Managers' views

Investing in the future: Japan's focus on sustainability

29/07/2016

Nathan Gibbs

Nathan Gibbs

Client Portfolio Manager, Japanese Equities

Japan is home to as many as 3,146 companies which were founded more than 200 years ago; some of which can be traced back more than 1,000 years.  We can consider whether this Japanese aptitude for corporate longevity can tell us anything about the sustainability of Japanese business models in the future, and their ability to reward shareholders over time.

Building sustainability

Sustainability can have a variety of meanings but in recent years investors’ approach to sustainability has coalesced around the principle of Environmental, Social and Governance (ESG) factors. Companies’ attitudes to the stakeholders represented under these headings; employees, regulators, shareholders and the environment are now broadly viewed as indicators of future sustainability.

Japanese companies typically have strong social characteristics as principles of lifetime employment and community support have always been part of corporate ethos.

Conversely, Japan is regarded as a significant laggard in governance issues compared to other developed markets globally. In recent years the corporate cultures of certain companies have wrongly targeted “survival at all costs”, leading management to fraudulently disguise loss-making activities in order to preserve the status quo. These individual instances highlight the need for better governance at the board level.

While the current management and governance structures in Japan have evolved over centuries to be aligned with local culture, the system can often appear to lack dynamism and effectively restrict any real challenge of management decisions. At the same time, advances in technology and information flows, also mean that successful business models can now become obsolete much faster. New entrants with a radically different business model can rapidly undercut an established company’s market position, or the value of a brand can be permanently impaired by a scandal. As a result, more than ever before, companies need to innovate to survive and to embrace transparency. In this sense, it may now be dangerous for management thinking to be influenced by the same social factors that have enabled companies to endure for centuries. Investors now need to build into their decisions an analysis of the factors, which allow sustainable business models not only to survive, but also to grow over time.

Clear communication and engagement

Central to a broader development of this theme is a need for companies to explain their position to investors. This in turn requires a legal and regulatory framework which makes clear the rights and responsibilities both of companies and investors. Surprisingly, Japan has muddled through without such a framework which has arguably prevented the stock market from truly fulfilling its role as an efficient mechanism for capital allocation.

The Governance code & Stewardship code introduced by the current government are significant steps in the right direction and these will help to establish the principle of engagement between investors and companies.

This engagement ultimately leads to a much better dialogue between companies and investors in terms of the uses of capital and the returns which can flow from it. This is also closely tied to principles of sustainability as academic studies consistently show that companies with higher ESG scores have better operational performance and benefit from a lower cost of capital.

Establishing a more rigorous framework for governance also allows investors to place more faith in quantitative scoring of particular factors. There are also vital qualitative judgements to be made, for example, about whether these external directors are truly independent, whether they understand their fiduciary duty as directors and whether the company provides adequate training to enable them to fulfil this role. These specific issues will form an increasingly large proportion of Japanese research going forward and this can’t be fully replicated by using only third party data or quantitative approaches. While improved governance is unquestionably a positive for the stock market in aggregate, by enabling clearer analysis of differentials between companies, it also argues in favour of active management and on-going engagement in order to fully reflect these differences in client portfolios.

Conclusion

The recent volatility in Japan’s currency and stock market makes it particularly important for investors to maintain a focus on these positive longer-term stories. On-going developments in Japan are helping to ensure that investors with such a long-term approach will ultimately be rewarded. Identifying these opportunities at the company level requires not only an awareness of measurable factors, but also an increased research effort and a consistent application of qualitative analysis of corporate behaviour.

 

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