Although Japanese equities appear relatively inexpensive compared to other major global markets, most Japanese firms have produced little excess return in the past 10 years and offer only a limited chance of adding shareholder value
Trading at the weighted average of 1.4 times book value, Japanese equities look relatively inexpensive against other major global markets (1.8 times for Europe and 2.8 times for the US) and their historical average of 2.2 times.
Those who experienced the mega-bull run of the Tokyo stock market in the 1980s probably still remember the incredibly high premium valuation enjoyed by the Japanese market at that time. So what has caused the de-rating?
The chart offers a fundamental answer. Japanese companies on aggregate have hardly earned any excess return over their cost of capital in the past 10 years. Theoretically, they should not trade above their book values ' indeed, 54% of TSE first section companies have price to book ratios (PBR) of less than one times. The current low valuation may simply be a reflection of investors' low expectation of shareholder value creation in Japan.
It is worth considering what may have contributed to this view. First, Japanese companies have focused too much on sales growth and market share expansion at the expense of profitability. This is evidenced by average operating margins staying within the tight range of 3%-5% over the past five years. An example of this is excessive competition for market share in the retail industry, which has led to an over-expansion of new stores in the past few years and has ultimately dragged down operating efficiency and corresponding profit margins.
Typically, loss-making or low-margin operations are kept alive as long as they can be subsidised by other profitable businesses within the firm. Olympus, for example, has a great franchise in endoscopes for medical use, which benefit from a high profit margin. However, its overall profitability has been undermined by its camera division, which has been struggling to break even in the past few years.
The high corporate tax rate has also hurt profit margins. A recent survey by the Japanese government shows that Japanese companies have to pay the highest effective tax rates compared to their international peers in the US and the UK. This is mainly down to the difference in the treatment of tax incentives with respect to research and development costs in the various countries.
The second major factor is that Japanese management has paid little attention to shareholder value as it either does not understand the importance of it or does not feel the pressure to enhance it.
Why this is this so? Japan Inc is mostly managed by employees instead of entrepreneurs. As the seniority-based personnel system still dominates, there is arguably a missing link between performance and reward. Management incentives such as performance-based bonuses and stock options have been introduced slowly over the past few years but the penetration ratio is still low.
Moreover, senior executives, who have usually spent more than 30 years climbing the corporate ladder, tend to maintain a conservative and risk-averse stance when designing their business strategies once they have reached the top. This is mainly due to the fact their succession to the top tends to coincide with the fact they are within a few short years of retirement and hence are due a substantial retirement bonus, historically an important feature of Japanese executive remuneration.
Also, corporate governance is a new concept to most Japanese corporations. A significant proportion of the shareholdings are still in the hands of friendly stakeholders such as banks and business group affiliates that would never question the management on poor business performance or vote in favour of a hostile takeover bid.
While ownership by institutional investors is rising, most still lack clear proxy policies in comparison with their US and UK counterparts. What is more, management surveillance by external directors is still absent in most Japanese companies.
When interviewing companies in Japan, we are consistently told by management that it is extremely difficult to find people from outside the firm that can serve on the board and provide good advice on the business operations. Consequently, there often appears to be a misunderstanding that the external board director's role is to provide general counsel and advice rather than help monitor the operations.
Understanding return on assets is a further aspect of shareholder value that is adolescent in Japan. Mabuchi Motor is a world-class manufacturer of miniature motors enjoying high margins but with a return on equity (ROE) that has been declining over the past five years from more than 10% to 7%. The margins have remained stable but its asset turnover and financial leverage is falling. This is because the company generates ¥30bn operating cashflow each year but only spends ¥5bn on capital expenditure and pays out a further ¥3bn as dividend.
Last year, management indicated it preferred to keep the cash on the balance sheet for future investment opportunities but had no plans to invest in any new business outside the market it knows best, that of the already matured miniature motor market.
As the largest shareholder of the company (the Mabuchi family only owns 30%), the management should have the most incentive to enhance shareholder value but it simply did not see it as any kind of priority. Interestingly enough, Mabuchi introduced its first ever share buyback programme earlier this year.
Another major factor for the poor recent return on assets in Japan is the depressed cost of capital. Management finds it easy to support low-margin business with the low cost of capital. It has also induced excessive investments that ultimately push down the profit margin. But why is it that the capital providers are not demanding a better return?
The nominal interest rate is close to zero. In order to keep the troubled borrowers alive, the Bank of Japan has been supplying free capital to the banking system but the poor return on capital has failed to drive out domestic savings. It would appear Japanese savers are willing to accept the inferior return from investing in their domestic financial assets.
In addition, the demand for loans has reduced due to the structural decline in corporate capital spending resulting from the excessive investments made in the 1990s.
Despite this criticism of shareholder value creation in Japan, we believe investors should not write off the country completely. Japan is changing, although the pace is still slow. Japanese management is beginning to place more focus on return on capital and shareholder value. Personal performance and the company's profitability are beginning to carry greater weight in the remuneration formula. Corporate governance is improving as the unwinding of cross-share holdings is gradually dismantling the stakeholder structure.
Value creators are still scarce commodities in Japan but they do exist. Hoya delivers high return on capital by deploying capital only to businesses in which it has strong competitive advantage and pricing power, like photo mask blanks and eyeglass; Takeda keeps restructuring and divesting its non-pharmaceutical businesses to enhance the ROE despite making record profits; and Nissan Motor shows the huge potential return from a successful turnaround of past value destructors.
Stockpickers focusing on bottom-up research should be able to dig out more value creators in Japan in future.
Japanese companies have focused too much on sales growth and market share expansion at the expense of profitability.
The high corporate tax rate has also hurt profit margins.
Corporate governance is a new concept to most Japanese companies.
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