Corporate governance is improving, but not by enough

Ryohei Yanagi, CFO of Eisai Co. Ltd. talks about Japan’s corporate discount before the BCCJ in Tokyo late last year.  (Picture courtesy of BCCJ)

First published by The Japan Times

Quick test: Two banks “A” and “B” offer interest rates of 2 percent and 5 percent on deposits, respectively. All else being equal, at which bank would a rational person prefer to deposit their savings?

If you chose “B” (the correct answer) your financial acumen exceeds that of many Japan CEOs. The country loses its fair share of foreign inward investment because most CEOs do not understand that global investors, like domestic savers, have a choice. Who would forgo the opportunity of earning 3 percent more over the 2 percent hurdle benchmark rate set by bank “A”? Not a rational person.

Global investors scour the globe in search of companies producing shareholder returns greater than their hurdle rate. Calculating the hurdle for firms is more complex than is our simple bank savings deposit example, but the same idea applies. Firms whose return on equity exceeds their hurdle attract investment. Those which do not are discarded.

For corporate Japan, the hurdle rate is a “magic 8 percent.”

TOPIX listed companies making less than 8 percent return on equity (ROE) trade at 1.0 times their price to book ratio (PBR). That is, investors will pay no more to buy these firms than the cost of the firm’s tangible assets, comprising desks, computers, machines and the like. Above 8 percent, however, PBR rises proportionately with increasing returns. For these more profitable firms, each is valued more than the sum of its parts.

Japanese firms whose price to book ratio is below 1.0 destroy value, thinks Ryohei Yanagi, chief financial officer of pharmaceutical company Eisai Co. Ltd. These firms aren’t value creators. They’re value destroyers, he told a group of British Chamber of Commerce in Japan members late last year in Tokyo. Yanagi is visiting professor at Waseda University. He also helped draft the Ito Review, an Abenomics initiative to reform corporate governance in Japan. The report concludes that Japanese firms must produce more than 8 percent return on equity to create shareholder value.

During the bubble era, corporate Japan’s price to book ratio was about 1.7 times. Since the 2008 Lehman shock PBR has hovered around 1.0. Even after Abenomics caused share prices to double, average PBR barely improved. By global comparison, PBR is roughly 2.0 in the United Kingdom and 3.0 in the United States.

Yanagi believes Japan’s PBR is stuck near par because Japanese firms are overcapitalized. His research suggests about ¥200 trillion of cash and securities sleeps on the balance sheets of non-financial corporations. Investors lose 8 percent of ¥200 trillion each year equal to ¥16 trillion they could otherwise expect to earn if the amounts were returned and reinvested more wisely. “Inefficient asset management destroys value, resulting in low price to book ratios,” Yanagi told this author in a followup interview.

Business schools have long taught how to objectively price capital according to the Capital Asset Pricing Model. The model provides a shared narrative financial managers use to guide investment decisions. But it is not well known or widely used in Japan, where old-guard CEOs have no conscious understanding of the cost of capital. “They understand the cost of debt. But the cost of equity is invisible,” as they don’t have to pay cash to service it, notes Yanagi.

Here, CEOs cling to “safe” cash. Why they do is a matter of Japan’s history and culture. After World War II the nation started rebuilding its economy from scratch. There were no wealthy individuals or equity providers to fund corporations. To fill the gap, banks provided capital under Finance Ministry governance.

At the time CEOs had few cares other than to keep good banking relations. Bank and insurance cross shareholdings released CEOs from concern about minority shareholders, foreign takeovers, etc. While Japan achieved miraculous growth during the 1950s and ’60s, a cash holding mindset also took root.

Today, the old guard cling to “safe” cash — the more the better. Yanagi imagines CEOs telling themselves, “I love cash. I want to sleep with cash. I’ll never invest. I’ll hold cash for the rest of my life.”

To find out if global investors might be discounting the value of excessive balance sheet assets, Yanagi surveyed 140 institutional investors. He asked what they thought ¥100 of corporate cash was actually worth. The vast majority said it was worth only ¥58.

He also analyzed historic data of non-financial companies listed on the Tokyo Stock Exchange spanning the 10-year period through June 2016. Data analysis corroborated his qualitative findings. Investors value ¥100 of cash at ¥86 in companies with good corporate governance (firms like Komatsu and Omron), at ¥48 in firms with average governance and at ¥10 in those with poor governance.

Yanagi believes foreign investors worry CEOs won’t invest or return their money. To protect themselves, they either avoid investing in Japan altogether or discount expected returns. “That’s exactly what is happening in the market,” he says. Yanagi calls it the “corporate governance discount.” Global investors ignore it at their peril.

Last year’s high-profile proxy fight between U.K.- based Asset Value Investors and Tokyo Broadcasting System Holdings exemplifies the problem. The U.K. activist fund bought around 2 percent of TBS’s shares, which traded well below book value. Then they pressured TBS to return cash to investors, to be paid for by the sale of securities TBS held in firms unrelated to their core broadcasting business. By forcing management to return sleeping assets, AVI and other shareholders expected to make a quick and easy $500 million profit.

AVI’s proposal was nonetheless severely defeated in June 2018 at TBS’s annual general shareholders’ meeting. Why did TBS shareholders turn down easy profit? Roughly half of TBS shares were cross shareholdings held by insiders. “They’re all friends of TBS’s CEO. They protected current management,” explains Yanagi.

Yanagi warns foreign investors who think they can profit by investing in Japanese companies whose shares are cheap based on price to book value: “It’s a value trap because cross shareholders always vote in favor of the firm’s management in any event.”

Unsurprisingly, Japanese corporate boards are the least independent out of 21 nations surveyed by Institutional Shareholder Services in 2012-2013. Yet corporate governance is slowly improving.

Poorly run companies are under international and domestic pressure to adopt global standards of capitalism. Global investors like AVI seek greater returns and better corporate governance. Japan’s government has a similar agenda. Through Abenomics, Prime Minister Shinzo Abe introduced the Stewardship Code, the Corporate Governance Code and Ito Review guidelines. Before Abenomics in 2012, for example, no independent director was required to sit on the boards of corporations. Now, two are.

Between 2012 and 2015, foreign ownership of Japan’s listed companies surged from 24 percent to 27 percent. Firms with balance sheet cash and securities exceeding market capitalization declined from 29 percent to 11 percent, according to Yanagi’s estimate. But what did Abenomics really achieve?

Over half the board members of Japanese firms are insiders, while over half the boards of U.S. and U.K. firms are independent. Cross shareholdings here are high at around 30 percent of the market, albeit down from about 60 percent in 1990. In comparison, the level of U.S. cross shareholdings is currently around 5 percent.

Yanagi conducted two surveys, one before Abenomics and the second after, to add depth to these statistics. In the first, he asked global institutional investors if they were satisfied with Japan’s corporate governance. In 2012 only 10 percent of global institutional investors surveyed said they were “satisfied.” In 2018, approval ratings more than doubled from 10 percent to 27 percent. Still, over half were “unsatisfied.”

He also conducted two more “before and after” surveys. This time he asked global investors if they were satisfied with corporate Japan’s return on equity. Satisfaction levels jumped from 5 percent before Abenomics to 28 percent after. Still, the vast majority were “unsatisfied.”

Japan still lags behind its peers. Corporate returns improved from 5 percent before Abenomics to about 9 percent today. “We improved from 5 percent to 9 percent, but we have yet to achieve the U.K.’s 13 percent or the 17 percent return on equity in the U.S.,” says Yanagi. He adds, “We are improving, but not by enough.”

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