Japan ups the ante on corporate governance

August 19, 2021 09:31
Photo: Reuters

As the world cast their eyes on the Tokyo Olympics, international investors turn to Japanese equities in the hunt for attractive opportunities brought by the country’s ongoing structural changes. As a long-term investor in Japanese equities, we believe it is crucial to look beyond the headlines and delve into the fundamentals. Amongst the myriad of factors, corporate governance and regulatory reform is one of the most prominent ones we keep under close watch, as it is expected to have a lasting impact on companies’ performance and return.

Measuring the impact of governance and regulatory reform is no exact science, but a key aspect of improvements seen in Japan has been the introduction of stewardship and corporate governance codes, in 2014 and 2015 respectively. These regulatory guidelines have effectively provided a framework for improvement for Japanese companies—a road map to becoming more economically productive, globally competitive, and better positioned to attract international investment. The recent revision of Japan’s Stewardship Code and Corporate Governance Code, in 2020 and 2021 respectively, provides an opportune time to revisit the progress made to date, expectations moving forward, as well as some of our own firsthand engagement experiences with Japanese companies and regulatory bodies alike.

More holistic approach to increase board independence

Board independence levels continue to be an area of increasing importance in Japan. Governance codes currently include increased external director representation on Japanese company boards and improved diversity at both senior management and boardroom levels. Certainly, clear progress has been made, with more than 90% of TOPIX-listed companies boasting two or more independent directors on their boards more recently. The increase in outside representation is certainly positive and signifies crucial progress in moving Japan closer to global best practices.

However, we believe a more holistic approach is necessary, looking at a company’s whole governance structure, the separation of powers, and a board that is acting in the best long-term interests of shareholders.

Slow progress made on board diversity

The Japanese Corporate Governance Code includes a direct reference to diversity, stating that boards must have a level of gender and international diversity to help ensure they can operate effectively. Five years ago, in 2016, the percentage of women directors represented on Japanese company boards was just 4.8%. However, the government has vowed to rectify this situation, targeting certain industries. Greater regulatory demands have been placed on the energy and utilities sectors, for example, where companies continue to lag behind global market peers when it comes to boardroom diversity. Progress is slow, but inroads are clearly being made. In 2020, the percentage of female company directors in Japan has more than doubled, to 10.7%.

Diversity is an issue that we continue to extensively engage with companies we are invested in, providing guidance on best practices and the potential benefits to long-term performance, as well as pushing for improved levels of disclosure.

Positive direction for the long haul to eliminate cross-shareholdings

Corporate cross-shareholdings have been directly referenced in the most recent update of the Stewardship Code, calling for additional corporate disclosure on the practice. Capital misallocation and reduced market discipline resulting from complicated company cross-shareholdings have long been viewed as among the most serious corporate governance problems in Japan. It is not uncommon for Japanese companies to own large shareholdings in other companies for reasons unrelated to pure investment purposes, for instance, in order to strengthen relationships with customers, suppliers, or borrowers.

The practice, which is often criticized for supporting underperforming companies, reducing company returns on equity through inefficient capital allocation, and insulating management teams from shareholder interests and engagement, has been under regulatory scrutiny for years—and definite progress has been made. Cross-shareholdings as a percentage of total market capitalization were well above 30% at their peak in the early 1990s, but this level has progressively declined since then and today sits at around 10%. This positive trend should continue to reduce the protection of underperforming management teams and free locked-up capital so that it can be more efficiently deployed elsewhere.

While it will take time to eliminate cross-shareholdings completely, with pressure from industry bodies and a regulatory focus on challenging vested interests likely boosting capital efficiency and improving returns potential, the current trajectory is positive.

ESG disclosure paradox

In October 2020, the Japanese government pledged that the country would achieve net zero carbon emissions by 2050. As a result, we are seeing an increase in carbon emissions disclosure from Japanese companies; not yet to the levels displayed in Europe, for example, but a clear improvement nonetheless.

That said, our own engagement with Japanese companies on ESG disclosure reveals an interesting paradox. While Japan leads the world in terms of the number of companies signed up to the Task Force on Climate-Related Financial Disclosures – the globally recognized benchmark – until the recent net zero announcement, most companies’ disclosure reporting was actually fairly average, both in terms of level of detail as well as a lack of actionable items.

Improving shareholder returns

The focus on corporate sector reform has been a key influence in the rise in company earnings and profitability seen in recent years. The quality of Japanese companies – in terms of governance standards, profitability, and, ultimately, returns paid to investors – has continued to visibly improve, closing the gap with European and US equity markets. Companies have been allocating capital more efficiently, paying higher dividends and increasing share buybacks, and these improved returns have been attracting greater foreign investment. The level of share buybacks by Japanese companies reached a record high in 2019, as both regulators and management teams looked to deliver higher returns to shareholders.

We believe, this focus on improvement in Japan’s corporate governance and regulatory reform will only gather pace, creating both risks and opportunities for companies as they respond to, or fall behind, the pace of change.

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Archibald Ciganer is Portfolio Manager, Japan Equity Strategy and Jocelyn Brown is Head of Governance, EMEA and APAC at T. Rowe Price