Japan’s equity renaissance
Two countries, India and Japan, dominated the conversation at the recent 3,000-peoplestrong HSBC Annual Global Investor Summit in Hong Kong. As readers are familiar with India, I will talk about Japan, where following decades of stagnation, Tokyo’s benchmark Nikkei 225 broke past its 1989 peak on February 22, 2024. While stable macro-economic, favourable geopolitical conditions and leaner balance sheets have energised its equity markets, governance reforms have had an equally important role to play.
Japan began focusing on governance reforms from the turn of the century, with a call for independent directors and board committees. Initially there was scepticism regarding independent directors’ ability to understand a company’s culture and contribute to its growth since they had not been with the company for 30 years! It was only after Shinzo Abe came to power for a second time in 2012 that the governance reforms gathered pace. And it may not be out of place to mention the India Governance Scorecard that I have periodically written about was thanks to the generous support from the Government of Japan during Shinzo Abe’s tenure.
“Reforms, new policy ideas, and civil society participation arrived in a heady rush (with Abe),” says Jamie Allen, who recently stepped down as secretary general of the Asian Corporate Governance Association (ACGA), a non-profit membership organisation driving effective corporate governance practices throughout Asia. He lists the Japan Stewardship Code of February 2014 (it has undergone two revisions since, in 2017 and in 2020); the Ito Review, in August 2014, which put return on equity (ROE) and corporate competitiveness on the map; the Corporate Governance Code of June 2015; a new third system of board governance, the Audit and Supervisory Committee Company, in 2015; the growth of sustainability reporting, strongly encouraged by the Financial Services Agency and the Ministry of Economy, Trade and Industry (METI); the emergence of new director-training institutes; an official set of Guidelines for Investor and Company Engagement in June 2018; new METI guidelines on group governance in June 2019.
“Part of (Abe’s) government’s genius was to link CG reform not to risk reduction — as in most markets where governance is a corrective to excessive corporate risk taking — but to the long-term growth of companies and the revitalization of the underperforming Japanese economy,” avers Jamie.
This is reiterated in the “Ito Review of Competitiveness and Incentives for Sustainable Growth — Building Favorable Relationships between Companies and Investors”, published by the powerful METI. As resistance to change emanates from cultural facets, the Ito Review noted that “increasing capital efficiency in the broadest sense is crucial from the perspective of Japan’s survival”.
There have been two updates to the Ito Review. The 2017 review focused on company-investor engagement or “collaborative value creation” and the 2022 review on “sustainability transformation”.
METI has remained concerned that Japan Inc was cash-heavy and that the financial indicators for Japanese companies trailed their European and United States counterparts. Years of poor capital allocation led to low ROE and low price to book (P/B). Approximately half the listed companies on the Prime Market and 60 per cent in the Standard Market have ROE below 8 per cent and P/B ratios below 1. This contrasts with 5 per cent for the S&P 500 and 22 per cent for the STOXX 600. These financial numbers called for a shift in mind-set from a “profit and loss” focus to being driven by “balance sheet and cash flow”. This meant limited interest from global investors.
The challenge was to link governance and financial performance, which the Tokyo Stock Exchange did through its focus on capital allocation (which, together with succession planning, is one of two priorities of any board).
In March 2023, the exchange asked companies with a P/B ratio below 1 to disclose specific policies and initiatives to lift their value above it. While there may have been other financial indicators for companies to focus on, like return on capital equity or return on capital employed, the exchange narrowed in on P/B, which is now the prominent indicator.
Since then, companies have begun focusing on capital efficiency. They have begun buybacks, mergers, spinoffs, unwinding crossholdings, and disposal of treasury stocks. All these are standard tools for any well-managed company but were shunned by Japanese enterprises. As peer pressure builds — Honda Motors’ $1.5 billion buyback announcement was followed by Toyota Motor offering to buy back $1.0 billion — it is easy to understand the change in Japan.
As the directive is not binding, the exchange has begun releasing a list of firms that have disclosed plans to increase their capital efficiency. In doing so it is obliquely naming and shaming companies that have not articulated a plan — as they don’t find mention on this list.
“The Tokyo Stock Exchange’s Action Plan for companies to disclose on board awareness of their cost of capital and to improve ROE is a culminating factor signalling improving returns for shareholders,” said Amar Gill, who this month assumed charge as secretary general, ACGA.
The Japan story is still in its early days. But the lesson it holds is that companies, regulators, and the broader market micro-system all need to continuously evolve to ensure that a country’s capital markets remain robust.