The Thrill Has Gone for Foreign Investors Weighing Japan's Firms

Foreign investors are starting to question Japan Inc.’s commitment to becoming more capital-efficient.

So says Ryohei Yanagi, who wrote key parts of the Ito review, the government-backed blueprint for the biggest overhaul of corporate governance in decades. Some overseas money managers are losing faith in the revamp because they think executives aren’t taking it seriously, said Yanagi, a lecturer at Tokyo’s Waseda University, citing his own annual survey of institutional investors overseeing 100 trillion yen ($890 billion).

Japan started a governance code for companies in June after creating principles for investors in 2014. The main goal is to make cash-hoarding firms increase return on equity, a measure of profit from shareholder funds. Yanagi, who proposed the 8 percent ROE target included in the Ito review, says about three-quarters of foreign stock owners are unhappy with the results.

QuickTake Remaking Japan Inc.

“Global investors are disappointed,” Yanagi, who is also chief financial officer at drugmaker Eisai Co., said in an interview in Tokyo last week. Fund managers see the new measures as “nice to have, but actual improvements have been too slow. They say there’s no substance.”

The sheen is coming off Japan’s governance overhaul just as the nation’s stocks get buffeted by a global equity selloff as central-bank easing shows signs of losing its market potency. By one measure, earnings in the world’s third-largest stock market are poised to retreat more than 20 percent this quarter. The benchmark Topix index has slumped 18 percent this year through Wednesday, and foreigners have dumped the nation’s shares for four straight weeks. Companies still hold record amounts of cash.

ROE Decline

Return on equity is falling after jumping earlier in Prime Minister Shinzo Abe’s term. ROE at Topix companies stood at 7.8 percent at the end of December, down from a high of 8.6 percent at the end of June. In the quarter before Abe returned to power in 2012, ROE was 4 percent. For firms in the Standard & Poor’s 500 Index, it’s 12.6 percent.

Fewer than half the companies in the Topix exceed Yanagi’s 8 percent target. About 600 members of the 1,934-company index even fall short of a 5 percent level set by Institutional Shareholder Services Inc. The proxy adviser tells its institutional-investor clients to vote against appointing directors at companies that don’t meet that standard.

Equity Spread

Yanagi says his studies show that 8 percent ROE is needed to outpace investors’ cost of capital. One challenge, he says, is that about 90 percent of Japanese chief executive officers don’t know what their cost of capital is. Companies should disclose their equity spread -- the difference between ROE and cost of capital -- to give investors an idea of whether they are creating value, Yanagi said.

“I proposed this to the stock exchange, but they said it’s still too early to adopt it,” Yanagi said.

For Yanagi, lack of awareness of this metric is one reason so many companies in Japan trade below book value. More than half of Topix firms have a price-to-book ratio of less than 1. By contrast, about 85 percent of companies in the S&P 500 have market values that exceed their net assets.

In Yanagi’s survey this year, just 23 percent of overseas money managers said they were satisfied with Japanese corporate governance. That’s down from 29 percent in 2015. Since the start of last year the nation has seen a flurry of corporate scandals, including Toshiba Corp. admitting to artificially inflating profits for almost seven years and Asahi Kasei Corp. saying a unit had falsified data for foundation piles after one of its building sagged sideways.

Strong Compliance

On paper, companies are following the 73 principles of the governance code. Some 1,858 firms on the first and second sections of the Tokyo Stock Exchange disclosed responses to the rules -- which are on a comply-or-explain basis -- by the end of December. About 78 percent complied with at least 90 percent of the regulations, while 12 percent obeyed every single one.

“It was supposed to be substance over form, but foreign investors say it’s become more form over substance,” Yanagi said. “Many responses have taken the form of box-ticking and have been superficial. To use their words, they say many are paying lip service.”

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