Positive earnings surprises, relatively low valuations and stellar GDP growth have yet to ignite a Japanese stock market rally this year, leaving some market veterans focusing on corporate governance reform as the final lever that needs to be pushed.
Three and a half years after the government introduced a stewardship code for local institutional investors and more than two years since the launch of a governance code for listed Japanese companies, there are signs of progress — from record dividend payouts to a quadrupling of firms with two or more independent directors on their boards over the past four years.
Still, if corporate governance is moving in the right direction, most of what has been done so far counts as "low-hanging fruit," said David Smith, Singapore-based head of corporate governance with Aberdeen Standard Investments.
The fact that investors aren't finding a treasure trove of value stocks here, despite more than 40% of Tokyo Stock Exchange-listed companies trading below book value, shows that the state of corporate governance in Japan remains "very, very primitive," said Ken Hokugo, director - corporate governance with Japan's ¥11.8 trillion ($108 billion) Pension Fund Association, Tokyo.
Japan's governance code laid the groundwork for deeper, more constructive engagement between shareholders and the managers and board members of the companies they invest in, with guidelines on topics ranging from the number of independent directors for corporate boards to how to deal with related-party transactions.
Money managers expect a handsome payoff should the governance bar continue to be raised, but anticipate a tough slog in getting there.
When corporate governance reform in Japan reaches critical mass, investors with exposure to Japanese equities will begin to see rapid improvements in both alpha and beta, predicted Jiro Nakano, Tokyo-based head of Japan equity fund management with Nikko Asset Management Co. Ltd.
But that moment remains years away, and only sustained pressure from managers and asset owners can bring it forward, said Mr. Nakano.
Moves in response to the code so far have been more a matter of form and less the needed changes in mindset, he said. By way of example, he noted that, while dividend payouts have risen in line with a doubling of profits over the past five years, cash-rich Japanese companies haven't increased payouts as a proportion of earnings.
Still, some market veterans see the stage being set to take corporate governance in Japan to the next level, where a richer dialogue between companies and institutional shareholders will lead to more intelligent risk taking and greater value creation.
"Much of the focus to date has been on capital/balance sheet efficiency," such as share buybacks and dividend payouts, but "the next stage may be more focused on operational restructuring of businesses, divesting non-core businesses and investing in core areas," said Kathy Matsui, Tokyo-based chief Japan strategist with Goldman Sachs & Co.
Daisuke Tsuchiya, a Tokyo-based director, global financial management, with KPMG's Japan Corporate Governance Center of Excellence, said his team is beginning to see local companies move beyond the "formalities" to focus more on areas such as business strategy and return on equity. For all industries, excluding financials, return on equity rose to 8.53% in the fiscal year ended March 31, from 7.54% the year before, he said.
A number of money managers likewise say they see the cup as half full.