Corporate governance in Japan seems to have improved since the Global Financial Crisis of 2008. Several important developments have occurred, which should improve shareholder returns and how corporations are run. Last year, the newly introduced JPX‐Nikkei 400 Index made it clear that a return on equity of 8% or better was needed for inclusion. This is a very clever way to use Japan’s shame culture to force underperforming companies into taking not-so-popular actions, such as firing employees, spending cash on their balance sheets to acquire other companies, and selling unprofitable divisions, with an eye toward improving shareholder returns.

The Japanese Financial Service Agency also introduced a “Stewardship Code” targeted to institutional investors, and the Tokyo Stock Exchange just approved a Corporate Governance Code, which encourages Japanese companies to behave in such a way as to improve corporate governance As part of the new code (and reflecting pressure from foreign investors, among others), there is increasing pressure to add outside directors to the boards of Japanese companies in order to protect shareholders’ interests. Many Japanese companies tend to be very insular even today, and are primarily run by Japanese men who studied at a small number of very prestigious universities. Japanese boards have the fewest female directors among OECD countries: only about 3% of board seats are held by women in Japan vs. a global average of about 18%1.

These initiatives are encouraging and support investors’ expectations of better long‐term investment returns in the future. However, some serious headwinds remain for the substantial improvement of corporate governance and shareholder returns in Japan. These include: 1) a lack of laws regulating professional investors, such as ERISA, and the nonparticipation of proxy voting by many professional investors as a result; 2) rigid labor regulations and labor market; and 3) a lack of the use of stock as a significant portion of management’s total compensation, to name a few.

Regardless of whether Japanese corporate governance improves substantially from this point onwards, my colleagues and I have identified what we believe to be a superior and sustainable way to invest in Japan for long‐term capital appreciation. After being disappointed by so many Japanese corporate managements in the past 15 years, we have begun to concentrate our efforts on finding managements that have been more forward-thinking about shareholder value. We have visited and/or met with more than 1,000 corporations in Japan over the last 15 years and have come to realize that a company where the founder is still actively involved in management and owns a sizable stake generally has a better long‐term track record. What’s more, the stocks of those companies have performed well even in the two lost decades of the post‐Bubble era.

Our research indicates that founders are the most vested shareholders in all areas, having the most emotional, reputational, and monetary capital invested. They take enormous pride in their creations and often have a strong, long-term commitment to the company’s success. These individuals tend to have a high degree of management skill, as well as specific industry knowledge and a deep network, enabling them to gain the confidence of the very conservative Japanese banking industry and other financial resources.

Risk capital is still not very well-developed in Japan. The total amount of venture capital funding is one-sixth of that in the US, and the Japanese venture capitalists themselves are not as experienced as their American counterparts, and therefore, are generally less qualified to give management advice. Japanese company founders must be independent thinkers and exceptional managers to start, sustain, and grow their companies in a very difficult entrepreneurial environment. One cannot even compare the founders with the famous Japanese “salary man” (hired hand) managements. From the outset, even before we started our in‐depth analysis of this group of companies and their stock performance, we suspected that the salary man managements had little chance of beating these unique, very motivated and focused managers with vested interests in their firms.

In order to test our hypothesis, we constructed the Japan Founders Index (the “Index” or “Founders Index”)—a group of companies that met the following criteria:

  • Index constituents must have a founder involved in the operations of the business.
  • The founder must own shares of the company and must not have sold shares other than for regulatory/compliance reasons.
  • Index constituents are reviewed quarterly for eligibility, which includes seasoning, market capitalization, and liquidity requirements.
  • The index constituents are rebalanced quarterly and are weighted equally at the beginning of each quarter.

With analyst Utako Kojima’s assistance, we back‐tested the performance of the Index[1] using the criteria above to select companies in the beginning of each year, in order to avoid survivorship bias. We painstakingly analyzed many original, Japanese documents provided by the stock exchanges, the FSA (Japan’s Financial Service’s Agency), and the companies themselves to create a list of the Founders Index constituents each year from 2001 to 2012. Since 2013, we have been managing this Index internally at Horizon Kinetics, with quarterly rebalancing — and the results were even better than we had expected. The Japan Founders Index outperformed MSCI Daily TR Net Japan Index (“MSCI Japan”)[2] by 5.2 % per year since 2001. This performance is even more impressive considering that this period includes the three‐year stretch from 2006 to 2008 when small, entrepreneur‐run stocks suffered very serious indiscriminate sell‐offs after the infamous Livedoor incident.[3]

The chart below summarizes the returns of the Japan Founders Index vs. the MSCI Japan and TOPIX (the Tokyo Stock Price Index).

Horizon Kinetics Japan Founders Index 3.30 update

 

As it stands today, the Japan Founders Index has 149 members and an average market capitalization of $2.2 billion, which is much smaller than the MSCI Japan Index. 84% of the constituents are in the service industries, where capital investment requirements are lower and internal cash flow can better support their operational cash needs. The Founders Index has very little overlap with more well‐established Japanese indexes, such as the MSCI Japan (only 6.6% overlap).

Knowing most of the current constituents of the Founders Index, we believe that, regardless of external environments, these companies should continue to outperform their more traditional peers. It is very fitting that when we were looking for a joint venture partner in Japan to create a mutual fund based on the Index, our final choice was a member of the Japan Founders Index, as he understood the concept immediately and acted swiftly to make it happen, whereas more traditional financial firms were very slow to move, even though many of them liked the idea, as they did not want to try something new and different.

 

[1] Back‐tested performance is hypothetical (it does not reflect trading in actual accounts) and is provided for informational purposes to indicate historical performance had the index been available over the relevant period. Actual performance may be materially lower than that of the index, as the index does not include expenses and fees. Such results do not represent the impact that material economic and market factors might have on the investment adviser’s decision‐making process if the adviser were actually managing client money. Back‐tested performance also differs from actual performance because it is achieved through the retroactive application of portfolios designed with the benefit of hindsight.

[2] The MSCI Daily TR Net Japan Index is a free‐float adjusted market capitalization weighted index that is designed to track the equity market performance of Japanese securities listed on Tokyo Stock Exchange, Osaka Stock Exchange, JASDAQ, and Nagoya Stock Exchange. The MSCI Daily TR Net Japan Index takes into account both price performance and the reinvestment of dividends after the deduction of withholding taxes using a tax rate applicable to non‐resident institutional investors who do not benefit from double taxation treaties. Dividends are reinvested at the close of trading on the day the security is quoted ex‐dividend.

[3] http://www.nicmr.com/nicmr/english/report/repo/2006/2006spr03.pdf

 

Ayako Hirota Weissman is Senior Portfolio Manager and Director of Asia Strategy at Horizon Kinetics LLC, and has over three decades of investment experience in US and Asian equity. Prior to managing investment in Asia and Japanese equity, she was Managing Director and Senior Portfolio Manager of US Equity at Solomon Smith Barney Asset Management.