Japan: more corporate governance, more value

Japan adopted a corporate governance code for the first time in 2015. Among other things, it contains principles that focus on creating shareholder value in the long term. The code is not mandatory, but companies do have to explain why if they do not abide by it. The code was updated in June 2018 and several principles were made more explicit. We will analyse in more detail a couple of aspects of the revised code, which we believe to be a major step forward.

Economic logic

In Japan, many listed companies own holdings in their listed suppliers and/or customers. According to the Tokyo Stock Exchange, listed companies own 22% of the listed market and commercial banks own 3.5% (figures from 2016). This means that 25% of the market value is invested based on principles that may not be in the interests of shareholders. After all, companies that own holdings in their suppliers or customers may lack discipline or lose sight of economic logic in their dealings with these business partners. These cross-holdings can consequently be risky and may constitute inefficient capital allocation. The new version of the corporate governance code encourages companies to present plans for reducing such holdings. The code is therefore helping to put the topic of cross-holdings on the management’s agenda. We see this as a significant improvement.

KGSCF in Japan - May 2018

Photo: The team in Japan, May 2018

Independent board members

The previous version of the corporate governance code stipulated that companies had to include at least two independent board members in their board of directors. The revised code raises the bar slightly higher. If it is deemed necessary, companies need to ensure they have a ‘sufficient number’ of more than two independent board members. Based on our visits to companies in Japan, we have concluded that most companies have already complied with this or are seeking independent board members. The difficulty lies in finding independent board members with relevant knowledge of the sector who can challenge the company’s executive management. Discussions on the profile and role of these independent board members could lead to a more diversified board of directors and ultimately to improved decision-making. We believe that this has the potential to create substantial value.

“Solid management and good governance are essential to small caps.”

Actual progress

We are convinced that solid management and good governance are essential to small caps, as these lead to improve decision-making. In this respect, external independent board members with (international) knowledge of the sector are an important positive factor. The focus that the Japanese corporate governance code places on the return on equity capital, contributes to discussions on capital allocation, including the level and effectiveness of cross-holdings. The changes will of course not occur overnight, but there is plenty to be positive about here. At the same time, it should be taken into account that not all companies are ready to take these steps. In our search for value we therefore conduct a targeted search for companies that can demonstrate actual progress on corporate governance.

Fiduciary duty

The revised code devotes specific attention to the dialogue with shareholders. It stipulates that businesses also need to enter into constructive dialogue outside the general shareholders meeting, with a view to contributing to sustainable growth and increasing their value in the medium to long-term. From the other side, based on the Japanese code, shareholders in Japan need to meet their fiduciary obligations by conducting positive dialogue with the companies in which they invest. In short, for both Japanese investors and businesses, there is a framework that can stimulate the value of companies and sustainable growth via constructive engagement.

Kempen’s approach to engagement

We believe that the requirements contained in the revised code are a good match for the investment philosophy we apply to small caps, which is based on value creation for the long term (see figure 1). We are therefore prepared to view implementation of these changes from a long-term perspective. More importantly, we regularly discuss topics such as capital allocation, investor communications and other governance-related topics with companies. Conversations with local investors and corporate governance specialists have shown that aggressive, activist investors with a short-term investment horizon create their own disappointments on the Japanese market. During our visits to Japanese companies, we’ve noticed that most were open to discussions on corporate governance and to suggestions in this respect. One thing is certain in our opinion: the changing corporate governance environment in Japan requires a long-term outlook and constructive dialogue between companies and engaged shareholders.

Philosophy KGSCF

Figure 1: Kempen’s investment philosophy for global small caps closely matches trends in Japan.

With the Board of Directors

Our engagement in the companies in which we invest is demonstrated by our regular visits. This also applies to our Japanese equity interests. We travelled to the land of the rising sun for the fifth time in June 2018 and talked to fourteen companies. Most of these have been in our portfolios for a considerate amount of time. We brought up several aspects of the corporate governance code, including the reduction of cross-holdings, the aim of increasing the number of independent board members, communications to investors and analysts, and capital allocation. We also spoke to experts and local investors about the governance trends in Japan. At the invitation of Kempen, the Dutch embassy in Tokyo also participated in the meetings, further strengthening our relationship with these companies. In many cases, we talked directly to members of the board of directors, something that is not necessarily the norm in Japan.

Read more on our Japanese opportunities in our Quarterly of February 2017 

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