Corporate governance tailwind not lifting Japanese stocks

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.

Change can be significant even if dramatic changes can't be expected overnight, said Dean Cashman, a portfolio manager with Eastspring Investments (Singapore) Ltd., overseeing $11 billion for clients invested in Japanese equities, including the firm's $3.43 billion Japan Dynamic Fund.

When it comes to "the types of conversations you can have with companies, the grasp of the issues you're talking about" and the understanding of governance requirements, things are "definitely improving," he said.

By way of example, Mr. Cashman cited conglomerate Hitachi Ltd.'s May 2016 sale of finance affiliate Hitachi Capital — a decision to hive off a profitable but non-core business — as a "big change" from the corporate norms of previous decades.

As part of Eastspring's due diligence on Hitachi in 2015, Mr. Cashman said his team raised its concerns with management about the potential drag the "cash hungry" financing arm could impose on Hitachi's balance sheet. The next year they did a deal, he said.

As of July 31, Hitachi was the top holding of Eastspring's Japan Dynamic Fund with a 5.5% weighting.

Other money managers cited Tokyo-based Mitsubishi Heavy Industries Ltd.'s decision in August to withdraw from a high-profile magnetic-levitation train project in Japan to focus on other business segments as evidence of stricter return hurdles being put in place by companies now.

If improving corporate governance has not yet proved a powerful catalyst for Japan's market, it should count as a tailwind in what otherwise has been a year of supportive economic headlines.

Analysts say roughly 70% of Japanese company earnings results beat expectations for the quarter ended June 30. "It was a real barn burner, and earnings estimates for the calendar year are rising quite strongly," said John Vail, New York-based chief global strategist with Nikko Asset Management.

On Aug. 13, meanwhile, the government announced annualized GDP growth for the quarter ended June 30 of 4%, crushing consensus forecasts of 2.5%.

Despite that good news, with the yen strengthening 6.6% against the dollar since the start of the year, the broad TOPIX index of companies listed on the first section of the Tokyo Stock Exchange has risen only 6.65%, a fraction of the 13% to 27% gains for markets in Hong Kong, Singapore and Seoul.

Strong earnings and GDP growth are tactical reasons to add exposure to Japan now, and State Street Global Advisors has moved to an overweight position in Japan (as well as Europe) this year from underweight through the end of 2016, while moving to underweight from overweight in the U.S., said Kensuke Niihara, a Tokyo-based managing director and head of the investment solutions group and currency at SSGA Japan.​

On a longer-term basis, good momentum on corporate governance should provide underlying support for the Japanese market, he said.

Adrian Helfert, a Durham, N.C.-based managing director and multisector senior portfolio manager with Amundi Pioneer Asset Management Inc., said the strong capital expenditure numbers in Japan's latest GDP report, together with strong consumption numbers, might help explain why growth seen as far exceeding that country's potential growth doesn't seem to be spurring inflationary pressures. Possibly labor-saving capital investments are helping the country offset a workforce that's been shrinking for years due to Japan's growing cohort of seniors, he said. Amundi Japan had assets under management of ¥4.7 trillion as of March 31.

David Latto, a Geneva-based senior vice president with Unigestion SA and portfolio manager of the firm's $230 million Japan equity strategy, said his visits with institutional investors in Germany and London over the past month found considerable interest but also concerns about the market's volatility.

Mr. Latto agreed things are moving in the right direction when it comes to a number of corporate governance-related topics, with dividend payouts going up and cross-shareholdings going down, but "a ton of stuff" remains to be done.

Nikko's Mr. Nakano noted Germany took five or six years from the 2002 introduction of its corporate governance code to effectively put that new approach into effect. Japan could take 10 years if asset owners, money managers and listed companies alike don't redouble their efforts, he predicted.

The Pension Fund Association's Mr. Hokugo said getting a regulatory nod for institutional investors to work together on governance-related goals is the key to moving forward, to overcome the significant hurdle that cross shareholdings of "allegiant shareholders" — with typical holdings of 35% to 40% of a company's stock — pose in influencing management. For now, such collaboration can leave investors open to legal risks of insider trading, he said.