Cash-Hoarding Japan CEOs Made Index Pariahs in Abe Plan

In Japan, where company strategies curtail return on equity to half the global average, the government has a new weapon to shame chief executive officers into boosting returns: a stock index.

The JPX-Nikkei Index 400, an investment gauge with members selected for their profitability and use of cash, was started in Tokyo earlier this month. It’s the brainchild of officials in Prime Minister Shinzo Abe’s Liberal Democratic Party, who said they advised Japan Exchange Group Inc. in formulating the measure after outlining a version in campaign literature published in 2012. Companies on the broader Topix index posted an average return on equity of 6 percent over the 10 years through 2013, compared with 12.6 percent for the MSCI World Index, data compiled by Bloomberg show.

While Abe makes no mystery of his attempts to engineer inflation to boost the economy, his foray into indexes is less well-known, and may be unprecedented in developed markets, according to Sumitomo Mitsui Trust Holdings Inc. The JPX-Nikkei 400 was devised to prod Japan’s biggest public retirement fund into putting more of its 124 trillion yen ($1.2 trillion) in stocks, SMBC Nikko Capital Markets Ltd. said.

“I’ve never heard of anything like this happening anywhere else,” said Ayako Sera, a Tokyo-based market strategist at Sumitomo Mitsui Trust Holdings, which has the equivalent of $651 billion in assets. “It sounds like something that would happen in China, where government control runs deep,” she said. “It’s very shady.”

LDP Manifesto

Indexes matter because institutional investors as well as government bodies buy stocks they include in order to tie returns to the success of a broad swathe of the economy. The buying can increase the value of those companies, allowing them to raise more capital for expansion.

JPX-Nikkei 400 members are chosen based on return on equity and cumulative operating profit, which each account for 40 percent of the selection criteria. Market value makes up the remaining 20 percent. Companies that don’t meet corporate-governance criteria may be replaced.

Even after the Nikkei 225 Stock Average, one of two benchmarks for the broader Japanese market, surged 57 percent last year for the biggest gain since 1972, designers tossed out about one-third of its constituents when compiling the JPX-Nikkei 400.

Rejects included Panasonic Corp., which is restructuring to improve profits after record losses, Olympus Corp., an endoscope and camera maker whose accounting fraud led to a revamp of its board, and Tokyo Electric Power Co., the utility at the center of the biggest nuclear accident since Chernobyl.

Two Objectives

“Being chosen for the JPX-Nikkei 400 will be like getting a certificate from the government,” said Kiyoshi Yamanaka, executive officer for T&D Asset Management Co. “In the long term, ROE should improve as companies who were not chosen for the index, and who care about how investors see them, try to get onto the measure.”

An LDP policy paper titled J-File 2012, released Nov. 27, 2012, proposed using a share index to influence corporate priorities and improve the competitiveness of public investment funds. The Tokyo Stock Exchange should design a 300-company measure tied to factors such as ROE and corporate governance, according to a party document expanding on the plan in May.

While Atsushi Saito, the chief executive officer of Japan Exchange Group, said the Tokyo exchange owner and Nikkei Inc., its partner in publishing the index, came up with the idea themselves, that’s not the whole story, according to Yasuhisa Shiozaki, the deputy policy chief for the LDP.

“It was us,” he said in an interview on Jan. 21. “They said 500 companies at first,” while the LDP suggested 300, “so they took the middle ground and chose 400,” Shiozaki said.

Record Cash

The index’s first goal is to change the behavior of Japanese companies by creating an incentive to boost profit margins and avoid holding too much cash, according to Jonathan Allum, a London-based strategist at SMBC Nikko Capital Markets. The second is to get big investors such as the Government Pension Investment Fund to put more of their holdings into the stock market, rather than government bonds, he said.

Return on equity at Japanese companies in the 10 years through 2013 has been among the lowest of 24 developed markets tracked by Bloomberg. The Topix’s average was 6 percent, beating only Greece’s ASE Index, data compiled by Bloomberg show. Companies in the Standard & Poor’s 500 Index delivered 13.6 percent, while the Stoxx Europe 600 Index returned 13 percent and the MSCI World Index’s average ROE was 12.6 percent, the data show.

Business Values

Japanese corporations’ low returns are rooted in business values, said Naoki Kamiyama, chief equity strategist in Tokyo at Bank of America Corp.’s Merrill Lynch unit. Companies sacrifice profits to increase market share and hoard cash as a buffer against bad times.

Profit margins, or the difference between sales and expenses, average just over 4 percent for companies in the Topix, compared with 9 percent for the S&P 500, Bloomberg-compiled data show. Japanese companies’ cash holdings rose to a record 224 trillion yen ($2.17 trillion) in the third quarter, almost the size of Russia’s economy, according to a Bank of Japan report released Dec. 19.

Japan’s 10-year government bonds yield 0.64 percent, the lowest rate in the world, while retirement costs for the world’s oldest population are rising. The Government Pension Investment Fund, or GPIF, owned 71.9 trillion yen in domestic debt as of Sept. 30, making up 58 percent of its assets, it said in its quarterly report.

Share Performance

“If GPIF takes the initiative and uses this index for a large amount of investments, the move itself could improve the share performance of the constituent companies,” said Bank of America Merrill Lynch’s Kamiyama. “If everyone starts investing in this index they can start pointing fingers at the companies without high ROE. I think it’s correct for the government to use policy to try to change people’s behavior.”

A panel appointed by Abe to advise the government on how to overhaul GPIF said it should increase investments in riskier assets and consider using the new measure for equity investments instead of the Topix, which “includes stocks lacking sufficient investment profitability.”

GPIF President Takahiro Mitani said last month the fund is “still considering” whether to use the JPX-Nikkei 400 as its benchmark. ROE for companies in the JPX-Nikkei 400 averaged 11.1 percent over three years, almost twice the 5.7 percent average for the Topix, Japan Exchange and Nikkei said in November.

Investors are waiting to see whether GPIF will put money in the new index before deciding to adopt it themselves, according to Tomomi Yamashita, who helps oversee 639 billion yen at Shinkin Asset Management Co. in Tokyo.

Strategist Doubts

“I’m still watching as the pension funds haven’t decided to use JPX-Nikkei 400 yet,” he said. “If GPIF starts using it as a benchmark, then other pension funds will follow.”

Strategists are skeptical the JPX-Nikkei 400 will achieve the government’s aims.

For SMBC Nikko’s Allum, any index tends to promote passive investment, “regardless of what’s in it.” The JPX-Nikkei 400 also selects companies based on return on equity without considering their valuations, he said.

“Buying high-ROE stocks isn’t necessarily a good strategy in itself,” Allum said. “Investment is about quality versus value. Being included in the index is a badge of honor for the company. But for the investor, you may end up buying cyclical stocks at the top of the cycle.”

The ruling party shouldn’t be attempting to change anyone’s behavior using a stock benchmark, according to Sumitomo Mitsui Trust’s Sera.

‘Less Sway’

“The government should do other things to improve corporate performance,” she said. “Not create an index, but something that’s actually part of economic policy, such as lowering corporate tax rates or easing regulations -- something a normal government would do.”

Equity owners have less sway in Japan than in Europe or the U.S., with the needs of employees, business partners and other stakeholders seen as equally important, said Peter Elston, the Singapore-based head of Asia-Pacific strategy at Aberdeen Asset Management Plc., which oversees $321 billion.

“Everyone talks about Japan having experienced two lost decades, but actually if you were a girl working the elevator in a department store, it wasn’t a lost decade for you because you kept your job,” Elston said. “That is at the expense of profitability and the expense of minority shareholders.”

First Month

In its first month of trading, the JPX-Nikkei 400 has produced the same result for investors as the Topix, with both gauges falling 6 percent. The Nikkei 225 decreased 7.9 percent over the period.

The JPX-Nikkei 400 fell 2.5 percent to 11,063.66 at the close of trading in Tokyo today, while the Topix slipped 2.6 percent to 1,224.09 and the Nikkei 225 lost 2.4 percent to 15,007.06.

The JPX-Nikkei 400 is aligned with plans by Abe and Bank of Japan Governor Haruhiko Kuroda to end 15 years of deflation, according to Resona Bank Ltd., Japan’s fifth-largest lender by market value.

“Too many companies in Japan have poor profitability, but deflation and an extremely strong yen gave them no choice but to tolerate lower margins to compete globally,” said Koji Toda, chief fund manager who helps manage about 18 trillion yen at the Tokyo-based bank. “If Abenomics continues to weaken the yen and spur higher prices, ROE and profits will begin to recover.”

Yen, Inflation

Japan’s currency has fallen about 19 percent against the dollar since Abe came to power in December 2012. Inflation in the nation accelerated in November at the fastest pace since 2008. Consumer prices excluding fresh food rose 1.2 percent from a year earlier, government figures Dec. 27 showed.

“It is odd when the government gets involved in the construction of a stock index,” Neil Azous, founder of Rareview Macro LLC, a Stamford, Connecticut-based advisory and research firm, said in a Jan. 21 interview. That’s not true in Japan, “where the lines have already been blurred by the co-mingling of monetary and fiscal policy,” he said.

Abe will be hoping the JPX-Nikkei 400 succeeds in its goals, as sustaining the rally in Japanese equities will be critical to his approval ratings, according to Jeff Kingston, director of Asian Studies at Temple University in Tokyo.

“Most people assessing the impact of Abenomics see the stock market as the best public barometer for how it’s working,” Kingston said. “The market isn’t something he can afford to neglect.”

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