18.07.2018

Polar Capital

Japan - An activist-led bull market?

Japan - An activist-led bull market?
Exactly how important are shareholders to a business? Well, it is a question academics will continue to debate indefinitely but the answer will normally be: very.
As simple as it sounds, this concept has taken a while to spread to Japan, home to the world’s second largest equity market. In Japan, investors have begrudgingly accepted that domestic management teams place far less focus on shareholders than they should do. The largest culprit for this issue is the cross-shareholding culture that exists, that is, it is common for companies to invest in the equity of their customers and suppliers. The aggregate effect of this means a large proportion of the companies’ share base can be held by related companies that have different requirements to normal shareholders. These cross-shareholders typically support management, no matter how badly they are running the company, to promote a healthy relationship with their customers or suppliers. Given this hurdle, it has been extremely difficult for other shareholders and activists to promote change in even the most poorly-run companies.
However, this dynamic is shifting and has been for some time. Since Prime Minister Shinzo Abe’s election, we have seen a gradual change in how cross-shareholdings are looked upon from within Japan. In 2015, a new corporate governance code was released which meant Japanese companies had to state if and why they held equity positions for reasons other than economic rationale. The code was revised in June 2018 to put further pressure on companies by requiring management to disclose their plans to reduce these holdings. They may sound like small steps, but it is the first time that companies have been challenged publicly and we have already seen dividends from these efforts with many companies choosing to unwind cross-shareholdings.
The implications of companies reducing cross-shareholdings should not be underestimated. Underachieving companies will no longer have guaranteed approval from key shareholders but will instead have to answer to a more aggressive and financially-motivated shareholder. It will also open the door to activist investors who have so far failed to have the same success in Japan as they have overseas.
One of the most interesting pieces of activism in Japan currently surrounds Alpine Electronics*. The company is a listed subsidiary of Alps Electric, who owns 40% of the company. Alps Electric is attempting to acquire the remaining 60% of shares at a price that values the company at ¥135bn. Alpine Electronics currently has ¥90bn in cash and investments suggesting an enterprise value in the region of ¥45bn for a business generating ¥10bn of profits annually.
Alpine’s current shareholders have naturally pushed back against this deal. In the recent AGM, around 50% of shareholders (excluding the parent company) voted against the current board members re-appointment. Alpine’s board is struggling to understand why shareholders are opposed to this deal which is evidence of Japan’s problems. The vote on the takeover is in December but one thing is clear - minority shareholders will reject this deal.
When it comes to valuations, the Japanese market is still the most attractive in the world with a significant valuation gap existing between it and other developed markets. Will increasing activism help close this valuation gap? It will certainly help. In the example above, Alpine Electronics clearly should not be valued at a price-to-earnings ratio of 4.5x on an ex-cash basis. However, the poor management in place has resulted in a horrifically overcapitalised business returning minimal amounts to shareholders. Investors have taken the view that assets will never be used more efficiently.
Alpine is just one example of the potential value to be unlocked in the Japanese equity market. If the widespread misallocation of capital can be remedied through a changing of the guard on shareholder lists, from friendly, related companies to financially literate and return-focused, professional investors, it is possible we could see a bull market in Japan unrelated to the global cycle and yen exchange rates in a long overdue change.
Chris Smith, Co-Fund Manager Polar Capital Japan Value Fund
16 July 2018

* Polar Capital Japan team is invested in Alpine Electronics Inc.

Link to the document: Japan - An activist-led bull market?

 

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