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Where next for Japan ahead of the AGM season?

24 April 2024

The Tokyo Stock Exchange is targeting companies with low valuations and its initiatives should inherently benefit value stocks as Japan’s rally broadens.

By Emily Badger,

Man Group

It is a year since the Tokyo Stock Exchange (TSE) published new corporate governance guidelines pressing Japanese companies into driving greater capital efficiency and profitability.

Much has happened since. Now it feels the corporate governance movement is firmly embedded and tangible progress has helped to propel the Nikkei and the Topix to new heights. All of this is underpinned by a pivot towards an inflationary economy following decades of deflation, prompting the Bank of Japan to exit its ultra-easy monetary policy stance last month.

All eyes are now on the annual general meeting (AGM) season in June when more corporates are set to disclose their plans to improve shareholder value. While we are not expecting overnight change, we are anticipating some significant announcements.


Plenty of room to improve

While disclosure rates so far have been impressive, 35% of corporates have still not responded to the TSE’s demands to outline their initiatives. These laggards find themselves firmly under the microscope and must explicitly outline the reasons for not making the required changes.

The TSE continues to ramp up the pressure in other ways. Earlier this year it published a detailed set of requests alongside case studies of companies that had made a head start on improving their corporate governance.

It now publishes a monthly list naming those companies which have disclosed their initiatives – thereby exposing those which have failed to do so – which acts as an important incentive for management teams. The shame associated with not disclosing adequate initiatives weighs heavily on firms and executives.

It is not, however, all stick and no carrot. Positive announcements have generally seen strong reactions. Research by Goldman Sachs has highlighted how companies’ willingness to respond is reflected in their share price performance. As of the end of 2023, an equal weighted basket of the 810 TSE Prime Market names that had responded to the TSE’s request outperformed non-responders by around 12%.


Activist pressure

While there have been many examples of improvements since the turn of the year, with cross shareholdings – a longstanding bugbear of investors in Japan – increasingly under the spotlight, there is mounting pressure for these to be reduced at a faster rate. Some of this pressure came from activists. Indeed, the first quarter saw a 156% year-on-year increase in the number of activist events.

Activists have been relatively successful in cases where they specifically target outsized cross shareholdings. For example, in early 2023, Dai Nippon Printing announced that it would conduct a record share buyback of around $2.2bn and aim to generate $1.6bn in cash through the sale of cross shareholdings. This followed reports that an activist investor had built a 5% position in the stock with the goal of encouraging similar initiatives.

There are many such examples, and they often encourage rival firms, fearful of being targeted themselves or seeming inactive relative to a competitor, to pre-emptively act themselves.

Where next?

While progress to date has been encouraging, a large portion (43%) of listed stocks on the TSE Prime market still trade below book value, a far higher percentage than rival markets. For comparison, just 2% of the S&P 500 and 23% of the Euro Stoxx trade on a sub 1x price-to-book (P/B) valuation.

So far, many companies have focused on low-hanging fruit to improve their return on equity (ROE) – easy-to-achieve initiatives like the reduction of cash and/or cross shareholdings to enhance balance sheet efficiency.

At the forthcoming AGM season, some additional announcements of this ilk are expected. To some extent this is already being reflected in the share prices of the most likely candidates for change.

But the average Japanese corporate balance sheet remains unlevered and cash rich. The percentage of companies with net cash on their balance sheet remains high at 46% versus 14% in the US and 21% in Europe. That means there is plenty of work left to do on this front.

However, the more radical improvements to underlying profitability and the successful reform of cost structures, business models and business portfolios will take time to implement. But these longer-term solutions should extend the longevity of corporate governance reforms as an investment story.


A broader rally

With a policy that is generally targeting companies with low valuations, the TSE’s initiatives should inherently benefit value stocks.

Yet very much like the US, Japanese market breadth over the last 12 months has been narrow.

Performance has largely been driven by a select number of top cap value stocks as well as some technology stocks – even though these two areas of the market are expected to benefit less from the corporate reform push.

The reason is that foreign investors, who have flocked back to Japan, have focused on a small collection of well-known companies. With some stocks now looking overvalued, we expect the rally to broaden to more value names.

Moreover, the TSE has emphasised the need for the wider market to focus on long-term improvements to shareholder value; simply reaching 1x P/B – something some companies will achieve simply through market appreciation – is not going to be enough.

A year ago, we said ‘this time is different’. Given the disappointments of the Abenomics era, this was a bold claim. But the TSE has proved it really does mean business – and corporate Japan, long so adept at resisting change, is finally listening.

Emily Badger is a portfolio manager in the Japan CoreAlpha strategy team of Man Group. The views expressed above should not be taken as investment advice.

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