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Japan is finally catching up

Japan Trust

Japan Trust - Investment Trust Range

Japan is making clear strides in terms of corporate governance, where it was once a laggard, and is now moving towards global norms. Fidelity Japan Trust PLC’s Nicholas Price explains that they’re beginning to see a shift in corporate mindsets in Japan and dissects exactly what that means for profitability and shareholder returns.

Key points

  • The introduction in the last few years of growth-orientated governance reforms have been instrumental in driving change across Japan’s corporate landscape.
  • The need for companies to reorganise their business portfolios and adhere to governance reforms has led to an increased focus on the dissolution of parent-subsidiary listings.
  • Using our extensive analyst resource, we are able to identify laggard companies in ESG that are implementing real change and moving up the governance scale.
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The introduction of growth-oriented governance reforms such as the stewardship code (2014) and the corporate governance code (2015) are instrumental in driving corporate governance change in Japan. We are seeing a gradual shift in corporate mindsets, with management now paying far more attention to profitability targets such as return on equity (ROE), as well as increasing shareholder returns to record highs.After what has seemed like an interminable period of underperformance, UK equities are finally showing signs of recovery and now look well placed for strong future performance relative to other regions. The event that investors have fretted about since 2016 could coincide with an unusually strong year in relative performance for the UK. While this might seem counter-intuitive, the market often finds a way to confound expectations.

Overcapitalisation

Despite the significant increase in shareholder returns in recent years, Japanese companies remain overcapitalised. Improvements in earnings and cash flows have offset much of the improvement in capital management. Indeed, around 56% of TOPIX-listed companies are net cash versus much lower levels in the US and Europe. This level of overcapitalisation means that they need to increase their payout ratios to 100%+ to get their ROEs up to global standards. That’s a tough decision for corporates to make. Either they undertake more aggressive acquisitions and domestic consolidation, or they have to raise payout levels quite significantly.

In addition to a significant increase in buybacks, we are seeing a pick-up in tender offer activity in Japan. The need for companies to reorganise their business portfolios and adhere to governance reforms has led to an increased focus on the dissolution of parent-subsidiary listings. This has prompted management to reconsider their subsidiary listings. We are seeing concrete developments on this front, with the value of tender offers in 2019 reaching the highest level in more than ten years. For example, we saw Sony divest its stake in Olympus and industrial conglomerate Toshiba announced the conversion of three listed units into wholly owned subsidiaries.

Is there a governance premium in Japan?

On the contrary, I believe that there is a governance discount in Japan, which can be detected and exploited more readily by being on the ground. By working closely with our Sustainable Investing team in Japan, we are able to identify laggard companies that are implementing real change and moving up the governance scale. For example, there are many Japanese companies that trade on an ex-cash price-to-earnings ratio (PER) of 5-10x and as they move from a governance discount to a governance premium, we can capture significant upside potential. As a result, there is ample scope for further investor flows given the large number of value creation opportunities in Japan.

Sustainable investing (ESG) in Japan

At Fidelity, ESG (environmental, social and governance) factors are considered and integrated into our research analysis. As the portfolio manager, I analyse the effects of these factors when making bottom-up investment decisions, and whether they have the potential to affect the long-term value of an investment. By working closely with our team in Japan, we are able to identify laggard companies that are implementing real change and moving up the governance scale. When the efforts of these companies are recognised by the market, there is a good chance for them to be revalued.

The portfolio has a significantly lower carbon footprint versus the overall market, which is largely a reflection of the bias towards mid/small cap growth stocks in low-emission industries such as B2B and B2C online services. Among larger companies, examples of highly rated names held in the portfolio include Murata Manufacturing, a global leader in capacitors and communication modules that rates highly in cleantech and chemical safety, and Daikin Industries, an industry-leading maker of air conditioning equipment that scores well in health & safety and carbon/toxic emissions.

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Important information

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