Unlocking Investment Opportunities in Japan

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Georgie

Welcome to the Ask AVI podcast series. I’m your host, Georgie Frost. Coming up in today’s episode, the focus is on Japan. We’ll be exploring the impact of changes in corporate governance in the country and how this shaping the Japanese business landscape. I’m joined by Joe Bauernfreund, CEO and CIO at AVI Japan Opportunities Trust, and Daniel Lee, Co-head of Japan Research.

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We’ll be sharing their valuable insights for investors looking for growth and opportunities.

Daniel, Joe – welcome. So tell me a little bit more. What is happening in Japan with corporate governance?

Joe

Well, when the late Prime Minister Abe came into power around 2012, he introduced a number of measures that collectively became known as Abenomics, and these were designed to fire up the economy.

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There were three arrows to Abenomics. The first two dealt with monetary and fiscal policies, but the third arrow is the one that really interested us, and that involved the introduction of a corporate governance code and a stewardship code that collectively try to encourage companies to do more for shareholder returns and try to encourage shareholders to pressure companies to do more to deliver those returns.

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And as part of those measures, companies were tasked with generating higher returns on equity, boosting share prices and engaging with shareholders such as ourselves. So we became interested in Japan to a greater extent after a few years, having seen the corporate governance code in operation, and we were attracted to the large number of very cheap companies that exist in Japan, coupled with the idea that through constructive shareholder engagement with these companies, we could work with them in partnership to deliver more shareholder returns.

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Georgie

How does this situation differ with the West?

Joe

Well, historically, companies in Japan weren’t that interested in shareholders. They were interested in other stakeholders. By that, I mean they wanted to make sure that the company had as many employees as possible, that those employees had a job for as long as possible, and that when they retired, they had as large a pension pot as possible.

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And shareholders came very low down in the pecking order. What the corporate governance code and stewardship code tried to do was to promote the interests of shareholders, and at least equalise them with those other stakeholders. Now, in the West, in other countries, what we see is that shareholders are the heart of what companies do, sometimes to the detriment of other stakeholders.

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But for Japan, this was a big shift in policy and in perception.

Georgie

How has this situation, how have the changes, led to you investigating these opportunities that are there? What opportunities have arisen?

Daniel

Well, as I mentioned, the historic culture of Japan was shareholders at the bottom and that was reflected in valuations. It’s very cheap valuations in Japan. And that’s still the case now where we see the changing environment not reflected in share prices and valuation.

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And that creates an opportunity as a value investor to take advantage of those mispricings in the Japanese market and to work with companies on improving their corporate value and raising the awareness of the importance of shareholders.

Georgie

Can you give me an example of a company that’s benefited from these changes?

Daniel

Secom Joshinetsu was a company that was in the portfolio until June 2021, when it was taken private by its parent company.

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So there was a norm in Japan where companies would own other listed companies to protect the subsidiary from nasty shareholders or foreign influence. And the corporate governance code has sought to change that. And as part of that change, the parent company decided to purchase the subsidiary company at a 66% premium to the prevailing share price, which was obviously a huge benefit to AJOT as we

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were large shareholders in that company.

Georgie

Can you walk me through the process of how your research team looks into these companies, this area, in terms of vesting?

Daniel

There are 4,000 companies in Japan. So we’re going from 4,000 companies to 20 companies that are in AJOT’s portfolio. So we’re conducting screens, deep fundamental analysis. We’re trying to find the 20 most undervalued companies that are growing their earnings.

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And where there is an opportunity for AVI to engage with management, to improve the share price and to address the undervaluation. That’s a very detailed and rigorous process to find those 20 companies. And each company takes a few months to research with the team. We have a team of seven people with one person in Tokyo. And the research process involves speaking to the company – ex-employees, to competitors – and really understanding the growth prospects for the company and why it trades at an undervaluation and what we can do to address that come through.

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Georgie

Can you give me examples where engagement has resulted in better corporate governance practices?

Joe

Yes, we had a stake in a business called Fujitec. Fujitec is one of the largest escalator and elevator businesses in the world, with its headquarters in Japan. And like all our companies, it was very cheaply valued. But there was a reason why it was valued cheaply.

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First of all, it had too much cash on the balance sheet, which is an inefficiency that suppresses returns and keeps the share price low. But there were more fundamental corporate governance impediments here that led to a low valuation, including the fact that the company had a poison pill in place which protected it from unwanted predators, particularly foreign companies trying to take over, Fujitec.

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We built up a very constructive, friendly relationship with the company. We presented them with a very detailed analysis of why we thought their share price was undervalued and what they could do to remedy that. And in the end, we took that presentation public and wrote a public letter which enabled other shareholders to understand the extent of the undervaluation and what needed to be done about it, and in turn, allowed them to engage with management.

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All of that led to Fujitec Management implementing a strategic review that addressed capital allocation issues, corporate governance issues, as well as operational and strategic initiatives to help boost profitability. And we had a very positive and friendly relationship with management even after we went public. And the result of that strategic review was that they implemented many of the suggestions that we made.

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The share price went up. And having been a company that traded at a steep discount to where its international peers were trading, we were able to sell out, when it was trading actually at a premium to where its international peers were trading.

Georgie

How are you engaging with the companies in your portfolio?

Daniel

Well, as Joe mentioned, in a very friendly way, trying to be respectful of Japanese culture and of Japanese tradition, and we’re engaging in ways in which we can help the company while also helping other stakeholders.

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So although we’re trying to make companies more aware of shareholders and increase their importance to the company, it’s not at the expense of other stakeholders, which resonates well with management. So we’re looking at issues of capital efficiency, corporate governance, shareholder communication and an overall strategy and how we can help the company grow. And we do that by understanding the companies in a lot of detail and taking large stakes in them.

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Georgie

Specifically, the corporate governance practices. How are you engaging with companies to enhance that side of it?

Joe

It’s been an educational process. So if you think about it, Japanese companies which hold by the corporate governance code eight years ago, they need to do more for shareholder returns, they need to boost returns and equity. And this hasn’t been something that’s been at the forefront of their minds in the past.

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So they’ve had to adjust. They’ve had to acknowledge the fact that shareholders deserve a return, and that they need to listen to shareholders and talk to us and hear what we’re thinking. And at the same time, Japanese shareholders haven’t been used to expressing their view, certainly not to expressing their dissatisfaction with companies, when that arose. So both sides really have been through this educational process.

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They’ve learned that not only do shareholders need a return, but that the boards of directors are there to preserve or protect the interests of shareholders and the best way to achieve that is by having independent voices on the board. So we’ve seen a big increase in the number of independent directors on boards from a very low start ten years ago.

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Georgie

How much of a shift was that in terms of business culture for Japan? It’s only been eight years. And therefore, what risks does that present to investors?

Daniel

Yes, the Japanese companies aren’t going to change their culture overnight. Certainly, if that’s the investor’s expectation, they’re going to be disappointed. What we’ve seen is that every year there’s been incremental improvements and that’s come from shareholder pressure, but also government and regulatory pressure.

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Every year that’s ratcheting up slowly, slowly. And if you step back and look at the changes that have happened over that eight-year period, they’re quite significant. And that, again, is the opportunity because those significant changes haven’t been reflected in valuations. So we see companies that are significantly more shareholder-friendly, improved corporate governance, a better business strategy than we saw eight years ago.

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But the valuations are still just as cheap.

Georgie

So in sum, Joe, looking to the future – where are the opportunities? Where are the risks?

Joe

So the opportunities still exist in Japan. There are still hundreds of cheap companies. There are good businesses and in partnership with us, we’re finding more and more situations where management want the share price to go up.

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Unknown

And they’re looking to us to provide some assistance on that. The risks are that old habits die hard. And it’s probably fair to say that in Japan over the last few years, it’s been a case of two steps forward and one step back. So you’ve had two examples of good things happening, but there are still bad actors, and there’s still situations where they want to keep the old ways and they’re not that interested in shareholders.

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But fundamentally, I think, the commitment of the government, the regulators, the stock exchange and more and more investors coming into the market, both foreign and domestic, which is really important, suggests that this time might be different in Japan. And having been a market that’s been a value trap in the past, there’s a sense today that there really has been a change.

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Georgie

I’m curious, Joe, you look across the globe, how different, how special, how unique is Japan?

Joe

Japan is unique. And Japan is very different to anywhere else in the world. And, as an investor, one has to adapt the way we do things in Japan from how we do things elsewhere in the world. And the investors who are most successful in Japan have taken that on board and respect the unique culture of Japan.

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And rather than make them do what we’re used to doing in the West, we find some kind of compromise, where they adopt some of our values, but we respect their values as well.

Georgie

Joe, Daniel, thank you so much. And thank you for joining us on this episode of Ask AVI. We hope you’ve gained some valuable insights about corporate governance in Japan and have an understanding of how this creates investment opportunities, which the team at AVI Japan Opportunities Trust look to capitalise on.

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For more episodes of ask AVI and information on different investing strategies, please head to the website AssetValueInvestors.com. And remember, informed investing leads to empowered decisions.