Karen See investigates a giant economy attempting to shake off the legacy of history.
Karen graduated BSc (Hons) in Economics with Japanese from University of Birmingham in 2011. Karen joined Baillie Gifford in 2012 and is an Investment Manager in the Japanese Equities Team.
Japan has a dividend pay-out ratio around half that of other major markets. Many investors regard this as evidence that its companies lack a dividend culture. However, changes already implemented are having a positive impact on returns. And there is more to come.
We can trace the corporate Japan of today back to the start of World War Two. The military government wanted to channel resources into supporting the Japanese war effort. Dividend payments were suspended in favour of re-investing capital in industrial production facilities, and bank lending overtook the securities market as the main source of corporate funding.
The average debt-to-asset ratio for companies by the start of the 1950s was over 60 per cent, compared to less than 30 per cent in other countries. Companies struggling to pay off debts undertook debt-to-equity swaps in order to survive. As a result, the percentage of listed companies owned by financial institutions rose sharply. It was not only banks that owned more stocks – companies came together to form alliances to defend themselves against takeovers and outside influence.
After the war, Japan united to rebuild the country and the economy. A new social contract was drawn up where workers agreed to work hard without demanding high wages in return for job security. This is when lifetime employment and seniority pay, the two hallmarks of the Japanese employment system, were established. Even today, most senior managers rise through the ranks of the company. Loyalty is rewarded with a seat on the board. As a result, their priority is safe-guarding their fellow workers’ jobs. This is one reason why Japan has the reputation of not being shareholder-friendly.
In many ways, the current system is outdated. It was made for the post-war recovery era. Japan has failed to adapt the system to reflect its new economic and social reality. However, it seems that change is now happening.
One driver is the need to counteract the effects of an ageing population, leading to a shrinking workforce. Management is waking up to the fact that increasing productivity – rather than upholding a jobs-for-life culture – is crucial if Japan’s economy, and society at large, is to continue functioning.
The influence is diminishing of financial institutions that favoured interest repayment in place of dividend payment, cash hoarding ahead of growth investment and risk aversion over risk taking. Listed companies must now have at least two independent directors on their board and institutional investors are also required to be more active stewards of the business. These measures have introduced greater challenge to the way managers run the business. They can no longer rely on friendly cross-shareholders to keep them in their post, nor can they continue to ignore the interests of other shareholders.
The headlines look promising so far. Total returns have doubled in the past four years, through dividend pay-outs and share buybacks. The number of independent directors has risen dramatically, from 50 per cent of listed companies having none at all to 90 per cent having two or more. And there are other subtle changes in the background.
One of the problems with corporate Japan from an investor’s perspective is that management’s strategic agenda is often detached from shareholders’ interests. One way of solving this is by increasing insider share ownership. In 2013, before the introduction of the two governance codes, only four companies in the TOPIX 500 had any form of stock-based compensation in place. This had risen to almost 350 by 2017. Greater inside ownership should encourage those with executive power to think more like owners rather than simply as managers.
The dramatic rise in the number of independent directors on Japanese boards in recent years is promising. However, this is only the start if board dynamics are to change. Unless the role of these independent directors comes with explicit powers to challenge management and with well-defined governance duties, they could fail to have a meaningful impact on the way business decisions are made. There is more to be done, but it is pleasing to see the proportion of TOPIX 500 companies with a committee board structure having increased from 20 per cent to 70 per cent in just two years.
Returning to dividend pay-out levels, here too we can see a difference. This is evidenced by a greater portion of Japanese companies showing dividend-related targets in their medium-term plan. Only 8 per cent of the top 1,200 companies had an explicit dividend target in 2004; in 2016, the figure had risen to 43 per cent. This suggests that management teams are finally incorporating shareholder returns into their capital allocation decisions.
Many global income hunters exclude Japan from their strategies, thinking that its lack of shareholder-friendly operations impedes the income Japanese companies can generate. We disagree. We think that a reforming Japan presents a unique proposition to investors.
Changing attitudes in Japan and a great team track record at Baillie Gifford are just two of the reasons you may like to consider this Japanese equity fund. Watch our video with Darius McDermott, managing director at Chelsea, to find out more:
Investment markets can go down as well as up and market conditions can change rapidly. The value of an investment in the Fund, and any income from it, can fall as well as rise and investors may not get back the amount invested.
This article does not constitute, and is not subject to the protections afforded to, independent research. Baillie Gifford and its staff may have dealt in the investments concerned. The views expressed are those of the manager, are not statements of fact, and should not be considered as advice or a recommendation to buy, sell or hold a particular investment. If you are unsure whether an investment is right for you, please contact an authorised intermediary for advice. Baillie Gifford & Co Limited is authorised and regulated by the Financial Conduct Authority (FCA) and is an Authorised Corporate Director of OEICs.
Find out more in our Japanese Income Growth Fund Factsheet.