Japan’s Return to DividendsKaren See, Investment Manager. Fourth Quarter 2018
For many who have experience of investing in Japan, the phrase ‘Japanese Income Growth’ may seem an oxymoron, given the common complaint that Japan doesn’t have a ‘dividend culture’. And, with a dividend payout ratio that is less than half the long-term average of its peers, perhaps this sentiment is justified. However, it did set me wondering, why did Japan take such a different path to other developed markets with respect to making dividend payments? Can a country really not have a dividend culture? So I turned to history to help me understand how Japan’s approach to corporate governance has evolved and why it might become more income-friendly in the future, as the government tackles the issue of shareholder misalignment.
It all changed with the war
The turning point came following a series of social and political shocks. We can trace the beginning of the corporate Japan we know today to the start of World War Two. The military government wanted to channel as many resources as it could into supporting the Japanese war effort, so it started working more closely with the zaibatsu groups and their banks in a bid to maximise production and put in place an industrial infrastructure. In this environment, dividend payments were suspended in favour of re-investing capital in industrial production facilities. During this time, bank lending overtook the securities market as the main source of corporate funding. The relationship between banks and corporates became a lot more intertwined.
After the war, the zaibatsu system was dissolved by the Allied Occupation Forces (AOF) as it tried to curb the influence of this powerful group. The zaibutsu companies’ shares were bought for pennies and sold cheaply to the public. During this period, the AOF also established a legal framework to protect investors’ interests. Ironically, it was also around this time that the shareholder-friendly nature of Japanese corporates, where dividend payouts were a regular feature and a company’s key stakeholders were aligned, started to reverse.
The suspension of wartime compensation to companies in the 1940s meant that many businesses had to take out bank loans to survive. 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 the debt ended up taking out debt-to-equity swaps to survive. This marked the beginning of banks playing a major role in the share ownership of listed companies: the percentage of listed companies owned by financial institutions went from 10 per cent in 1949 to 43 per cent in 1988. Banks were not the only institutions that started owning more stocks. With the dissolution of the zaibatsu system, corporates started to come together to form alliances, known as the keiretsu system, to defend themselves against take-overs and outside influence – often centred around their own trading companies or large banks, and with cross-shareholdings.
Workers busy in the shipbuilding yards of Yokohama, during Japan’s post war recovery, circa 1950s.
© Paul Popper/Popperfoto/Getty Images.
After the war, the whole nation worked together to rebuild their country and 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. These have far-reaching implications on how corporations are run in Japan to this day. Most people in senior management rise through the ranks of the company. Their loyalty to the company is rewarded with a seat on the board and because of this, their top priority is safe-guarding their fellow workers’ jobs. This legacy remains.
Management’s interests have moved some distance from that of the company’s shareholders: representatives from the main banks often sit on the board, steering strategy towards business conservation rather than growth. Managements are composed of those whose loyalties lie with their fellow workers and therefore are unwilling to close down divisions or cut jobs when required, and a large bloc of cross-shareholdings from other friendly corporates conspire to make sure that management cannot be booted out under their watch. All of these are reasons why Japan has garnered the reputation of not being the most shareholder-friendly place to invest in. But many forget that it once was. Corporate ownership policy has responded to social and political changes in the past, and can do so again.
In many ways, the current system is vastly outdated. It was made for the post-war recovery era with very specific economic goals in mind. Japan has failed to adapt the system to reflect its new economic and social reality. However, it seems that we’re finally reaching the point where change is both desired and necessary.
One factor that is driving change in Japan is the need to counteract an increasingly ageing population and with it a shrinking workforce. Management are beginning to realise that focusing on increasing productivity – rather than upholding the job for life culture – is crucial if Japan’s economy, and society at large, is to continue functioning in a sustainable manner. This change in attitude alone should be liberating: when safe-guarding jobs is no longer the management’s top priority, it gives them more scope to implement effective business strategies.
The key change in post-war Japan that set everything else in motion was the dramatic revamp of corporate ownership. A powerful, long-term focused inside shareholder (the zaibatsu families) was replaced by financial institutions that favoured interest repayment to dividend payment, cash hoarding over growth investment and risk aversion over risk taking. With the mandated unwinding of cross-shareholdings, the influence of bankers is significantly diminishing. The unwinding of cross-shareholdings started more than two decades ago. However, it took the introduction of the Stewardship Code and Corporate Governance Code, in 2014 and 2015 respectively, for the increasingly dispersed corporate ownership to make a tangible difference to overall shareholder returns.
Total Shareholder Returns of Japanese Listed Companies
Source: Mizuho Securities Equity Research, based on TSE.
Note: Note: TSE 1st listed companies as of each fiscal year end excluding financials and Japan Post. Net amount of share buybacks (reported on cash flow statement). Data as of 19 October 2018.
This increase in shareholder returns is the fallout from the government finally tackling the root cause of the problems at the heart of the share ownership system in Japan: the misalignment of interests between inside and outside shareholders. Listed companies are now required to have at least two independent directors on their boards. Institutional investors are also required to play a more active role as the stewards of the business. Both these measures have introduced greater challenge to the way in which managers run the business. They can no longer rely on their friendly cross-shareholders to keep them in their posts, nor can they continue to ignore the interests of shareholders. It is still early days, but changes so far are encouraging.
Progress so far
The headline matrices are looking promising so far. Total shareholder returns have doubled in recent years, through dividend payouts and share buybacks. The number of independent directors has also risen dramatically. In 2015, half of listed companies had no independent directors; by 2017, 90 per cent had at least two. However, there are a few more subtle changes happening in the background that are worth highlighting.
The dramatic rise in the number of independent directors on Japanese boards in the last couple of years is a promising start. However, this is only the first of many steps companies need to take if they are serious about changing board dynamics. It is all well and good having these newly-appointed independent directors in place but unless their roles come with explicit powers to challenge management and well-defined governance duties to perform, it could be that ultimately they fail to have a meaningful impact on the way in which business decisions are made. Undoubtedly there is more to be done, but it is pleasing to see the proportion of Topix 500 companies that have a committee board structure having increased from 20 per cent in 2015, to 70 per cent two years later in 2017.
One of the key problems with corporate Japan from a shareholder’s perspective is the complete detachment of management’s strategic agenda from that of shareholders’ interests. One way of solving this is by increasing insider share ownership. Back in 2013, before the introduction of the two governance codes, there were only four companies in the Topix 500 that had any form of stock-based compensation in place. This has risen to almost 350 by 2017. Greater inside ownership, particularly at management and board level, should encourage those with executive power to think more like owners.
Returning to the dividend payout levels of companies, here too we can also see a difference. This is evidenced by a greater portion of Japanese companies including explicit 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, this figure had risen to 43 per cent. This is a good sign because it suggests that managements are finally incorporating shareholder returns into their capital allocation decision making process.
Risk and IMPORTANT INFORMATION
The views expressed in this article are those of Karen See and should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect personal opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.
This communication was produced and approved on the stated date and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.
Potential for Profit and Loss
All investment strategies have the potential for profit and loss, your or your clients’ capital may be at risk. Past performance is not a guide to future returns.
Any stock examples and images used in this article are not intended to represent recommendations to buy or sell, neither is it implied that they will prove profitable in the future. It is not known whether they will feature in any future portfolio produced by us. Any individual examples will represent only a small part of the overall portfolio and are inserted purely to help illustrate our investment style.
This article contains information on investments which does not constitute independent research. Accordingly, it is not subject to the protections afforded to independent research and Baillie Gifford and its staff may have dealt in the investments concerned.
All information is sourced from Baillie Gifford & Co and is current unless otherwise stated.
The images used in this article are for illustrative purposes only.
The TOPIX Index Value and the TOPIX Marks are subject to the proprietary rights owned by Tokyo Stock Exchange, Inc. and Tokyo Stock Exchange, Inc. owns all rights and know-how relating to the TOPIX such as calculation, publication and use of the TOPIX Index Value and relating to the TOPIX Marks. No Product is in any way sponsored, endorsed or promoted by Tokyo Stock Exchange, Inc.
Baillie Gifford & Co and Baillie Gifford & Co Limited are authorised and regulated by the Financial Conduct Authority (FCA). Baillie Gifford & Co Limited is a unit trust management company and the OEICs’ Authorised Corporate Director.
Baillie Gifford Overseas Limited provides investment management and advisory services to non-UK Professional/Institutional clients only. Baillie Gifford Overseas Limited is wholly owned by Baillie Gifford & Co. Baillie Gifford & Co and Baillie Gifford Overseas Limited are authorised and regulated by the FCA in the UK.
Persons resident or domiciled outwith the UK should consult with their professional advisers as to whether they require any governmental or other consents in order to enable them to invest, and with their tax advisers for advice relevant to their own particular circumstances.
Important Information Hong Kong
Baillie Gifford Asia (Hong Kong) Limited 百利亞洲(香港)有限公司 is wholly owned by Baillie Gifford Overseas Limited and holds a Type 1 licence from the Securities & Futures Commission of Hong Kong to market and distribute Baillie Gifford’s range of UCITS funds to professional investors in Hong Kong. Baillie Gifford Asia (Hong Kong) Limited 百利亞洲(香港)有限公司 can be contacted at 30/F, One International Finance Centre, 1 Harbour View Street, Central, Hong Kong. Telephone +852 3756 5700.
Important Information South Korea
Baillie Gifford Overseas Limited is licensed with the Financial Services Commission in South Korea as a cross border Discretionary Investment Manager and Nondiscretionary Investment Adviser.
Important Information Japan
Mitsubishi UFJ Baillie Gifford Asset Management Limited (‘MUBGAM’) is a joint venture company between Mitsubishi UFJ Trust & Banking Corporation and Baillie Gifford Overseas Limited. MUBGAM is authorised and regulated by the Financial Conduct Authority.
Important Information Australia
This material is provided on the basis that you are a wholesale client as defined within s761G of the Corporations Act 2001 (Cth). Baillie Gifford Overseas Limited (ARBN 118 567 178) is registered as a foreign company under the Corporations Act 2001 (Cth). It is exempt from the requirement to hold an Australian Financial Services License under the Corporations Act 2001 (Cth) in respect of these financial services provided to Australian wholesale clients. Baillie Gifford Overseas Limited is authorised and regulated by the Financial Conduct Authority under UK laws which differ from those applicable in Australia.
Important Information South Africa
Baillie Gifford Overseas Limited is registered as a Foreign Financial Services Provider with the Financial Sector Conduct Authority in South Africa.
Important Information North America
Baillie Gifford International LLC is wholly owned by Baillie Gifford Overseas Limited; it was formed in Delaware in 2005. It is the legal entity through which Baillie Gifford Overseas Limited provides client service and marketing functions in America as well as some marketing functions in Canada. Baillie Gifford Overseas Limited is registered as an Investment Adviser with the Securities & Exchange Commission in the United States of America.
Ref: 35723 ALL WE 0152
Karen See Investment ManagerKaren 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.
YOU MAY ALSO LIKEInsights.Visit Baillie Gifford's Insights page.Global Alpha 2022 Research Agenda.In their Research Agenda for 2022, the investment managers consider the benefits of deep work in helping them find growth opportunities.A New Era of Exploration.Our international investors are explorers: which of the disruptors and innovators will deliver?On The Grid.David McIntyre and Calum Holt summarise their thoughts on the potential transformation of the European energy industry and how this is being embraced in our Multi Asset funds.