The Capital Cycle Podcast - Shareholder Value in Japan

Episode Date: September 30, 2024

Slowly but surely, shareholder interests are becoming more important in corporate Japan, in part reflected in rising M&A activity. Presented by Edward Chancellor With Bill Arah, Marathon founder and Portfolio Manager JapanFor more information, or to access select articles from Marathon’s Global Investment Review publications which accompany this podcast series, please visit www.thecapitalcycle.co.uk Hosted on Acast. See acast.com/privacy for more information.

Welcome to the Global Investment Review podcast from Marathon Asset Management. My name is Edward Chancellor. With me today, I have Bill Ara, a founding partner of Marathon Asset Management, and long-standing Japan specialist and portfolio manager. Good to speak to you again, Bill. Indeed. Very nice to see you again. So, Bill, you have been what the Americans call constructive. on Japan through the long years of the lost decades of Japan's post-bubble economy and chronicled over the years how corporate Japan was changing and that eventually this would produce much better returns for investors.

And you now, I think, are saying in your latest piece, this time is different. Indeed, I think it's different, but it's a continuation. And so, as you say, I think for the last 20 or 30 years, there has been a very, very gradual, slow change in the mindset of corporate Japan. There are two ways one could look at it. And I think that one is that the cost of capital has been rising for Japanese companies as their share prices on those extraordinary high valuations of the late 80s and 90s declined. but also there's been an opening of the market for corporate control, and that's what you're talking about in your new piece. Indeed. So I think the critical thing that is actually changing in Japan is the nature of what it means to be a shareholder,

of what management feels its primary obligation is. And that is at that very top overarching level, that is really what corporate governance is all about. And so if you look at Japan in the post-war period, the clear primary goal of management was to look after and protect its employees. And you had a lifetime employment system that prioritised the claims of the employees within the corporate structure. And what is happening in Japan, and it's been very gradual and it's been sociological, is that claim for a variety of reasons has been eroding. And if that claim is eroded and if management no longer thinks that their primary obligation is to their employees, it leaves a vacuum. And what has been happening in Japan is that vacuum as being gradually being filled with a sense that the shareholder is the key stakeholder who should be having a louder voice at the table.

So, Bill, you start this piece talking about the impact of Japan moving away from its ultra-easy monetary policy and saying that there is a political demand for a strong yen as there is a political demand for higher returns on capital in Japan. Can we talk just a bit about your thoughts on the currency? Because when monetary policy shift took place in July, in July, there was a bit of turmoil in the markets. The Niki went down sharply. But you see the shift in monetary policy, the normalization of Japanese interest rates or convergence with the other developed markets, is actually in the long run positive.

Am I reading you correctly? You're completely right. I mean, Japan has been a complete abnormality in the last 10 or 15 years by having set up a correlation whereby a weak yen led to a stronger equity market. And that was largely because the only buyers of the Japanese equity market were foreigners. And so the norm in every market is that a strong currency is good for your equity market. It bottles up liquidity in your system. It drives valuations higher.

And so I think one of the striking things in Japan is, you know, it's now 20 years since the yen sort of was peaking at below 80. And then we were there again in a decade ago or so. And so we've, we've had a very long period where the yen has, in effect, almost halved, despite the complete absence of inflation in Japan over that period. And if you go back to one of the reasons why this governance change has been coming through, it's the sense that Japan is trying to create wealth. And it's a political driver. And the political driver. And the political support behind it and a lot of it came out of Koizumi, the prime minister 15, 20 years ago. And it was based on the idea that if Japan is going to have meaning, if Japan is going to have

political visibility, and if Japan is going to be strong, it needs to create wealth. There was a very clear sense that improving efficiencies, creating wealth in the system, would create a stronger Japan. Well, although Japan has been creating wealth and the equity market's been going up, it's been offset by the fact that yen has been going down. And so from a global perspective, Japan has continued to be almost irrelevant.

So, Bill, you say in your piece that as Japanese monetary policy converges with the rest of the world, you see a change in market leadership of stocks from the last decade for the rest of this decade. So what do you see the change from the sort of easy money? Yeah, I mean, if you go back to when marathon started in, you know, the mid, mid-late 80s, when Japan was the world's biggest stock market and was 55% of the world index, the Japanese index bore no relationship to the current Japanese index.

The Japanese index in the 1980s was a domestic index. It was dominated by domestic companies, financials, asset plays, and it mirror. to some degree the nature of the economy. So the Japanese economy is a very domestic economy. It's about 80% domestic. And what has happened in the last 20 or 30 years is as the foreigner has bought and the domestics have sold and as the yen has weakened,

we now have an index that is not in line with the nature of the Japanese economy. We have an index that is basically a global cyclical play on a weak yen. And as I say, I think for a variety of, of reasons in Japan, that cycle is turning. And we're going to go back to a period whereby you need to have a more domestic focus in the Japanese market. Which everything else being equal would work well when the yen was strengthening, at least for foreign investors. Indeed, indeed, yeah. So Bill, and one could talk for hours about, or days, let's say, on the change in shareholder value in Japan. but in your piece, your latest piece, you focus on the opening of the market for corporate control,

and in particular you discuss two recent marathon purchases, both of which are underperformers, but which you see as potential takeover targets. So would you like to just sketch the sort of the change in the market for corporate control? Perhaps we could discuss the Couchard bid for Seven and I as a backdrop, and then get into your particular names? The evolution of governance so far in Japan and the growing interest in its implications has been, to a large degree, very, very passively driven.

And by that I mean, it's been people looking at the assets that companies own, at the shares they own, at the real estate they own, at the strength of the balance sheet. And it's simply been saying that if those assets belong, to you the shareholder, then the share price is too cheap. But we haven't really had a market that has been thinking in terms of, well, if the companies belong to the shareholders, what happens if you get a new shareholder who wants to buy all the company? And what happens if you then can

look at the valuations, not as a passive investor, but you can start valuing the active components of a company, the R&D, the technology, the brand leverage, economies of scale. all those aspects which are so important in markets outside Japan are basically valued at zero in Japan because there is no active market for control of companies. You know, the Kushtar bid for Seven and I is very interesting whether it will be allowed to go through or whether Seven and I will come up with a defence or whether indeed a competing perhaps more Japanese consortium will try and come in, I don't know. But I think that the precedent it's set is terribly important.

Because if Japan is going to be a global player, if Japan is going to be strong, if Japan wants the yen to be a more important currency, it has to be open. And if it's open, it has to be open both in terms of Japanese companies buying foreign companies, Japanese companies buying Japanese companies and foreign companies being able to buy Japanese companies. Should we talk about your two recent stoppics? start. As we've been talking about foreign business, you draw attention to Shiseido, the leading Japanese cosmetics company. So it's cosmetic, exactly. And it's a company that's, it's a company that has been a sort of prestige brand in Japan for decades. And traditionally,

of course, its main market was Japan. It was to some degree a play on wealth creation. So So when you started getting wealth creation in Japan and you've got consumption picking up on the back of it and people would buy more expensive cosmetics and Chisado did quite well. And then, of course, in the last sort of 10 years, we've had this huge boom in tourism, particularly in the run up to COVID and driven by the Chinese. And Chisado became a very popular market play on Chinese buying of Japanese branded luxury items. in their case, cosmetics. And what has happened in the last few years is following that boom and Shiseido gearing up to be ready to exploit that demand, the demand has collapsed, partly because COVID initially came through.

And then we have the political tensions between Japan and China. And the Chinese have, to a considerable degree, stopped buying the Japanese branded areas. So Shisado's share price, having been very, very strong, has come all the way back again. The interesting thing on Shiseido is that in the medium to longer term, the international business and particularly the Asian business remains very interesting. And it might not be so Chinese driven, but tourism to Japan is hitting new peaks again and a number of visitors is continuing to rise. But also, as I say, there's this issue that the Japanese seem to me to be potentially at the beginning of a long wealth creation domestic cycle that will again power domestic. consumption. And so the stock is, you know, the valuation is just over one-time sales, which for a quality global brand name is very, very cheap. It's difficult to see the Japanese could argue

that it's of national importance. So you can't help feeling that were there to be a bidder for Shiseido, it would be difficult to argue against it. Right. And Shisadeo much, much cheaper than, say, L'Oreal, the dominant French. because much much cheaper but but also and I think it's important that if you if you're an active buyer you're looking for something you can do and with Chesaida you have the brand leverage and you have the positioning in Asia which is obviously very good but you also have the opportunities to just make the structure much more efficient because it's still laboring under this overhang of costs that they built up prior to and during the Chinese growth spurt and so there are a lot of opportunities.

opportunities to both leverage on the positive side and also make the structure more efficient. Interesting. So if you talk about your second, the second stock you mentioned, which is a different kettle of fish, let's say. It's a very different kettle of fish. So it's, it's IHI, it's one of Japan's leading defense contractors. Its mainstay business is aeron engines and aerospace. And it had a lot of problems in the last couple of years with the Pratt and Whitney engine issue. they took a loss of about $2 billion, which to some degree they've been able to offset. But the share price obviously became very weak, and particularly on concerns they might have to do a financing, and if the losses kept building. It's become clear in the last six or nine months, both in the case of IHI, but more broadly, that that concern is probably wrong and that we're past the worst and we're moving forward.

And if you go back 10 or 15 years and look at IHI, it was a very highly valuable. company because aerospace engines and the after-sales servicing was seen as a very stable quality business and worth 18, 20 times earnings or more, the global peers are more. Earlier this year, you could buy IHI on consensus earnings forecasts on about eight times earnings. And it's now rallied, but it's still a real laggard versus its defense contractor peers in Japan, and particularly Mitsubishi Heavy, which has become a market darling. And I think the really interesting thing there from a, so the stock's very cheap and it's coming out of a difficult period, but on the particular focus of M&A and acquirers, we just had, you know, the Draghi report on Europe,

arguing for the need of a more coordinated policy response and the needs to try and have a clear vision for how one is going to put together things like defence and digitalisation and so on. and the Japanese are similar. The Japanese have a very disparate, inefficient defence structure where different companies do different bits and it's put together in different places. I think if Japan is going to develop a logical, coherent defence structure, they need to start putting some pieces together.

Now, it would be totally impossible for a foreign company to acquire IHI because of its defence role, but for a larger domestic one, and particularly Mitsubishi heavy, it would make enormous sense. There are real synergies in terms of business operations and how you could integrate those businesses. And I think, as I say, if you look at the relative valuations, but you then start looking at things like R&D and cash flow and so on. Companies in Japan don't value them. R&D multiples in Japan are very, very low. Cash flow multiples in Japan are very, very low.

because in nearly all industries, there are too many players. You know, one of the key, I think, medium-term goals of Japan is to create stronger players, bigger, stronger players. And I think IHI against that backdrop would be a perfect company to be absorbed by an MHA. Interesting. You think when Marathon started out, that was what was happening in the US, wasn't it? The consolidation of American industry.

I remember one of the early GIRs was on General Dynamics, U.S. defense. Yeah, you're absolutely right. So somewhere I've got our very first presentation documents, and one of the charts we used was from General Dynamics, and they called it the management reinvestment matrix. And it was all about the idea that rather than just growing, you should focus on where you're strong and be willing to exit those areas where somebody else could pay more for the business

than you could. And I was looking actually quite recently that the share price of general dynamics is up a hundredfold since then. They were. And that basis, IHIs got quite a long way to go. Yeah, there is an element. I think the bull story for Japan is that Japan is getting into the position that corporate US was getting into in the 1980s and 1990s. And as we say, the shift to shareholder value. So, Bill, thanks for this discussion.

And I hope next time you write another piece, we can continue the conversation. Very good. Thank you very much, every. Thank you. Thank you for listening. If you'd like to access the global investment reviews and or the podcast, you'll find them at the Marathon Client Portal. Do join us again next time.