diversity in the boardroom. During the first year of the campaign, 54 Japanese companies (19% of those in Japan that we engaged with) added their first female board member. Many other companies responded to our guidance by establishing diversity-related targets designed to grow the pipeline of female talent within their organizations.
Companies can take further action to improve the quality of dialogue by having executive and outside directors engage with investors more regularly. Board-level discussion presents a valuable opportunity to communicate our views as a stakeholder. It also provides context on the unique culture that exists within each boardroom, such as how freely ideas are exchanged and the extent to which ESG-related risks, long-term strategy and capital allocation decisions are deliberated, all of which are helpful to us in our investment process.
ESG scores on the rise
In April 2019, State Street Global Advisors launched R-Factor, our proprietary ESG scoring system that uses commonly accepted transparent financial materiality frameworks to generate a unique score for listed companies.
We began sharing our R-Factor scores and scoring methodology with Japanese companies, which has increased the quality of our discussions. Removing opaqueness around ESG materiality in the scoring process encourages companies to focus on these important issues while providing them with the ability to meet our expectations. This helps make markets more sustainable and create long-term value for investors.
In Japan, we utilize the Japanese Corporate Governance Code as the framework by which we compare the governance practices across listed companies. Based on our analysis, we have found that, on average, the overall R-Factor scores and the corporate governance component scores for Japanese companies have been consistently improving since the Stewardship and Corporate Governance codes were introduced.
Integrating ESG into fundamental analysis
Our Fundamental Growth and Core Equity team’s bottom-up stock analysis focuses on companies that have high quality, sustainable earnings growth and trade at a reasonable valuation. Active engagement with the management teams is crucial to understanding internal company dynamics, long-term strategy and the approach to ESG. We favor not only those with a strong emphasis on governance but also those that are making value-added strategic changes and are effectively communicating these changes to the investment community.
The team assesses these characteristics within a proprietary framework called Confidence Quotient (CQ). The CQ provides a score of the qualitative factors that the team believes contribute to long-term sustainable growth. ESG considerations are a critical input to the CQ score.
One example of a company making positive changes is a leading Japanese air conditioner manufacturer, which has a comprehensive approach to ESG and an outstanding Environmental Vision Plan. The company focuses on reducing the environmental impact of its energy-efficient air conditioners.
We have also been impressed with the global nature of the company’s board of directors, including a thought leader in the chemical industry and a regional expert who leads the company’s Indian subsidiary.
We have been impressed by a global cosmetics company that has been a leader in diversity for many years after launching their Gender Equality Action Plan aimed at promoting the cultivation of corporate culture. By establishing robust diversity-related targets, the company has created a pipeline of diverse talent through the levels of their organization. This company also stands out for using ESG criteria as key indicators for management compensation.
Joint engagement helps identify investment candidates
State Street Global Advisors’ Fundamental Equity team works closely with the Asset Stewardship team. During a recent fundamental research trip to Tokyo, the Stewardship team accompanied our fundamental research analyst to company meetings. This was extremely valuable, as we were able to build on each other’s expertise in analyzing companies through different lenses. We had productive conversations with management regarding shareholder returns and corporate board impact.
The Japanese Corporate Governance Code encourages companies to diversify their board of directors; however, many companies are not making impactful changes. Some companies do not comply with the code at all, while others add outside directors merely as a box-ticking exercise and do not enable these directors to influence change within the organization. In our meetings together, we were able to discern which companies were truly changing their strategies and cultures and constructively engaging with shareholders, and those that were not.
We continue to see a range of potential investment opportunities in Japan. On a bottom-up basis, we are finding stocks with strong catalysts for investment and attractive valuations. These companies tend to be global leaders in their industries and have strong management teams. They lead in areas such as internet of things technology, factory automation, auto electrification and energy saving products.
Several of our Japanese holdings are benefitting from the emerging consumption in China and Southeast Asia and strong demand for Japanese consumer products. However, the strongest driver for our investment across all of our holdings in Japan continues to be improvements in corporate governance thanks to the new governance and stewardship codes, and this is where we see a significant opportunity for positive engagement to make a difference to asset values.
By Wendy G Agnew, senior equity analyst, Japanese equities; Benjamin Colton, head of Asia-Pacific; and Thomas Kronzer, portfolio strategist, State Street Global Advisors
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