In recent months, Brandes analysts visited over 35 companies in Japan, including many that are held in Brandes strategies, and a number of potential investment opportunities. The Q&A below summarizes Mr. Omura’s observations and insights. While not to be construed as generalizations of the Japanese market or any industry as a whole, these reflections are integral to the process of analyzing and deriving the intrinsic values of Japanese companies worthy of inclusion in client portfolios.
Q: As a fundamental, bottom-up value investor, why is it important to visit Japan?
SO: Visiting businesses in Japan, and in other countries where Brandes invests, enables us to learn as much as we can about the companies held in our strategies, while at the same time helping us uncover potentially undervalued investments.
These visits aid us tremendously in our research process. They add to our understanding of the industries we cover globally, deepen our knowledge of company-specific trends and profit drivers, and further strengthen communications and relationships between the companies and Brandes.
Q: What are key takeaways from your discussions with company management officials in Japan?
SO: Three main themes stood out from our discussions: 1) consumer-related areas in Japan remain challenged; 2) companies are considering evolving business strategies; and 3) awareness of corporate governance is on the rise.
Q: What consumer-related areas have experienced challenges and why?
SO: While not surprising, and similar to global trends, specialty retail industries such as furniture, jewelry and apparel continue to face difficulties amid changing consumer preferences, both in terms of products and ways to shop.
Companies targeting consumers have felt the impact of an aging population, years of deflation, proliferation of buyers’ choices from e-commerce, and low consumer confidence brought on by slow wage growth. Competition is intense as companies struggle to regain store foot traffic, which has been on the decline.
Q: What are the long-term implications of these challenges?
SO: We believe many specialty retailers are going through a variety of changes for which the ultimate outcome is not yet clear. What we think is clear is that the changes will be difficult and time consuming for company managements.
In our view, domestic-oriented businesses have come to grips with the possibility that the long-term demand for many products and services in Japan will likely be flat or even decline due to demographics and hollowing-out effects (i.e., the decline of a country’s manufacturing sector when producers opt for low-cost facilities overseas).
We have also observed that after a decade of low consumer consumption activity, many companies have been looking to diversify away from business lines geared toward consumer-oriented demand and shift their focus to business-to-business operations.
An important investment consideration is whether consumer businesses have strong enough balance sheets to withstand an extended period of difficult operating environments.
Q: How are Japanese companies in general adapting to the evolving business landscape?
SO: While companies worldwide are constantly reviewing operations to improve and grow, a number of company managements we met with consider using the following strategies to remain competitive:
- domestic consolidation; 2) diversification into other types of business; 3) expansion outside Japan organically or through mergers and acquisitions; and 4) innovation/investment.
- How would you compare domestic consolidation strategies in Japan versus those in the United States?
SO: Compared to the United States, where domestic consolidation has often led to increased market share and in many cases significant cost synergies, consolidation in Japan has not led to immediate, significant cost benefits due to numerous hurdles preventing large-scale personnel reduction. As such, consolidation in Japan tends to be a defensive measure to help protect/increase market share, potentially reduce competition, and pursue higher sales through the consolidated workforce.
Q: How are businesses diversifying to remain competitive and how do you view these moves?
SO: Some companies have contemplated synergistic diversification (i.e., the concept of broadening a company’s business outside its home market through strategic alliances with other companies, joint ventures or acquisitions) in markets where they have a strong standing.
Brandes tends to support this move as long as the amount of capital deployed is reasonable compared to the expected future returns. While broad diversification may turn out to be successful, our preference is for companies to use their existing strengths to cultivate new fields in similar or adjacent fields, instead of venturing into industries and countries where they have no relevant experience.
Other companies have considered chasing new “growth” fields, at which we expressed significant doubt. We strongly questioned the rationale of this move, and will continue to hold management accountable for such decisions.
Additionally, expansion outside Japan organically or through mergers and acquisitions has been a trend over the past decade as many companies have come to realize that Japan could be in a low/no-growth state over the long term.
While we are not against international growth, our discussions have continued to center on the prices paid for assets outside Japan, which we believe have tended to be on the high side. Another key issue is companies’ ability to integrate and manage such assets.
Q: Can you give examples of ways companies can innovate?
SO: Auto component manufacturers are good examples. Many seek to capitalize and adapt to the digitalization of automobiles, a long-term growth opportunity.
Other methods of innovation that some companies have been implementing include passing along legacy know-how and fostering new ideas by investing in the younger generation. Increasing R&D spending for specialty chemical and pharmaceutical companies are other examples.
Q: How is your portfolio positioned given the evolving business landscape?
SO: Our Japanese holdings are fairly diversified across industries and many have implemented positive measures to overcome challenges, including the strategies mentioned above (consolidation, diversification, expansion outside Japan and innovation).
Q: Regarding corporate governance, what improvements do you see and why are they important?
SO: Due to the introduction of the Corporate Governance Code and the Japan Stewardship Code a few years ago, many companies now seem more prepared to discuss core governance issues in depth.1
We have been actively engaging with Japanese companies for over a decade and it is encouraging to note that many have now expressed their willingness to conduct more meaningful dialogues on topics ranging from board composition and director independence, to poison pills (a method to discourage hostile takeovers) and maximization of returns on equity (ROE). These discussions help us learn about companies’ strengths and challenges and their effect on business value.
A broad trend toward improved corporate governance has surfaced among public companies. In 2016, 97.2% of all Tokyo Stock Exchange First Section companies had appointed external directors, a significant increase over the 46.7% that had done so before Japanese Prime Minister Shinzo Abe was inaugurated in 2013.2
Moreover, dividend payments and share buybacks among Japanese firms have been on the rise over the last several years, reflecting efforts to improve shareholder value. However, they still lag those of firms from markets such as Australia, the United Kingdom and parts of Europe.3
Q: As a long-term investor in Japan, what areas of improvement do you want to see?
SO: While we agree with the general investor sentiment that there has been an improvement in Japan’s corporate governance overall, we believe a considerable gap exists between our view of proper management of shareholder capital and how company managements view it. Many of the companies’ beliefs regarding cost of capital, the need to achieve a certain level of return on capital, and what ROEs mean to shareholders, are still fairly underdeveloped, in our opinion. We expect meaningful progress toward these initiatives will take time.
As engaged, long-term minded shareholders, we will continue to advocate for positive change, as we believe the initiatives above represent key issues for many of the companies we own. Ultimately, we believe improvement in these areas could lead to increased shareholder value.
We are confident that our diligence, patience and focus on valuation enable us to select Japanese investments that offer attractive return potential for client portfolios.
1Japan’s Corporate Governance Code establishes fundamental principles for effective corporate governance for public companies in Japan, contributing to the development and success of companies, investors and the Japanese economy through companies’ actions to achieve sustainable growth and increase corporate value. The Stewardship Code provides a framework that would promote sustainable growth of companies through investment and dialogue, with the goal of encouraging institutional investors to get more involved with the companies that they invest, eventually leading to better run, faster growing companies. Sources: http://www.jpx.co.jp/english/equities/listing/cg/tvdivq0000008jdy-att/20150513.pdf; http://www.fsa.go.jp/en/refer/councils/stewardship/20140407/01.pdf
2Source: Citi Research, Japan Equity Strategy-March 2, 2017
3Source: Citi Research, Japan Equity Strategy-March 2, 2017
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