David Herro, a $35 billion money manager who learned about Japanese corporate governance the hard way, says for all Shinzo Abe’s efforts, the nation remains 30 years behind in how its companies are run.
Boards are too big and lack diversity, while balance sheets have too much cash, said the chief investment officer of Harris Associates. Herro, whose firm was one of the largest shareholders in Olympus Corp. during its $1.7 billion accounting fraud, says corporate Japan is held back by a reluctance to welcome outsiders and he’s not sure companies buy the government’s push for change.
“Japan has gone from zero to two,” Herro, named Morningstar Inc.’s international stock fund manager of the decade in 2010, said by phone from Chicago on May 20, referring to the overhaul of rules for companies in the past two years. “It’s improving. But we need to get to eight, nine or 10.”
Governance is in focus in Prime Minister Abe’s Japan, with the country starting a new code next week that will call on firms to name two independent directors. It also introduced stewardship principles for institutional investors and a stock index designed to stop firms hoarding cash. Equity analysts have talked up the changes, with Merrill Lynch Japan Securities Co. describing the policies as a “return revolution.”
Companies are starting to display the behavior Abe wants. An index of business spending turned positive last quarter. Dividends and share buybacks will increase by 25 percent this fiscal year, according to Goldman Sachs Group Inc. Return on equity for Topix index companies climbed to 8.2 percent this month from 5.9 percent two years earlier. The stock gauge trades near a 7 1/2-year high.
Yet some of Japan’s biggest stocks are making headlines for the wrong reasons. Toshiba Corp. is embroiled in an accounting probe that it says will reduce profit by at least 50 billion yen ($407 million). Housing-materials maker Lixil Group Corp. has postponed earnings pending an investigation and said one of its units will file for insolvency.
Toshiba “goes to tell you having an effective board is critically important,” said Herro, 54, who still owns Japanese shares from Toyota Motor Corp. to Honda Motor Co. “If you have clean corporate governance, then you have a more proactive management team, you have people pressing and questioning management. If you have a good audit committee you don’t have these scandals.”
Herro has been down that road before. The face of Harris throughout the Olympus affair, he watched as shares of the endoscope maker plunged more than 80 percent in the month after it dismissed its president. Michael Woodford had been asking questions about transactions that the company later admitted were fraudulent. Herro said in October 2012 that the situation at Olympus was eventually fixed and had a happy ending and that he’d doubled his holdings.
Harris owned 1.1 percent of Olympus as of March 31, according to data compiled by Bloomberg.
“Olympus played a big role” in the governance changes, Herro said. “Japan could have swept it under the rug like they typically do, or they could have done some self-examination,” and it took the latter route, he said.
Herro oversees three funds at Harris. The largest, the Oakmark International Fund, has about $30 billion and counts Toyota and Honda among its top ten holdings. Japanese shares make up 11 percent of its assets. Harris owns 14 percent of Daiwa Securities Group Inc. and 13 percent of engineering-outsourcing provider Meitec Corp., according to finance-ministry filings from February.
Honda needs a more diverse board, he said. All 13 of the carmaker’s directors are Japanese. While Toyota is well run, it should buy back more shares, according to Herro. Better use of capital at companies across Japan would ward off shareholder activists, the value investor said.
Cash holdings of non-financial companies in Japan were equivalent to 48 percent of the nation’s gross domestic product at the end of 2014, according to calculations by Daiwa Institute of Research Ltd. That compares with about 20 percent in France and Germany and less than 10 percent in the U.S.
“We are all in favor of a safe balance sheet,” Herro said. “It’s like you own a $50,000 car and insure it for $5 million. It’s pointless. It’s a waste. Buying too much insurance is as much a crime as not buying enough insurance.”
Japan rose to third from fifth in a ranking of 10 Asian countries published by CLSA Ltd. and the Asian Corporate Governance Association in September 2014. It trailed Hong Kong and Singapore.
The nation lags behind in corporate governance because it’s too insular, according to Herro. He has doubts about how much companies believe in Abe’s changes.
“The good thing is, the government is on board,” he said. But companies also “have to want it. They have to realize why it’s good. That’s what I think is missing,” he said. “It shouldn’t have to be legislated. These are things that should be done anyway.”