September 17, 2014
The shareholder-return target Japan’s government set last month will spur change at the majority of the nation’s companies that don’t meet it, said Scott Callon, an investor who advised on the policy.
The 8 percent goal for return on equity agreed in a trade ministry review shows executives, government officials and investors are determined to see higher profits at Japanese businesses, according to Callon, who was the only foreigner on the panel that decided the target. A specific level will focus companies and give asset managers a standard to press them to achieve, he said. Just 792 of the 1,816 stocks on the Topix index have equity returns of at least 8 percent.
“This is the first explicit statement ever by the Japanese government that a minimum return is necessary in a public company to fund Japan’s future,” Callon, who oversees about $2.5 billion as head of Ichigo Asset Management Ltd., said in an interview in Tokyo on Sept. 8. “Driving low-performing companies to minimum acceptable levels is the biggest task. If you can get every company to 8 percent or above, that’s transformational.”
The report on best practices at the nation’s companies and financial industry, known as the Ito review after the panel’s chairman Kunio Ito, of Hitotsubashi University in Tokyo, is the latest measure aimed at making Japan’s companies more profitable and less prone to holding cash as the nation exits 15 years of deflation. Other steps include a government-backed stock index that picks companies with high profits and a stewardship code to enlist asset managers to engage in dialogue with firms on improving performance.
The 44 percent of Topix companies making the grade compares with 78 percent of firms in the Standard & Poor’s 500 Index, data compiled by Bloomberg show. The profit delivered on shareholders’ funds at Topix companies was half the global average in the 10 years through 2013. The measure fell 0.5 percent today in Tokyo, while the Nikkei 225 Stock Average slid 0.1 percent.
The review says Japan’s ROE falls short because profit margins are “significantly lower” than in the U.S. and Europe and companies hold excessive cash and deposits. The 8 percent target was picked because it exceeds the cost of equity capital assumed by most overseas investors, the review states.
“I would describe this project, along with much of the revitalization strategy, as Japan opening up to the world,” said Callon, 49. “One powerful way to motivate Japanese actors is to say, ‘this is what the global standard is.’”
The 53-member panel of academics, company representatives, investors and government officials debated for a year about which global best practices could be applied to Japan, paying particular heed to European models of corporate governance, Callon said, as they are less combative than the U.S. approach. While one goal was to attract overseas investors, the project’s ultimate motivation was to make the most of the nation’s assets in a mature economy with a shrinking population, he said.
The 130-page report, modeled on the Kay Review in the U.K., calls for the establishment of a forum for companies and shareholders to discuss issues from how businesses should disclose information to ensuring “constructive dialogue” between executives and investors. The debate about how companies are run in Japan has often been presented as a choice between focusing on customers and staff or shareholders, whereas those are not mutually exclusive, Callon said.
The management-investor forum will start this fall, most likely from October, and meet two or three times a year, Ito said at a conference in Tokyo on Sept. 10.
A focus on ROE isn’t new in Japan and has its own dangers, according to Hajime Kitano, an equity strategist at Barclays Plc in Tokyo. The Ito review is a “rehash” of a book published in 1994, Kitano wrote in a note last month. The ROE level set is arbitrary, and too high as efforts to boost profit margins through cost cutting may end up amplifying deflationary pressures and shrink the economy, he said.
Others have the opposite concern. Targeting a specific level of ROE could create a misunderstanding that reaching that goal is enough, Naoki Kamiyama of Bank of America Corp.’s Merrill Lynch unit in Tokyo wrote in a report dated Aug. 13.
For Callon, who has degrees from Princeton and Stanford universities, the report is already having having an impact.
Ichigo Asset “went to see a Japanese public company last week,” he said. “The head of finance said he had assigned the Ito review to every single person in the finance department. They had all read it.”
Boosting Japanese companies’ performance through corporate governance was positioned as a key pillar of Prime Minister Shinzo Abe’s growth strategies announced in June.
“Business in Japan is being transformed,” Abe said in a letter translated by Merrill Lynch and read out at its investor forum in Tokyo on Sept. 10. “Strengthening corporate governance is at the top of my reform agenda. There will be no place for the old-style company in the age of Abenomics.”
The Ito review also criticizes Japan’s sell-side analysts, saying an overly short-term focus and insufficient fundamental analysis are problems that need to be addressed.
Mitsubishi UFJ Morgan Stanley Securities Co. is changing to a “back-to-basics approach” due to the criticism of the industry in the Ito review, and will focus more on company fundamentals, the brokerage wrote in a note dated Sept. 5. It’s changing its rating system from one that forecasts returns versus the Topix to peer comparisons or absolute returns.
The Ito review is supposed to complement the stewardship code, the JPX-Nikkei Index 400 and rules on corporate governance currently being planned by the Financial Services Agency and the Tokyo bourse, according to Callon, who says the change taking place in Japan has support across the spectrum of government and industry.
“The mainstream has gone full acceleration for reform,” said Callon, who’s been in Japan for 25 years. “It’s the first time in my career I’ve seen that.”
* For the full text of the report or an executive summary go to http://www.meti.go.jp/english/press/2014/0806_04.html and scroll down to “Text of the report”.