Governance push putting Japanese equities on radar

Japanese companies' recent embrace of shareholder value and return on equity is gathering momentum this year, adding an upside argument to the case more often made for Japanese equities that touts the defensive qualities an unloved market can offer global investors.

While still a distinct minority, some institutional investors have begun positioning themselves for a potential payoff as companies that had previously been content to hoard cash now return more of it to shareholders via stock buybacks and dividend payouts, and — of longer-term interest — display a greater openness to addressing shareholder concerns.

One example: Hartford HealthCare.

In fairly quick succession, the Hartford, Conn.-based asset owner has moved from a long-maintained underweight in Japanese equities in 2015 to a market weight the following year and then, in 2017, a significant overweight of 10% of its combined $3.3 billion in endowment and pension assets, said David J. Holmgren, the health-care system’s chief investment officer.

With a 7.26% weighting now in the MSCI All Country World index, Japanese equities would currently account for roughly 4.4% of a typical balanced portfolio with allocations of 60% to global stocks and 40% to bonds.

“Our thesis is that changes to Japan’s corporate culture are going to drive improved shareholder returns” for years to come, Mr. Holmgren said. The fact that foreign investors remained net sellers of Japanese equities over the past year in favor of U.S. stocks — where dividends and share buybacks have been buoyed by transient factors such as the big corporate tax cut in 2017 — has only “increased our conviction” that a rotation to Japanese stocks is just a matter of time.

Mr. Holmgren said Hartford HealthCare’s “anchor” allocations for that thesis, made in early 2017, were divided between Simplex Asset Management Co. Ltd., a local “friendly engagement” activist with ¥577.8 billion ($5.3 billion) in assets under management, and a core strategy newly set up by the Tokyo office of Boston-based Wellington Management Co. LLP.

Nicholas Kong, the chief investment officer of the National University of Singapore’s more than S$9 billion ($6.6 billion) in endowment funds and reserves, said his portfolio is likewise overweight Japan, both for the potential gains the country’s shift in corporate culture can deliver — across a range of public and private asset classes — as well as for the defensive qualities offered by Japanese equities.

With depressed valuations for Japanese companies, in a global market where most assets are generously priced, the “air pocket” for Tokyo equities to drop when a risk-off environment finally emerges should be relatively small, he said.

For now, believers remain considerably outnumbered by skeptics, market players say.

“There are a few global investors who seem interested in Japan’s corporate governance story,” but a majority remains cautious or frustrated with the slowness of progress, said Taku Arai, deputy head of Japanese equities with London-based Schroders PLC.

Even as share buybacks and dividend payouts increase dramatically and companies announce return-on-equity targets and boost the number of outside directors, investors — for the most part — have been loath to allocate to the Japanese market, agreed Nicholas Weindling, a Tokyo-based executive director and country specialist for Japanese equities with J.P. Morgan Asset Management.

JPMAM’s Japanese equity team had $19.2 billion in AUM as of May 31, up from $16.2 billion two years before.

Japan’s focus on corporate governance started as a top-down affair, promoted by the government of Prime Minister Shinzo Abe, which came to power in late 2012, as a means of revitalizing the country’s moribund economy.

The government laid the groundwork for the more shareholder-friendly corporate culture by pushing through a stewardship code in 2014, followed by a corporate governance code in 2015.
After gradual progress those first few years, corporate governance is “finally starting to accelerate” now, said Yuya Shimizu, representative director and chief investment officer of Hibiki Path Advisors Pte. Ltd., a Singapore-based activist investor in small-cap Japanese companies with roughly $300 million in assets under management.

It’s still early days and for too many companies return on equity remains “just a number,” rather than a lodestar guiding the management of their businesses, Mr. Shimizu said. Still, “things are moving in the right direction,” he said.

From a Japanese perspective, the glass looks more half-full than half-empty because 10 years ago “there used to be no water in the glass,” agreed Shiro Hayashi, director of research and head of Santa Monica, Calif.-based Dalton Investment LLC’s Tokyo research office, Dalton Advisory KK.

Mr. Hayashi said Japan’s corporate governance story is catching the attention of more institutional investors now. Dalton’s Japan-focused strategies currently account for $2 billion of the firm’s $3.7 billion in global AUM, up from $1.5 billion of a $3.3 billion book of business at the end of 2015.

Managers on the ground in Tokyo report more subtle signs of progress, along with more easily quantified areas such as dividend payouts and share buybacks.

For example, noted Yasunori Nakagami, representative director and CEO of Misaki Capital Inc., a “constructive” Tokyo-based activist investment manager launched in 2013, over the past year or two, Japanese companies large and small have reached out to Misaki “to hear our views, ask our advice, (have us) do presentations at the board level.”

Market veterans say Misaki’s assets under management have more than tripled over the past three years from around $300 million to just under $1 billion. Mr. Nakagami declined to comment.

“The tone of the meetings we have now (is) quite different to what we had even two or three years ago,” JPMAM’s Mr. Weindling said.

Corporate executives used to point to what peers were doing to justify a modest 30% shareholder payout policy but now, more often than not, they are giving genuine thought to what their policies should be, he said.

The Japanese market’s dividend yield, meanwhile, at 2.5% currently exceeds the S&P 500’s 2% yield. Six or seven years ago, “you wouldn’t have brought it up (because it was) embarrassingly low,” he said.

Also, share buybacks announced by Japanese companies since the April 1 start of the current fiscal year have come to ¥3.4 trillion, up 90% from the year-earlier period, while the number of companies with more than two outside directors has jumped to 90% from 10% a decade ago, Dalton’s Mr. Hayashi said.

With broader share buybacks and higher dividends, Japanese corporate return on equity has improved dramatically, more than doubling to 10% since Mr. Abe became prime minister, said Daiji Ozawa, Tokyo-based CIO for Invesco Asset Management (Japan) Ltd.

That still leaves room for further gains if local companies can reach the global average of 15%, Mr. Ozawa added. Invesco’s Japanese equity team currently oversees ¥922 billion in AUM.

Whether Japanese companies will step up to the greater challenge of divesting unprofitable businesses — previously retained as key components of a lifetime employment system unraveling now in Japan — “is hard to say,” Mr. Ozawa said. But with the growing focus on corporate governance now, “the possibility is there,” he added.

That possibility could ultimately give Japanese equities a balance of risks and rewards that stands out in the current market environment, as the post-global financial crisis bull run pushes into its 11th year, proponents say.

Given the landscape of global valuations now combined with geopolitical issues, Hartford HealthCare’s Mr. Holmgren predicted that other sophisticated investors “will be dramatically adding to their Japanese exposure throughout 2019 and into 2020,” pulled in by the prospect of a transformation of the country’s corporate culture capable of producing long-term gains.