The environment for activist-oriented strategic investments continues to evolve rapidly in Japan, where vocal shareholders have gained considerable clout vis-à-vis other Japanese corporate stakeholders over the past few years. By far, the biggest change enabling this has been in the mindset of senior managers at publicly-traded companies. As recently as three or four years ago, many executives in Japan spent more time chasing profit or revenue growth than managing their companies’ balance sheets. Nowadays, thanks in part to the role played by activists, concepts such as return on equity (ROE), return on assets (ROA) and return on investment capital (ROIC) are at the forefront of senior managers’ minds. Moreover, leaders of companies with underperforming stocks now know their firms may become takeover targets. As a result, management is warming to activist shareholders with clear agendas and solid track records for boosting share prices. This ‘Constructive Activist’ model, which typifies strategic investments by SPARX Asset Management Co Ltd, seeks to engage in a dialogue with management on corporate best practices that is neither openly hostile nor over-friendly in nature. Unlike hostile activist funds, which have come under intense scrutiny in Japan, Constructive Activist funds tend to maintain a low profile, entering and exiting investments with little fanfare. And that may well be best suited for maximising returns, at least in Japan’s equity market.
What is an “Activist Investor?”
The term ‘activist fund’ has come into widespread use in Japan as well as overseas of late, but the modus operandi employed by these investors is not always understood. The definition of an activist in the investment world is broadly recognised as comprising a vocal as opposed to passive shareholder. But that can encompass strategies ranging from Eco-funds and ‘socially responsible’ funds (which were fashionable for a while in Japan) to those that focus solely on corporate governance or meeting certain quantitative metrics.
For the purposes of this article, activist funds are defined simply as those which proactively and directly make use of their status as a shareholder to influence company management. We will examine why this kind of fund has appeared in Japan, sketch out the historical setting for their development and explore the kinds of opportunities these funds are targeting. Further, even though ‘activist investment’ is a single term, it is difficult to generalise about the methods and techniques used, as these vary from one manager and fund to another. Accordingly, this article will simply outline the value creation investment strategy applied by SPARX Asset Management as one example of an activist investor.
Japan’s Social System: Migrating from Bureaucratic Control to a Market Economy
First, a little history is in order. For much of the past 50 years, Japan’s bureaucrat-led economic model experienced remarkable success as the nation grew into the world’s second-largest economic power.
Under this model, great emphasis was placed on corporate groupings based on the former zaibatsu industrial combines, which centred on the close relationships these groups had with their main bank. This involved a network of equity cross-holdings usually cemented by the majority shareholder status of the group’s main bank. Big banks therefore exercised strong influence over corporations in their group and, as a consequence, consumers and ordinary shareholders had very little sway over company boards. Because Japan achieved amazing economic growth and prosperity through much of the post-World War II period, broad-based corporate governance and shareholder rights for the most part were either dismissed outright or ignored. The system for allocating capital became the exclusive providence of the big banks operating under the heavy hand of ‘administrative guidance’ from the central government. This monolithic framework began to crack slowly, but surely, with the freer movement of capital that accompanied the 1985 Plaza Accord, when the yen was allowed to appreciate against the US dollar in a managed float. That unleashed a wave of competitive, market-driven forces that triggered a historic shift in Japan from a bank-cantered capital structure to one centred on shareholders.
The Japanese Stock Market after the Collapse of the ‘Bubble’ Economy
After the Plaza Accord, the Japanese stock market peaked in 1989 and then dropped drastically during the 1990s. As of April 2003, the Japanese stock market had dropped nearly 80%. The first major downturn in that structural swoon ran from December 1989 until August 1992. Over this 32-month period alone, the stock market declined 63%. Subsequently, from August 1992 until April 2000, the market traded in an extremely narrow range. After this relatively tranquil, if depressed, interlude, the market experienced a further serious slump – ending in 2003 – due to the ‘tough medicine’ reform policies adopted by Prime Minister Junichiro Koizumi. In this period, the Japanese stock market declined by about 60% from its already low levels. The big banks, which had been protected by a stable ‘convoy system’ of shared interests, found themselves caught up in the large-scale industrial restructuring brought about by this relentless market decline. Deregulation led to increased competition in the banking sector, so the status quo no longer protected the weakest banks. At the same time, banks big and small were forced to sell off much of their cross-holdings to write off mounting loads of bad loans. In this way, the decline of market valuations across the board invited a fundamental change in the existing business model and a broader structural reform of Japanese society. The unwinding of cross-holdings by banks caused a broader crumbling of the social structure that had supported Japan’s high post-war economic growth, by forcing companies to streamline via selling off unprofitable divisions, closing factories and downsizing unprecedented numbers of workers. As calculated by one foreign financial institution, cross-holdings had represented more than 50% of the entire Japanese equity market in the early 1990s, but have now been reduced to less than 20% in the space of just over ten years. With regard to corporate governance, this means there has been real change in the corporate culture: the concerns of big banks and creditors have taken more of a back seat to those of ordinary shareholders.
This structural shift in the market, namely the liquidation of the cross-holdings, can be said to be the major reason for the rise of ‘activist’ investors. At present, activists and shareholders whose interests coincide with them, namely, shareholders who stress stockholder profits, represent some 80% of the Japanese stock market. Needless to say, this offers an environment in which it is much easier to support activist activities than ever before. While activism has been prevalent in other developed economy markets like those of the United States, the activist-friendly environment is much newer in Japan. We have only to think back to the time when T. Boone Pickens became a major shareholder in Koito Manufacturing in 1989 – and failed to win over its management – to understand this.
Business Restructuring Takes Root
Another major reason for activists making inroads in Japan can be found in the balance sheet of major Japanese companies. In the depressed environment that followed the end of the so-called speculative asset-led ‘bubble’ economy of the late 1980s, investment valuations continued to fall, a condition referred to at the time as a ‘balance sheet recession’. In such an environment, there were few assets that could be spared to return to shareholders, so investment opportunities for activists were therefore quite limited.
However, in the severe deflationary environment of the 1990s, efforts by corporations to continue to reduce costs cut their break-even point to its lowest historical level ever. But as a result of that effort, companies were slowly transformed into organisations that were able to deliver profits. The upshot is that corporate profit levels in Japan have risen with sales to reach their highest levels of all time. Still, no matter how much Japanese enterprises increased their returns and cash flow, their liabilities have been so great that they have had to channel these earnings towards paying down debts. Since corporations have been using their plentiful cash flows to accelerate debt repayment, dependence on debt has already dropped well below their historical averages. This is especially true for large enterprises, which can finally be said now to have completely resolved their problems with excessive debt. So at present, Japanese corporations are steadily piling up cash on their balance sheets, and historically speaking, are the most cash-rich they have ever been. Balance-sheet restructuring has progressed to such an extent that there are now plenty of assets (such as cash) on the balance sheet that could, at least theoretically, be returned to shareholders. Surely this fact is another reason for the appearance of activists on the scene who seek to have this surplus cash on balance sheets returned to shareholders in the form of dividends, etc.
Japanese Stock Market Valuations
If one looks at the cash on the balance sheet from a valuation (corporate value) perspective, what would one see? Note that when a typical equity investor talks about valuation, it often refers to share price such as the PER (price-to-earnings ratio) or PBR (price-to-book ratio).
Currently, the PER or PBR of Japanese shares are at an extremely low level compared to the equity markets of other major countries, but for an activist, a comparatively cheap PER or PBR is not sufficient reason on its own to invest. Cheap is not enough. A prospective investment must be extremely cheap to make it worth the effort. Let’s examine valuations using standards based on enterprise value (EV) (ie stock capitalisation + aggregate amount of debt – cash on hand), which is used as the basis for valuing private corporations and acquisitions.
The EV/EBITDA ratio (EV divided by Earnings Before Interest, Taxes, Depreciation and Amortisation) is used to evaluate takeover prospects and indicate how many years it would take for the company’s cash profits to repay the acquisition cost. If this ratio is low, that company is said to be a relatively cheap acquisition target. In short, it is not a measure of share value itself, but rather of purchase value, an index that values a company’s ability to generate cash. When one looks at the Japanese share market with this EV/EBITDA ratio, one sees that Japanese corporations are comparatively cheap, even when comparing them using this acquisition valuation basis. There are few publicly listed companies anywhere in the world with an EV/EBITDA multiple of less than 5x, but in Japan, as of June 2006, 400 of the 2,500 listed companies with market capitalisation of ¥100 billion have EV/EBITDA multiples of less than 5x. This means that these companies are in a situation where five years of cash profits would pay for the acquisition of the company. In other words, these are bargain-sale prices. When activist investors view these companies from this perspective, Japan appears to be extremely cheap. This is yet another reason for activist investors to flock to Japan.
These very inexpensive purchase prices are directly connected to a greater number of mergers & acquisitions (M&A) and hostile takeover bids. This trend is also being systematically backed by changes to Japan’s commercial law, which should ease corporate takeovers by means of stock swaps, a change certain to accelerate the number and scale of deals in the future. On the one hand, there is an increase in the number of companies that are targets of acquisition, but on the other hand, this will likely lead to more competition among acquisition players, including buyout funds.
Signs of the Demise of Deflation
Another most important point when evaluating a company’s acquisition value is that Japan is starting to see an end to deflation, a major turning point in the Japanese economy. Until now, Japanese corporations have faced a deflationary environment, contriving to make profits through painful efforts such as cost reductions, and stashing cash in their balance sheets. Even though they are in their most cash-rich situation ever, what does the end of deflation mean for these kinds of Japanese corporations? It means an increase in earnings. For Japanese corporations that have slimmed down under the deflationary environment, it means an even more rapid expansion of profit. This means that the EV is even now increasing and becoming even cheaper. Another way of looking at this is that the risk of being taken over is increasing for Japanese corporations while investment opportunities are growing for activists. Why has the acquisition value of Japanese corporations stayed relatively cheap, and become even cheaper and why has this way of valuing acquisitions been adopted? The background for this is explained above by the structural changes in the Japanese share market. Until now Japanese companies were protected by cross-holdings, and they gave no thought to being an acquisition target. But now that these shareholdings have been liquidated, companies now can be more easily acquired. In spite of this dramatic change occurring in Japanese governance structures, managers have not changed their management style in response to this. This helps to explain what we have seen in Japan when activist funds have attempted hostile takeover bids or when Livedoor attempted to acquire Nihon Broadcasting.
What Japanese Corporate Managers Should Do
Japanese corporate managers are increasingly thinking of ways to pre-empt a hostile bid. But what can they do to abate this kind of takeover risk?
For Japanese corporations that continue to liquidate their cross-holdings and which have little hope of attracting stable stockholders, their only choices to prevent takeovers are to (1) improve valuations by heightening profitability, (2) improve their ROE and (3) improve other indices that show a return to shareholders or which increase their market capitalisation. In other words, they need to demonstrate to investors concrete plans to increase their earnings and their value. That also means investing in business fields with good prospects for growing revenue and, conversely, spinning off unprofitable investments through corporate restructuring efforts. It is also very important that they develop an M&A strategy from a buyer’s perspective. In conclusion, Japan Inc. is moving away from an approach centred mainly on the reduction of excessive debt and shifting into a phase of returning cash flow to its shareholders. This means it is necessary to re-evaluate balance sheets by making better utilisation of underused dividend boosting and share buyback policies.
In the past, many Japanese companies sought to improve their earning power through drastic improvements in ROE, primarily by boosting margins through restructuring and other cost-cutting measures. But in the future, the emphasis will need to be on total capital turnover. That is to say, corporate management strategies are changing from ‘deflation-fighting’ strategies in which earnings do not grow much, to ‘post-deflationary’ growth strategies that raise capital efficiency and increase profits. Although Japanese companies’ ROE is improving overall, when compared to global levels it is still low, with much room for improvement. This is particularly true for those sheltered Japanese companies that have been able to avoid structural adjustments and improve profitability. At the end of the day, it is well within the scope of Japanese managers to take it upon themselves to improve the attractiveness their company to shareholders. By enacting financial policies like shareholder-friendly Western companies, Japanese companies can effectively share equity with their true owners and efficiently apply funds. That process of normalising financial policies and capital structures will in turn greatly increase the attractiveness of Japanese stocks in a global context.
Given the increased risks of a takeover in the current investment climate, corporate managers who have previously been protected by their cross-holding webs are only now belatedly realising on whose behalf they must work: the average shareholder. And as corporate management’s sense of nervousness and awareness of this new order has spread, reform is being accelerated as never before. At the same time, investors who proactively use their influence as shareholders on companies that are not being managed in a way befitting the new environment are the core of Japan’s budding activist community.
Relationship Investment as One Form of Activist Investment
This article has detailed how investors can use their influence on corporate management to increase returns and also why these activists’ voices have been strengthened in Japan, but even though the term ‘activist’ connotes a single goal of increasing shareholder value, activists’ approaches are varied and cannot be generalised. Those who seek large increases in dividends over a short term have come under fire in the Japanese media as negative influences. Activists have therefore been put in the same class as ‘greenmailers’ who buy up shares and then sell them back at a high price to stakeholders. More and more ordinary Japanese consider the term ‘activist’ as synonymous to a hostile takeover bidder.
Nevertheless, activists are not always investors who engage in openly hostile activities. As one example, let’s introduce one of SPARX Asset Management’s investment strategies: the Value Creation Investment (VCI). This activist management fund began with seed capital from CalPERS, the largest pension fund in the United States back in February 2003. The hidden value gains in companies in which this strategy has invested over a period of 2-3 years are worth measuring. This is especially so because as the main shareholder in each of the fund’s target investments, the aim has been to constructively engage senior management, not drive them into a corner. It is a style of investing based on close interaction and strong relationships with management; akin to what’s known as ‘relationship investing’.
Under this strategy, while the VCI fund works to achieve effective mutual understanding with management of targeted companies, its goal is, of course, to maximise shareholder value. After considering the fundamentals-based potential of a company and the logical reasons its shares have become comparatively cheap, VCI concentrates its investment to become a major shareholder. The aim is to revise business practices of the target company in such a way as to maximise ROE by, for example, restructuring non-profitable businesses and optimising unused assets.
Above all, VCI investment targets are companies whose management exhibits seriousness about coming to grips with improving the efficiency of its assets and operations. The objective is not to boost fund returns by seeking higher dividends in the short term. Rather, the intent is to find companies with latent potential for significant organic improvements in earnings (reform in management awareness = improvement in shareholder value), and, together with management, work to extract that hidden value. In Japan, there are many companies with strong brands, distinguished histories and high-quality human resources, which at first glance appear to be sound, but are really suffering from a condition of chronic sickness. Companies with such problems suffer from an illness that can be remedied, but act like patients that do not seem to be aware that they are sick, that a cure is available or even how to search for the cure. The SPARX Asset Management VCI remedy is to inform these types of companies that they are in fact quite sick and we work with them to find a cure for their ailment and, as a result, vastly improve their corporate value.
It is important for VCI that there should be no sense of confrontation with the company, and there should be no arbitrary conditions placed upon the company at the outset. The point is to reach mutual understanding. It is impossible to fully explain in detail on paper how to exercise influence over such a shareholder for all intents and purposes. But for specific problems such as share buybacks, this type of fund actively exchanges opinions with company management. Another example concerns making commitments to the market. VCI frequently comes across cases where management has a clear target, say reaching ROE of 15%, but has not come up with any detailed plans as to how it will achieve this objective.
Other actions include counselling management on the repayment of debt and how to withdraw from unprofitable and non-core businesses (and dispose of them). Since most Japanese corporate managers have almost no awareness of balance-sheet management, the first step is often simply to convince them of the importance of this basic concept.
From SPARX Asset Management’s viewpoint as a bottom-up investor since establishment in 1989, the growing awareness level about balance-sheet management on the part of corporate managers and in the Japanese marketplace overall has been a welcome development. After all, the more investors who enter the market expecting returns on their investment, the greater the incentive for Japanese companies to start delivering shareholder returns and long-term value. With Japan heading into a period of great change for the investment community, VCI is at the vanguard of the efforts to find and capture value. While techniques differ among activist funds, their emergence is, on the whole, a positive catalyst for change. Based on this kind of historical awareness, SPARX Asset Management sees its role as a bridge between corporations and the marketplace. In recognition of this, VCI seeks to make investments that will play a significant part in the ongoing evolution of Japan’s equity market.
SPARX Asset Management Co Ltd was established as an independent investment advisory company in 1989 with shares listed on the JASDAQ exchange in 2001. SPARX is a Japanese equity investment specialist, which manages approximately US$13 billion (as of June 2006) using short- and long-term strategies. Entrusted with seed funds by the California State employees pension fund (CalPERS), the largest pension fund in America, SPARX commenced active investment in Japan with a corporate governance strategy in February 2003. At present, SPARX manages US$1.5 billion (as of June 2006) in its activist short and long strategies.