It is sometimes easy to think that the significant developments in Japan's investment landscape are solely due to international investors. These foreign investors are indeed more vocal and often exhibit a more aggressive approach. However, domestic investors should not be underestimated, as they wield considerable influence. Specifically, the top five domestic equity investors manage around ¥90 trillion. According to recent reports by the Nikkei, these investors are prepared to use their voting rights to challenge the appointment or reappointment of senior management at companies where governance improvements are deemed insufficient or where valuation remains too low. This stance, inspired by guidance from the Tokyo Stock Exchange (TSE), places additional pressure on Japanese management teams to initiate reforms.
New Governance Standards
Mitsubishi UFJ Asset Management
- Mitsubishi UFJ Asset Management will oppose management if the Price-to-Book Ratio (PBR) is less than 1.0x and the Return on Equity (ROE) is less than 8% for three consecutive years, starting from April 2027. This is a significant increase from the current threshold of an ROE of less than 5%. The initial focus will be on companies within the TOPIX 500. If these companies fail to present a strategic action plan by April 2027, opposition will be assured. You must have a plan but will be given some grace period to execute it and attain higher valuation and higher operating returns. Return hurdle is increased from 5->8%.
Nissay Asset Management
- Nissay Asset Management will oppose management at companies failing to address persistent undervaluation, as indicated by a PBR below 1.0x. This condition affects approximately 25% of the TSE Prime market. You must have a plan OR we will automatically vote against you!
Asset Management ONE
- Asset Management ONE, a joint venture between Mizuho and Dai-ichi Life, will oppose companies holding over 20% of their net assets in cross or strategic shareholdings (with the threshold at 40% for the financial sector).This policy targets inflated balance sheets and excessive cross-shareholdings.
Clearly these are not representative of every Japanese investor, but a major domestic pool of capital managers has effectively fully embraced the new TSE guideline on cost of capital and persistent undervaluation. For those corporate managers hoping that this corporate governance revolution will just go away the only good news is that there is a short grace period for them to make plans, act and start showing results. These measures also highlight once again how the bar for acceptable performance in Japan is steadily being raised through time.
Unacceptable Practices
The current landscape makes it clear that certain practices are no longer acceptable:
- Trading below break-up value (PBR less than 1x)
- Earning an ROE of less than 8%
- Maintaining more than 20% of net assets in cross-shareholdings
If these things are true of your company, you must develop a plan and try to resolve the problem OR risk losing your job.
Who might be caught offside by these rules today?
Today more than 20% of the Top 500 companies in Japan do not meet these simple criteria. With approximately 112 out of 500 companies trading below 1x PBR or achieving less than 8% ROE. Across the market around 50% of companies still trade below PBR 1x. In any case a significant proportion of Japanese firms will have to raise their game.
It is true that trading at liquidation value, and just barely covering your cost of capital and running a not totally bloated balance sheet is hardly a very demanding challenge. What is new is that it is a threshold that many Japanese firms have simply failed to cross so far and are now under tremendous pressure to do so.
Example: MS&AD Insurance Group Holdings
Let us take MS&AD 8725. Our non life insurance holding. They would clearly violate the 20% of assets in investment securities rule. Currently they hold 29 Japanese equity positions valued at over $100 million each. These 29 positions alone account for $17.4bn in value against a $27bn market cap. They have now committed to exiting all these positions.
How will they utilise this freed up capital?
We suspect a major policy of excess capital return to shareholders will commence. Yet despite this the firm still trades far below adjusted book. Unrealised equity gains are ¥2.25trillion which being very conservative is a ¥1.4trillion uplift in post tax book value. This argues for a gains adjusted book value of ¥5.5trillion and leaves MS&AD still trading at 0.75x adjusted book today. Clearly if they can buy back shares at below intrinsic value this will be very accretive to investors. We think a warranted valuation over 1.5x PBR is supported by a strong underwriting cycle and ROE exceeding 15%. A combination of undervaluation, massive capital allocation opportunity and improved earnings is a potent combination.
Is this really a big threat to management?
With the top 500 firms boasting a market capitalization of ¥460 trillion, and the entire market valued at about ¥500 trillion, management teams resistant to change are facing a potential 20% headwind solely from policy shifts enacted by large domestic asset managers. When foreign investors, constituting roughly 30% of the market, are factored in, incumbent management teams are likely to encounter significant challenges unless they adhere to TSE guidelines.
Zennor believes that this is a highly positive development. Firms will have to focus, reduce excess financial and non-core assets and think about how to raise returns and valuations. As owners of these businesses the increased alignment of management teams can only be a good thing.
