Abenomics and its associated corporate governance improvements seem set to continue as Yoshihide Suga became the 99th Japanese Prime Minister in September 2020, while political, corporate and investor ESG policies are also broadening out the focus on environmental and social matters. There is potential to design ESG strategies based on some of the cheapest valuations in developed markets, all of which makes it increasingly difficult to understand why Japanese equities remain such a neglected and unloved asset class.
The genesis of Japan’s government-led drive to improve corporate governance lay in the “third arrow” of Abenomics: the growth strategy, which is part of the Japan Revitalization Strategy. “The Abenomics agenda should continue as Suga is a close ally of Abe and is supported by a strong LDP majority in the Japanese parliament. He was the Chief Cabinet Secretary, and 15 of the new 20 cabinet members have experience in Abe’s previous cabinets. Another aspect of Abenomics – the central bank policy – should also see continuity, as BOJ governor Haruhiko Kuroda has a mandate running until April 2023,” says Alpha Japan President and CEO, Peng Tang.
The perception of Japanese employees consistently spending too much time in the office is an inaccurate older cliché dating back to the lost decade.
Peng Tang, President and CEO, Alpha Japan
There will be some changes of nuance around some policies, however. “Suga will bring his own signature to the policies, perhaps looking to address some of its shortcomings for e.g. more reforms on labour, immigration and tax, reform and digitalization of government services, online medical care, regional revitalization. There could be more of a role for women. There may be more focus on SMEs (smaller and medium sized enterprises) to push for consolidation to raise productivity,” says Alpha Japan Chairman, Michel Amsellem. These developments should be broadly positive for the corporate sector.
Japanese governance continues to improve, albeit from a low base in some cases. “Japanese companies were notoriously opaque and some of them were infamous for not having any investor relations department. There are still periodic scandals, as in all developed markets, but these are exceptions,” says Tang. Investors have also been pushing for improvements in corporate governance. Alpha Japan is a signatory of the “Principles for Responsible Institutional Investors” (the “Japan Stewardship Code”), which was first published in February 2014, then revised in May 2017 and revised again in 2020. The code has a comply or explain policy and “we have always adhered to all principles,” says Tang. The code, which has some overlap with the UK one, is reasonably onerous in asking investors to disclose the rationale for proxy voting on each and every agenda item. This reporting can be outsourced to proxy advisors, of which Alpha Japan uses several including ISS. Notwithstanding this proxy reporting, Alpha Japan’s mode of communication with companies is more discreet and suggestivist than activist. “We are fundamental investors. We might have 400-500 company meetings a year and may suggest things, including some ESG items, but we are not likely to become confrontational like an activist. We would be more likely to exit the position if companies did not behave as we expected,” says Tang.
The first edition of the Japan Stewardship Code, back in 2013, did quietly mention that investors should heed social and environmental risks, but this received very little attention or media coverage. The 2020 edition has more firmly asked asset managers to consider medium to long term sustainability as part of their investment management strategies, and Japanese corporates are doing the same. “Governance had been the main ESG concern in Japan under Abe’s 8-year tenure. Now Japanese companies are working hard on the E and S. They are looking at different concepts and approaches to develop their own one. The European perspective on ESG is different from the American approach and it may take a while to get uniform standards for the Japanese,” says Amsellem. The Corporate Governance Code of Japan is encouraging ESG disclosures.
As of year-end 2019, 223 Japanese companies supported the Task Force on Climate-related Financial Disclosures (TCFD), which was more than any other country
The Japanese Government is another force for harmonization. Suga has committed to carbon neutrality by 2050 (10 years earlier than China’s 2060 target), including next generation solar panels and carbon recycling. Japanese firms are starting to make better climate disclosures and are becoming more transparent on carbon footprints. Japan is arguably leading the world on climate disclosure as the Japan TCFD Consortium – a private/public partnership alliance of investors, banks, companies, Japan’s Financial Services Agency regulator and two government ministries – encourages this. As of year-end 2019, 223 Japanese companies supported the Task Force on Climate-related Financial Disclosures (TCFD), which was more than any other country and almost as many as in the UK and US put together. A substantial number have also committed to the Science Based Targets (a joint initiative of the Carbon Disclosure Project, UN Global Compact, World Resources Institute, and Worldwide Wildlife Fund) and several dozen belong to RE100, which commits firms to sourcing 100% renewable electricity.
Indeed, electric vehicles and hydrogen vehicles, which have become fashionable for investors in 2020, have been an important innovation focus for Japanese companies for many years. “They hold the largest numbers of licenses and patents related to electric vehicles and hydrogen vehicles. There had been plans to use hydrogen vehicles for transporting athletes around the Olympics,” says Tang. This was one of many plans to showcase Japan’s green credentials at the Olympics under the Tokyo 2020 Sustainability slogan, which included making the event carbon neutral, dressing staff in recycled plastic uniforms, and awarding medals made of recycled metals. Meanwhile, Japanese municipalities, banks and companies have been issuing “green bonds”, and Japan has developed its own standards for defining green bonds and avoiding “greenwashing”.
Investors are encouraging all of this. Japan’s Government Pension Investment Fund (GPIF), the world’s largest pension fund, signed up to the UNPRI in 2015 and has been influential. “The GPIF has moved to a smart beta approach and now has USD 37 billion of its assets linked to four ESG indices, representing 11% of the Japanese equity portfolio. This could encourage other pension funds to follow a similar approach,” says Amsellem. The GPIF has made its own TCFD disclosure report and its CIO, Hiromichi Mizuno, has been vocal about his views on the long-term role of investors in promoting sustainability.
Overseas investors are also agitating for change. June 2020 saw the first shareholder climate resolution in Japan, demanding that Mizuho Financial Group Inc make disclosures of climate risks and plans to align with the Paris Agreement. This was supported by 34.5% of votes cast including some Nordic institutional investors (Nordea Asset Management, Storebrand ASA and Kommunal Landpensjonkasse). Though the motion was defeated, it may well spur other similar actions.
“Socially, the pandemic has triggered a discussion about the Japanese corporate model and the purpose of a corporate. Traditionally, the company in Japan was seen as an extension of the family and jobs for life were common. Japanese companies were focused on stakeholder capitalism and reluctant to fire people. This has helped to keep unemployment down to 2.9% in July 2020, only up slightly from 2.3% in 2019,” says Tang. This should be seen in broader political context. “One of the largest ministries is the Ministry of Health, Labour and Welfare. In most other countries, these areas would be separate ministries, but in Japan these areas are tied up,” says Amsellem. “The perception of Japanese employees consistently spending too much time in the office is an inaccurate older cliché dating back to the lost decade when workers wanted more overtime to make up for lower pay. Abe introduced premium Fridays when employees could leave the office earlier once a month for social and family reasons,” adds Tang.
Alpha Japan’s long only fund has a 12-year track record that has earned it a 5-star Morningstar rating for performance while the manager is AAA-rated by Citywire. It is having a strong 2020, up 0.3%, beating its benchmark, which was down 6.2%, by about 6.5% as of 31 October 2020. It is ranked first quartile by Morningstar over 1, 2, 3, 4 and 5 years both in terms of return and Sharpe ratio.
The market neutral strategy, Nomura Investment Solutions PLC – Nomura Alpha Japan Long Short Fund, which has received The Hedge Fund Journal’s UCITS Hedge award, has also performed relatively well. In March 2020, when share prices were not being driven by fundamentals, it scaled back gross exposure and thus limited losses during the height of the Covid-19 panic. Since April 2020, the strategy has recovered most of the drawdown as fundamentals have been reasserted. “Stock selection has generally been working better as investors re-assess early winners and losers from the pandemic and think more medium to long term. Shorts however have been difficult to manage as Covid-19 has lured more retail investors into the market resulting in some distortions,” says Tang.
Alpha Japan has identified some interesting value stock picks but has not made a large overall wager on the value factor, which continues to lag behind growth and momentum in Japan, in common with other developed markets. “We recognize that the spread between value and growth is at a historically high level but are not going to make an aggressive timing call. We are closely monitoring this situation as it is very fluid, with occasional but short-lived bursts of value play,” says Tang. There is perhaps no need to overly emphasise value because most of the Japanese market is relatively good value.
Against this backdrop, Alpha Japan are increasingly confident about launching an ESG strategy. “The European investor base of Alpha Japan’s UCITS funds has also been important in shaping their ESG policies. ESG is already embedded in the investment philosophy, for our long only and hedge fund strategies, and there is a strong demand for strategies that are stronger on ESG,” says Tang, who expects a reasonable position overlap between the new strategy and the existing long only fund, PrivilEdge Alpha Japan – formerly named LO Fund Alpha Japan. The latter has 4 globes rating from Morningstar Sustainability and the maximum is 5 globes,” says Amsellem.
The new ESG fund will have somewhat stricter ESG criteria and probably lower portfolio turnover. Alpha Japan’s existing exclusion list covers controversial weapons, and some rare commodities, but very few Japanese companies are on its list.
More widely followed exclusion lists, such as that of Norwegian oil fund, Norges Bank Investment Management (NBIM), exclude more companies in China or Korea than in Japan. The NBIM list only exclude seven firms in Japan: six electric power companies (Hokkaido, Hokuriku, Kyushu, Okinawa, Shikoku and Tohoku) because they use coal powered electricity, and Japan Tobacco.
Japanese equities remain attractively valued on multiple metrics. “In terms of P/E ratios, Japan fares much better than other developed markets, with the Topix on 16.0x, S&P500 20.2x, Dax30 21.7x, Cac40 21.8x and Eurostoxx50 20.1x. The dividend yield of 2-2.5% on the TOPIX is also above US levels,” says Tang. In terms of price-to-book multiples, the spread between the S&P500 and the Topix stands above 2.5x, a 20-year high.
“About half of all listed companies are trading below book value and many are cash rich,” he adds “Japanese companies entered 2020 with the biggest cash reserves on record on their balance sheets: USD 6.5 trillion of cash and short term securities, up from USD 3.1 billion in 2012. This represents 130% of GDP and the majority of Topix companies have net cash while in the US only 14% of companies do. Whereas in the US cash is concentrated in the technology sector, in Japan it is spread over almost all sectors,” says Amsellem.
Ongoing cashflows are also being distributed. Since 2012, the payout ratio – buybacks and dividends combined – has risen from 35% to 60%. This may be partly due to pressure from activists, such as Oasis Management Company, RMB Capital, Asset Value Investors and Dalton Investments, which have made multiple proposals for companies to buy back shares or otherwise return capital. “In 2020, share buybacks are down 44% on average, but most companies have maintained their dividends,” says Tang. “Indeed, dividend payout ratios are actually expected to increase from 39% in 2019 to 51% this year. Meanwhile most companies’ Q2 earnings announcements have beat consensus forecast and overall EPS could make new records by FY 2022,” he adds.
Some companies have also embarked on ambitious corporate activity. Notwithstanding the Covid-19 crisis, 2020 has already seen the largest ever tender offer for a listed company, NTT’s 4.25 trillion Yen (USD 40 billion) buyout of mobile unit NTT DoCoMo, a stock which Alpha Japan has held.
Whereas in the US cash is concentrated in the technology sector, in Japan it is spread over almost all sectors.
Michel Amsellem, Chairman, Alpha Japan
Value could sometimes be unlocked by foreign takeovers. Japan is also reasonably open to foreign takeovers, and potentially more so than some other increasingly protectionist countries. Takeovers need to be reviewed for competition or security issues, but there is scope for overseas bids and Japan may be more open to a two-way traffic of business with its largest overall trading partner China than many developed countries. Japan had reportedly banned Huawei from supplying telecoms equipment, but it emerged in October 2020 that this was not the case. Since Japanese companies supply Huawei, the relationship is symbiotic.
Restructurings, such as spin-offs of underperforming or loss-making subsidiaries, can also help to unlock value and address conglomerate discounts. Holding companies, such as Softbank, often trade at a discount to their constituents and the cross-shareholding model can also add to discounts. These sorts of valuation anomalies have attracted some of the largest US activists such as Elliott, which is invested in Softbank, and Third Point, which is invested in Sony.
More traditional investors are also highlighting the value. Warren Buffet has taken 5% stakes in Itochu, Marubeni, Mitsubishi, Mitsui, and Sumitomo trading house conglomerates, most of which trade below book value. “Buffett has invested equally in the Japanese trading houses sector, taking stakes in all five major players. This provides exposure to globally facing Japanese companies,” says Tang.
Despite all of this, “foreigners were underweighted of Japanese equities by JPY 22 trillion as of December 2019, according to a Nomura study. They have been net sellers of another JPY 5 trillion from the start of 2020 to the first week of November, according to data from the stock exchange. Though Japan is the third largest economy in the world, it is perceived as a satellite market by investors. But Japanese culture could bring investors back to the market,” says Amsellem.
“It used to be very hard to get investors to travel to Japan. We really appreciate it when they do, and Japanese culture is attracting tourists to Japan. The number of foreign visitors has increased fourfold in about a decade from 8.6m in 2010 to 32m in 2019. It was expected to be around 40m in 2020 with the Tokyo Olympics, before the emergence of Covid-19. Japanese cuisine has also enjoyed strong popularity among all the other cultural exports and people across the world have become more familiar with everything Japanese,” says Tang.
Could politics be a catalyst for a resurgence of interest in the market? “Perhaps the first change of Prime Minister in 8 years and the headline investments made by Buffet could trigger a renewed focus on Japan as an investment destination. This is exactly what happened after Abe came back to power, as non-resident investors bought a net JYP 25tn of Japanese equities and futures within 2 years. During his tenure, the Nikkei 225 advanced by 130%, well ahead of the Eurostoxx50 up 25% and nearly matching the S&P 500 up 138%. Things are obviously different today in the middle of a pandemic, but the relative cheapness of Japanese equities and Japan’s superior handling of Covid-19 within the Asia-Pacific region could persuade some investors to re-allocate. Some 15 countries in the region have just signed the RECP, which covers 30% of the world’s GDP and population. The Nikkei 225 has already surpassed 25,000 for the first time in 29 years as the market saw net inflows from foreigners in early November,” says Tang.