Japan’s quiet revolutionDonald Farquharson, Investment Manager. Second Quarter 2019
Almost unnoticed, Japanese management is changing for the better. Head of Japan Donald Farquharson looks at the transformation drawing on the experience of three decades of engagement.
I first went to Tokyo in 1991, at the start of a four-year research secondment. Former Soviet airspace had just opened to European carriers, allowing me to fly non-stop from London rather than via Anchorage, Alaska and the North Pole.
Although overseas managers had been successfully investing in Japan since the 1970s, visiting companies – and particularly meeting senior management – was still unconventional. One of the first executives I met confessed he’d never been interviewed by a gaijin (foreigner) before. Another begged me to sell his company’s shares, as monitoring foreign ownership and reporting to the Ministry of Finance was so tiresome.
Much has been written about Japanese management, its contribution to Japan’s postwar economic miracle and subsequent ‘lost decades’. Very little has been written about more recent periods, in particular the nuances affecting competitiveness.
What then is so special about Japanese management? How is it changing and can it deliver competitive advantage? I base my answers on nearly three decades of observing companies, also drawing from academics and governance experts.
The end of groupthink
It is too easy to slip into cultural stereotyping and overgeneralisation about the pace and nature of change in Japan. But companies across many industries do face similar challenges: an ageing population, stagnant domestic markets, commoditisation of products and the threat from nimbler Asian competitors or multinational giants.
Many companies appear to be addressing these challenges in similar, predictable ways – with off-the-peg mid-term plans, or formulaic mergers and acquisitions in emerging markets, which will only incrementally bolster the top line. Sales are still regarded as an important measure of scale and total assets as a measure of power.
Japanese business continues to value group consciousness, despite knowing that herd instinct can be self-defeating. As the US business strategist Michael Porter observed almost 20 years ago, Japanese competitiveness tends to involve head-to-head competition in the same product category rather than genuine innovation, an example being the me-too offerings of its beer industry.
This practice is changing at a pace that should make investors sit up. The catalysts are partly demographics and partly evolving attitudes. The foundations of traditional Japanese HR – lifetime employment, seniority-based pay and single-company trade unions – have been crumbling since the 1990’s breakdown of the ‘convoy’ system, where government, regulators, banks and firms travelled together towards an agreed common goal.
The tight labour market is encouraging the restructuring of underperforming segments. I often see companies closing failing divisions to move personnel to faster-growth areas. Sony, for example, has all but stopped making consumer electronics. Lifetime employment has survived, but only for a lucky few. The five-year job retention rate has slumped, especially among young workers.
According to recruitment specialists Hays, Japanese companies now fill half their vacancies with mid-career job-changers; a third of them motivated by career ambition and another third by salary ambitions. This would have been unheard of just 20 years ago.
Demography is realigning the corporate pecking order. All employees under the age of 50 are part of a post-Bubble generation that does not presume that Japanese practices are best. The layout in newer office developments is subtly less hierarchical, implying a more open mindset among middle management, often seen as the bottleneck of new ideas. A more ambitious and less uniform management culture appears to be emerging.
New ways of working
The Japanese Government continues to press its reform agenda, though its success in reshaping business portfolios has been patchy and there has been a poor take-up of its tax initiatives. Prime Minister Shinzo Abe’s new economic policy package, provocatively described as a ‘corporate governance revolution’ and reflected in the revised 2018 Corporate Governance Code, subtly shifts regulatory emphasis from superficial structure to how capital is reallocated and more effective review processes.
Robots weld car bodyshells at Toyota’s Tsutsumi plant. © REUTERS/Toru Hanai.
When I lived in Japan back in the early 1990s there was little criticism of a system which favoured discipline, uniformity and group consciousness. Japan’s stubborn belief that firms exist not just for profit but also for social good now looks quite prescient. Consideration of wider stakeholders is more marked in Japan and studies suggest shareholders are much less driven by profit maximisation and short-term motives than elsewhere. Provided all stakeholders are treated equally, investors will benefit more than from short-term fixes, such as share buybacks.
Kodawari (uncompromising attention to detail) is highly respected in Japan yet, because it is expected, it is often unrewarded. Many companies complain to us about the low-margins available in Japan. Yet this creates opportunities for innovation around service and product delivery, where new skills can boost expansion elsewhere, especially where a high degree of consultancy is required. The success of Japanese engineering companies like SMC or Keyence shows this.
The revered Japanese concept of monozukuri (literally: ‘making of things’) takes for granted that excellence demands interdisciplinary coordination. Likewise kaizen (continuous improvement) rests on the belief that management processes can be perfected, and that the quest for perfection should be internalised by every worker. The kaizen concept demands consistent, small changes based on constant inter-communication. Semi-formalised ‘quality circles’ support employees in contributing ideas, encouraging patience and openness to trial and error.
Management in Japan is a bottom-up process. Top-down is antithetical to the practice of kaizen within monozukuri. Indeed, management strives to prevent work from becoming dehumanising, by involving everyone in a shared endgame. The automotive crisis of the late 1980s and 90s, when Ford and Renault took controlling stakes in Mazda and Nissan, and Chrysler bought into Mitsubishi Motors, helped spur the industry into improving internal capability and learning from others.
A third of the world’s top [automotive] components suppliers have a Japanese domicile.
Today, Japanese makers outperform US and European counterparts. A third of the world’s top component suppliers have a Japanese domicile. Much of this is due to a culture of sharing ideas, even between competitors, wherever mutually beneficial. Observe, for example, Toyota’s collaborations in hybrid and electric vehicle technologies with other Japanese – and even Chinese – carmakers.
Firms’ ability to build, integrate and share knowledge also extends to creative industries. Japan’s gaming sector, for example, builds on dense informal networks around Tokyo to exchange knowledge and develop ideas. The fashion industry is clustered in the downtown Tokyo hotspots of Harajuku, Shibuya and Akihabara, where competiveness-hampering structures and standards hold less sway.
The electronics and car industries are contrasting examples of Japan’s adaptiveness. In the analogue age suriawase (repeated adjustment and optimisation) afforded electronics’ makers advantages in design and integration of key components. The digital age, with its more modular architecture, is widely seen as having ushered in the decline of Japanese electronics.
By contrast, the car is still a highly integrated product, meaning that all components deliver all of the functions and can be optimised to improve quality. This is a better fit with the organisational capabilities of Japanese manufacturers.
It has not escaped the industry’s notice that today’s cars increasingly resemble the personal computer. How it deals with this will ultimately determine its survival.
More generally, Japanese management still seems to me to suffer from several structural weaknesses. These are: poor strategic decision-making; lack of specialisation and poor incentivisation; absence of shareholder orientation; poor financial literacy; and lack of diversity. The remarkably frank independent report on the demise of Toshiba in 2015 cited virtually all of these, in a company that had the same auditor for nearly 47 years.
That report called for “reform of the corporate culture”, blaming lack of accounting awareness, poor governance, opaque evaluation, a presumption against disclosure and unaccountable advisors. Whilst few are likely to be as extreme as Toshiba, such practices occur in other companies. We challenge them whenever we spot them. In many companies, there is still little or no reward for success. Not being seen to have fallen below a low bar is regarded as a good result. When failures happen, they must be concealed until the situation has been redressed. Most Japanese corporate scandals are less about substandard performance than efforts to cover it up.
Japanese organisation places strong emphasis on middle management and comparatively little on top executives. This can make company meetings with senior management frustrating and evaluating their quality and alignment challenging, to say the least. Everyday operational decisions are taken by middle managers, whereas major decisions need to be sent up the chain. Yet honne (what one genuinely feels) and tatemae (what one says to promote harmony) can impede objectivity.
This tends to lead to a lack of strategic prioritisation and timely decisions. The need for hanko (personal seal) rubber-stamping slows decision-making, encourages imitation and leads to fast-followers rather than risk-takers. This is an obvious weakness in the online age.
Many large firms still prefer generalists to specialists. Job rotation is seen as creating strong identification with the firm as a whole, rather than just a single department. Seniority still plays a major part in how businesses are organised and pay-for-performance remains relatively rare.
However, the old order is fraying. A recent Hays survey shows that almost two-thirds of Japanese are dissatisfied with their salaries while the low pay of senior executives fails to attract top international talent, especially in the technology and internet sectors.
There has been a long-held association of Japan with indifference to shareholder interests. As Akira Matsumoto, one of Japan’s most respected executives, said recently: “It’s shareholders last. That’s actually the best thing for them.” To be fair he was alluding to shareholder short-termism and his view is echoed by a growing number of corporate leaders.
Nevertheless, a tendency to seek stability, for example through cross-holdings, still prevails. As much as 22 per cent of listed shares by value is held by supportive corporations, a proportion unchanged from 15 years ago, according to US investment bank Jefferies, though banks and other financial investors have reduced their holdings.
Since Japan’s Corporate Governance Code was introduced in 2015, companies have been required to account for their cross-holdings to the Tokyo Stock Exchange. Only 10 per cent of companies phrased their reports in 2017 on the assumption that cross-holdings would not be held in future, and only 17 per cent included wording which even considered the possibility of disposals. Firms with large cross-holding shareholders have been shown to be less likely to undertake restructuring. Poor return on equity (ROE) is a function of both poor capital allocation and an associated management mindset which resists setting minimum thresholds.
Along with this goes poor financial literacy. Strikingly, almost half of Japanese corporates surveyed in 2017 believed that their ROE exceeded the firm’s cost of equity, whereas only four per cent of investors agreed. Cash balances are still growing 20 per cent faster than turnover according to CCGJ, a governance research firm. They calculate that, if 2012 cash levels to sales were appropriate, at least ¥25 trillion ($228 billion) in excess cash has built up since. The problem is all too common and is associated with risk aversion, management continuity and the weak authority of the central financial department. Identifying these factors helps us to understand the sort of company we are dealing with.
Another weakness is lack of diversity among Japan’s senior executives and board members. This is at odds with the large number of companies that want to expand abroad. Non-routine succession, often associated with strategic change, remains extremely rare. At 27 per cent, the gender pay gap is wider in Japan than elsewhere in the OECD and female board representation is negligible.
We have long argued for a stronger link between pay and performance in Japanese management and at last this is starting to happen.
But change is coming, for several reasons. First, a closer alignment of management reward with company performance; secondly the increased emphasis on governance; and thirdly, the changing nature of Japan’s corporate landscape. Whether or not external factors change behaviour, they seem to have been more effective in Japan than elsewhere.
We have long argued for a stronger link between pay and performance in Japanese management and at last this is starting to happen. Over two-thirds of Topix 500 companies now have share-based incentive plans. The difficulty is in distinguishing structure from actual behaviour.
The Tokyo Stock Exchange has clamped down on companies’ retaining retired executives as ‘senior advisors’. As well as improving transparency and accountability, perhaps retired executives will stop expecting paid consultancy and look for better long-term compensation and equity ownership when in post.
Another improvement has been the empowerment of the chief financial officer (CFO). As the person meeting investors, the CFO fulfils a vital role: aligning management with performance goals, improving financial literacy and providing challenge in the boardroom. Though many believe the behavioural impact of the Corporate Governance Code to be modest, viewed over a 30-year time frame it looks substantial.
For years, Japan relied on bank-led governance to reduce the risk of corporate conflicts of interest. Management claimed to have its own code of governance before it was formalised and believed that its sense of broader social responsibilities anticipated today’s environmental, social and governance priorities.
But the new code has undoubtedly made a difference. It gives powerful tools to activist investors and has transformed board dynamics by increasing the number of independent directors. There are obvious weaknesses, certainly: most ‘independent’ directors are hand-picked by the CEO; they often have limited external experience; and most prioritise defensive roles, such as risk management, general monitoring or compliance. They rarely challenge strategic objectives. Few firms have a formal system of identifying, developing and evaluating executive talent.
We have long argued for a stronger link between pay and performance in Japanese management and at last this is starting to happen.
There is improvement nonetheless. The revised code is much more prescriptive: ‘comply and explain’ rather than ‘comply or explain’. The focus has moved to the exercise of board powers; it clarifies the need for diversity (gender and international experience) and relevant skills of auditor directors; it presses all companies to have nomination and compensation committees, regardless of the formal governance architecture; it places greater emphasis on designing remuneration systems to provide healthy, long-term succession planning, appointing and dismissing the CEO; and it cites a need to identify accurately a firm’s cost of capital and provide a rationale for holding relationship equity.
Trailblazers such as Fast Retailing, the Uniqlo fashion retailer, have shown that it is no longer acceptable to coalesce around the median. Tadashi Yanai, founder and owner of over a quarter of the company, believes that successful firms should be fast-morphing organisms responsive to market nuances. He discourages standardised operating manuals and gives full autonomy to store managers – something he says prevents employee apathy and “mummification”. His business has set a new benchmark for Japanese managers and is widely followed.
Meanwhile, market forces are making themselves felt. Private equity and venture capital are having an impact. Hostile takeovers remain difficult as boards tend to be dominated by insiders and government often intervenes in failing companies, muscling aside private equity.
But Japanese companies are no longer forever. They are becoming more like their western counterparts, to be merged, bought, sold, split up or shut down as economic necessity demands. From the early 2010s, Japan’s IT start-up ecosystem has benefited from an effective pipeline of entrepreneurs, venture capitalists and angel financiers, promoting action throughout the ecosystem.
Ownership and management
It is a paradox of Japanese management that it thinks long term, yet has a low regard for shareholders. According to research commissioned by the Bank of Korea, 56 per cent of all global companies over 200 years old are Japanese and, until recently, Japan was home to the oldest known family enterprise in the world. Family culture has its roots in Japanese feudalism and Confucianism, seniority and social relations, mutual rights and obligations and belief in trust over achievement. Diligence, frugality, obedience to government and defence of reputation have a significant influence on codes of behaviour.
Japanese long-termism succeeds thanks to the harmonious relationships it helps create. It is generally supportive of research and development (at 3.3 per cent of GDP, Japan spends proportionately more than any country other than South Korea) even where the objective is not immediately apparent. Toyota, for example, is the world’s largest investor in artificial intelligence for autonomous driving, while accepting the redundancy of much of its research.
The relative success of founder – or family – run businesses is not particular to Japan, but it highlights a source of competitive edge. Founder-run businesses show better long-term thinking and a more strategic approach to risk taking. This contrasts to the survival mentality that goes with traditional ‘salaryman’ culture. Decision-making is usually faster in owner-run businesses, as the concentration of ownership and control speeds up decision and action.
Founder-run businesses show better long-term thinking and a more strategic approach to risk taking.
Owner-run businesses also tend to greater entrepreneurialism, risk-taking and optimism than large, salaryman-staffed businesses. By investing in them, we stand to gain from better decision-making, strategic vision and alignment.
In Japan more than elsewhere, the question of management quality and alignment is more nebulous. Equity ownership tends to be low in companies listed pre-1989, before the end of the Bubble, and alignment comes through institutional kaizen.
Many of the newer companies more closely resemble western counterparts in areas such as profitability, returns to shareholders and even issues such as board structure, performance-related pay and personnel promotions and so can be more easily compared. Asking questions about decision-forming and internal promotions won’t always produce satisfactory answers, but it may help you understand the organisation.
Much remains to be learnt, but the relationship between ownership and management structure with competitive edge is especially intriguing in Japan. With clearer reporting and alignment among many newer companies, it is easy to assume an edge, but there are obviously dangers of conflicts of interest between dominant and minority owners, and interference from non-commercial factors stemming from self-interested shareholders. Nevertheless, new external and internal influences are transforming opportunities and making this a particularly exciting time to be investing in Japan.
Risk Factors & Important Information
The views expressed in this article are those of Donald Farquharson 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. Baillie Gifford holds the following stocks: Fast Retailing, Keyence, Mazda, Mitsubishi, SMC, Sony, Toyota.
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.Baillie Gifford & Co and Baillie Gifford & Co Limited are authorised and regulated by the Financial Conduct Authority (FCA). Baillie Gifford & Co Limited is an Authorised Corporate Director of OEICs.
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.
Baillie Gifford Investment Management (Europe) Limited provides investment management and advisory services to European (excluding UK) clients. It was incorporated in Ireland in May 2018 and is authorised by the Central Bank of Ireland. Through its MiFID passport, it has established Baillie Gifford Investment Management (Europe) Limited (Frankfurt Branch) to market its investment management and advisory services and distribute Baillie Gifford Worldwide Funds plc in Germany. Baillie Gifford Investment Management (Europe) Limited is a wholly owned subsidiary of Baillie Gifford Overseas Limited, which is wholly owned by Baillie Gifford & Co.
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 Non-discretionary 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.
Ref: 39238 ALL WE 0212
Donald Farquharson Investment ManagerDonald joined Baillie Gifford in 2008 as an Investment Manager on the Japanese Equities Team. Donald is Lead Manager for the Japan Growth strategy which he has run since its inception in December 2009. He has 30 years’ investment experience dedicated almost entirely to Japanese Equities. He spent 20 years working for Schroders as a Japanese specialist and latterly Head of the Pan Pacific Equity Team and manager of the Schroder Japan Growth Fund plc. Between 1991 and 1995, he headed Schroders’ Research Team in Tokyo. He graduated with MA (Hons) in Arabic Studies from the University of St Andrews in 1987 and is a CFA UK charterholder. Donald became a Partner in 2017 and is Head of the Japanese Equities Team.
YOU MAY ALSO LIKEInsights.Visit Baillie Gifford's Insights page.Tomorrow’s Income Aristocrats.Income investing has been shaken by the coronavirus, but how will this affect the dividend payers of the future? Baillie Gifford investment manager James Dow gives us a glimpse of the potential star performers of tomorrow.International All Cap: the facts, ideas and resilience of today’s portfolioInvestment specialists discuss idea generation, stocks and portfolio resilience for International All Cap.How Do We Do What We Do? - Emerging Markets Investing.One ought to be an optimist to invest in Emerging Markets, but so very few analysts are. Baillie Gifford’s Emerging Markets team explain how they fly in the face of market inefficiencies in their search for excess returns.