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A Sustainable State of Mind
From the Nov 2020 SPARX Asset Management Special Report
With a mandate from end investors and institutions alike, asset managers around the world are pursuing ever more sophisticated and nuanced sustainable investment strategies. One area of potentially unique alpha is the Japanese equity market. After years of being neglected, shareholders have once again gained a powerful voice amid the dramatic shift in corporate governance that is ongoing even as you read this. This report looks at the many facets of the sustainable investment opportunities in Japan, and focuses on the approach of SPARX Asset Management, a firm that is leading the way in engaging with Japanese companies on issues of critical importance.
1 New Opportunities in Japanese Equities: The Transition from Volume to Value
There is an once-in-a-lifetime transition underway from volume to value that is creating new investment opportunities in the Japanese equity market. The corporate governance reform and Japanese population dynamics have played a key role in catalyzing this transition to a value-oriented mindset. As an investor, SPARX Asset Management plays an important role in helping companies understand this change, and we observed lately that Japanese companies are becoming more receptive to engagement with investors like us.
When you consider investing in Japanese equities, you cannot ignore the infamous “Lost Two Decades” – the years between Japanese equity market peak in December 1989 (as measured by Nikkei 225 Index) until 2012, when the former Japanese Prime Minister Shinzo Abe set forth his Abenomics stimulus policies. Why did the market struggle for so long, and what did Abenomics change?
The return of shareholders
Shareholders were absent for a staggering 70 years in Japan. From the end of World War II – which saw a transition from shareholder to bank governance – until the implementation of Abenomics, the concept of shareholder value was largely absent. Abenomics, however, opened the door for shareholders to make their way back into Japanese corporate governance sphere. Corporate Governance Reform started in 2013 and since then, the results have been impressive. For example, in the Tokyo Stock Exchange First Section with over 2,100 listed equities, the percentage of the companies with two or more independent directors was 18% in 2013; as of August 14, 2020, that number had dramatically increased to 95.3%. Global investors, as well, are recognizing that Japanese corporate governance is changing for the better.
Why were shareholders absent from the scene for more than 70 years? WWII was the cause for the transition from shareholder to bank governance. It may be surprising to hear that, prior to the war, the private sector was actually the largest single shareholder of corporate Japan. Some company groups, such as Mitsubishi or Mitsui, were very strong at that time. But in order to prepare for the war, the Japanese government implemented a controlled economic model and obtained shares from the private sector. In the aftermath of the war, the public sector became the largest single shareholder in 1947, and the government utilized the financial sector to direct capital into strategic sectors, such as materials plants and heavy industry. This led to financial institutions becoming the largest shareholder by 1989. When the bubble burst, bank shareholdings decreased, and the private sector – such as foreign and individual investors – increased. From that point until Abenomics constituted a transitional period with no single shareholder group having an outsized influence over companies. After this transitional period, the private sector has now come to represent 50% of corporate Japan’s shareholding, and shareholder structure change has come full circle with the private shareholder finally returning as the main actor.
The bank-led governance model worked well under the volume growth era underpinned by population and demand growth. Japan’s population steadily increased for 140 years until 2008. In 1868, when the Meiji Restoration occurred, and the Era of Samurai Warriors ended, the population was around 30 million. It increased fourfold into the first decade of the 21st century. The banks’ business strategy worked well under the volume growth economy as banks simply wanted to increase lending volume without considering the cost of capital. But after population growth peaked, this model ceased to work. A declining and aging population characterized by labor shortage is one of the key social issues in Japan and is forcing the government and corporate management teams to revise their growth strategy going forward. From an annualized population growth of 1% in the period between the 1950s and 1980s, Japan now faces declining population growth of -0.10%.
A declining population marked the beginning of the value growth era and a change in the focus of management and employment styles across Japanese companies. Labor market conditions have also changed from aggressive hiring during the population growth period to over-employment during the lost two decades, and now finally labor shortage. During these periods, the focus of management started with a priority of increasing volume, then to cost-cutting, and now finally to adding value. In Japan, labor mobility has been low due to regulation, so that companies could not downsize in the over-employment regime, forcing many to follow a business diversification or low-price strategy, with cost-cutting. But after 2010 with a wave of baby boomer retirements and a declining youth population, the Japanese market suddenly switched into labor shortage paradigm, and companies have begun seeking value adding strategies.
In that context, what are the questions management should be asking? Under this new paradigm, the quality of governance is key to creating value. Can the management tackle the labor shortage problem by improving productivity? Can they focus the business on its core competence to strengthen corporate brand value, and take advantage of industry consolidation as less productive firms exit their sector? In order to successfully transition to value-added model, a shareholder’s mindset is an absolute necessity.
To address that mindset, it is the sincere desire of SPARX to contribute to the improvement of ESG issues and investing in Japan, and we are using our position as the largest independent asset manager in Japan to engage with companies on that topic. We believe this can impact global ESG improvement and lead to positive strategy returns for our investors. With more capital and advice from global institutional investors, our impact can be very significant, and we appreciate their continued support for our activities.
2 A Fundamental Approach to Identify ESG Momentum
There is emerging evidence that ESG momentum can be a significant source of alpha over time. This premise identifies causation from change in the ESG fundamentals of a company, which are eventually reflected in their ESG scores, to its future stock price performance. This can take place via an increase in profitability and/or reduction in discount rates. As a result, by identifying changes in ESG fundamentals, investors may be able to increase the chance of “doing well by doing good.”
ESG scores assigned to companies are useful in this regard, but like any other scores they come with challenges in terms of availability, accuracy, and consistency. For example, the number of companies covered by ESG data vendors isn’t maximized given limited disclosure, especially in Japan. Most importantly, just like financial information, scores themselves may be priced in as soon as they are released. Ideally, therefore, any underlying structural change in ESG fundamentals should be identified before it is reflected in ESG scores. This is easier said than done, however.
In practice, there should be a significant time lag between the underlying structural change in ESG fundamentals and the resulting change in ESG score (see in figure 1). While some firms may simply need to better understand rating agency requirements, others are required to engage in long-term structural reform which, if identified early on, can allow investors to benefit from increasing valuations. Therefore, long-term perspective is essential.
Further, faced with a large investable universe, identifying which companies are most likely to benefit from ESG momentum is daunting – especially in Japan, where the universe contains more than 3,700 listed companies. The task is made even more difficult by Japan’s unique corporate culture and language barrier. Long-term experience in direct fundamental bottom-up research is therefore essential.
Yet many of these changes may not materialize despite the best intentions of corporate management. Some Japanese companies that would like to embark on ESG strategies just don’t know how to get started. In addition, new and improved ESG strategies are often met with skepticism by investors, which may discourage companies from proceeding. But when a company’s management expresses a desire to improve its ESG fundamentals, they are often more receptive to advice from investors like SPARX Asset Management, which in turn can help influence investors who, through active engagement, may be able to dramatically raise the chance of a company making real progress over the long run.
A fundamental approach
To take advantage of ESG opportunities, there is an important role to be played by a fundamental bottom-up stock picker with a long-term investment horizon. Indeed, SPARX strongly believes that a combination of structural understanding, bottom-up stock selection, and active engagement can capture ESG momentum in Japanese companies, as illustrated below.
Essentially, through fundamental bottom-up research we capture in advance what we anticipate ESG scores could be in the future, and apply the structural relationship that we learn to make a long-term financial forecast to estimate the intrinsic value. Let’s take a deeper dive into the above illustration.
- Non-financial Information at T-1 to Financial Information at T (A)
We first gain an understanding of the relationship between ESG, earnings, and cost of capital. To do so, we check available past non-financial information, including integrated reports, websites, third-party ESG scores, and other company/competitor cases based on our 30 years of experience.
- Non-financial Information at T-1 to Non-financial Information at T (B)
We check any changes in ESG by following the most recent news releases and conducting meetings. We meet with the company IR team and the management if possible, to check the future direction of their ESG activities. As a result, we often notice changes happening to companies. Most asset managers and investors use only quantitative screening. Our culture and history as an independent active manager are critical to successfully implementing this step.
- Non-financial Information at T to Financial Information at T+1 (C)
We utilize what we learn to make a mid- to long-term financial forecast. Through IR meetings, we check whether the management strategy integrates ESG factors, and the team discusses the feasibility of the management strategy based on their track record. For more than 30 years, SPARX’s investment approach has focused on qualitative aspects of the underlying business fundamentals to make long-term forecasts. What we do today with ESG is a natural integration with our 30-year investment approach.
Role of Active Engagement
Throughout our investment process, we believe that active engagement plays an important role in raising the chance of a company making real progress over the long run.
We place tremendous importance on discussions with companies to determine if they have built a foundation for sustainable growth by establishing strong relationships with shareholders, employees, business partners, local companies, the global environment, and all other stakeholders. If we see the potential for improved corporate value as a result of these dialogues, we demonstrate our support for management by actively investing in such companies. When necessary, we exercise our shareholder rights during general shareholders' meetings to actively motivate corporate management. Conversely, if after such discussions a company makes no changes to a management strategy that hinders sustainable growth, then we end our investment by selling all shares to protect the profits of the strategy’s investors. In short, our engagement activities revolve around dialogues that are meant to build strong relationships with the companies.
The adoption of coaching elements in our discussions has been particularly effective. Coaching is a communication skill meant to motivate the other party, and it helps spur investee companies to become more active because of our meetings. Based on the awareness levels of a company’s executives and IR managers and the specifics of its management issues, we determine whether coaching is appropriate (there are situations in which it could be unsuitable). When appropriate, we ask companies a series of questions to have them set goals, to consider their current situations in regard to these goals, and to create action plans to fill the gaps. After these meetings are over, companies reflect on their new insights, and if they ask for our opinion, we provide it. For the last couple of years, most discussions have been on ESG-related matters, and some of the companies with which we have spoken have held ESG briefings or improved their integrated reporting processes. These are the results of forward-looking corporate actions.
We expect two major types of results from our engagement – improving fundamentals and eliminating the value gap. The key issues for improving fundamentals are business models, financial strategies, and ESG strategies. Because these are companywide strategies, it is challenging to encourage change when top executives are not conscious of these issues. On the other hand, it is effective to back companies that are already highly aware of these issues. “Eliminating the value gap” means to eliminate a situation in which, for some reason, a company’s share price is lower than its intrinsic value. The main issues in such situations are IR strategies, ESG information disclosure, and corporate brand strategies. To create awareness among top executives, practical IR activities are also a key element, so we emphasize discussions with IR managers as well as with executives.
So far, our discussions as described have shaped our view of sustainable investing in two ways. First, companies with the potential to improve their ESG fundamentals are often undervalued and should therefore provide opportunities to generate unique alpha. Second, we advocate an integrated ESG approach where fundamental bottom-up analysis includes ESG considerations with active engagement. This resonates with SPARX’s fundamental bottom-up stock picking approach with a long-term mindset.
CASE STUDY: NINTENDO
Since its founding in 1889, Nintendo has operated a business centered on developing and manufacturing entertainment products. As expressed through its CSR policy of “Putting Smiles on the Faces of Everyone Nintendo Touches,” Nintendo’s history is one of growth through getting more people involved and making them happier.
Nintendo tends to have significant earnings volatility, depending on the success of its entertainment products. For example, the firm had three consecutive years of losses (FY3/2012 through FY3/2014) due to the subpar sales performance of the Wii U, the successor console to the blockbuster Wii. From an investor’s perspective, the stability and predictability of Nintendo’s earnings structure are causes for concern, and that has impacted SPARX Asset Management’s decision to make the company a long-term investment.
More recently, SPARX began to reconsider investing in Nintendo, seeing signs that business and external environmental changes over the past five years could contribute to improved profitability and growth potential for the firm. In 2015, under a new company president, the firm revised its basic policy from expanding the gamer population to increasing the number of people who enjoy Nintendo content. The strategy increased focus on Nintendo Switch, specifically its lifecycle and user engagement, launching new titles on a schedule that sustains business momentum. In the process of achieving this, Nintendo combined two separate development systems – one for handheld systems (like Nintendo DS) and one for consoles (like the Wii) – to concentrate its resources on the Nintendo Switch. The company has also created new revenue streams through online membership services and by launching a new revenue model based on membership fees.
In the course of its research into Nintendo, SPARX discovered that changes in the external environment were beginning to provide a tailwind for the company, as well. For example, in 2019, its lead developer, Shigeru Miyamoto, was selected as a Person of Cultural Merit, an official Japanese honor awarded to those who have made outstanding contributions to the nation’s cultural development. This signaled that gaming is starting to gain cultural credibility. In addition, the COVID-19 pandemic has created a need for people to relieve stress while they are stuck at home. The World Health Organization (WHO), which once warned about gaming addiction, has reversed its position and started a campaign to promote gaming.
Based on its research, SPARX observed a change in the economic value of Nintendo. A new management team altered the company’s operational quality. Operational changes resulted in concrete strategic decisions on lengthening product lifecycles and improving user engagement , and the firm has begun to improve the quality of its earnings through higher profitability and more stable performance. In addition, society at large has increasingly recognized the cultural aspect of games and their value as a communication tool, leading to greater medium- to long-term market growth potential than before.
Finally, before investing in Nintendo, SPARX calculated Nintendo’s corporate value to reflect the factors mentioned, and concluded that it is higher than the company’s share price. In doing so, SPARX raised its earnings forecast for Nintendo, taking into account market growth and higher profit margins, and also lowered its discount rate to reflect the decrease in the earnings volatility risk factor.
3 A Sustainable State of Mind
In the process of helping his parents evacuate Fukushima after the twin disasters of tsunami and a nuclear power plant accident, Yu Shimizu thought a lot about sustainability – why it mattered, what more needed to be done. The next year, in 2012, he launched the Japan Sustainable Equity Strategy and became its lead portfolio manager, at SPARX Asset Management. The team he leads does rigorous work reviewing Japanese companies one by one, looking for stocks in companies that are on the path to becoming “sustainable”, where the stakeholder value enhances its economic value. In his role, Shimizu views himself as a bridge between the world’s investors and Japan. II recently chatted with him about the unique aspects of Japanese businesses, and entrepreneurial spirit that pervades at SPARX.
What is the overall philosophy behind the Japan Sustainable Equity Strategy?
Its aim is the sustainability of three elements – the world, the investment chain, which includes the companies we invest in and asset owners, and our own activities. Our vision is to make positive contributions to a better investment chain where our investments help to build a better society and successful, growing businesses.
What should global investors who are not deeply familiar with Japanese companies know about them and their approach to sustainability?
Japanese businesses have had a sustainability-like mindset much longer than you might expect. There are about 2,000 companies in the world with a history of 200 years or more, and 65% of them are Japanese. One reason so many Japanese companies thrive for long periods of time is the philosophy of Sanpo-yoshi which means three stakeholders benefit from a business – seller, buyer, and community. For a long time that was the de facto solution for corporate governance. But actual shareholder rights lagged behind, because what we today refer to as a public company didn’t exist in Japan until 1865 – several centuries after European stock companies came to be. Shareholder rights were unclear in Japan for a long time, but there has been a lot of progress in that regard in recent years.
But we have much more to do. For example, as is the case with many countries, the Japanese people prioritize domestic issues. In terms of the supply chain, people monitor the domestic labor situation very strictly, but they don’t pay much attention to the labor situation in overseas factories.
What are the criteria used to determine which businesses to include in the strategy?
We view a business as sustainable when they create stakeholder value which enhances their economic value. We are not investing only in companies with perfect sustainability records. We also look at their potential and whether their ESG fundamentals are improving. One reason we look for businesses that are improving is valuations – companies with sterling ESG records are likely to be very expensive. Another, more important reason is that to help build a good society, we need to help the company that lags behind. In other words, we need to be forward looking and inclusive.
What are some signs of potential that you think indicate a company is improving its ESG profile?
Most common sign is the change in governance, and we try to capture the ripple effect from this. To do so, we view the stakeholder value holistically and structurally. Governance is the center of the stakeholder value, and social and environmental spread outward from there. Our definition of social is the direct stakeholders who have a relationship with the company – employees, suppliers, clients, and the local community. Environment is beyond social and therefore global. For example, a Japanese company and Brazilian forests are not directly connected, but the forest is s stakeholder all the same.
Being a Japanese asset manager must make those meetings with corporate leaders more productive. What are you looking for in the leadership?
The top management is very important as we consider an investment as is the support system for them. The improvement of a business’ fundamentals and the actions it takes depend on top management and how they motivate the employees. We like business leaders who are visionary, sincere and can clearly explain their rationale – we’ll take those traits over charisma any day. We do not like dictatorial leadership – we like leadership that is perceptive regarding stakeholders’ opinions, including ours. We also introduce our coaching methodology into conversations with the companies to let them know that we can help them improve. The purpose is to provide new information and awareness to the companies. For example, some companies are having ESG meetings after we suggested it. In another case, when activists were creating issues, we suggested the management that a vision statement would help, and the CEO sent a letter to investors as a result. Another company abolished its poison pill policy after our recommendations. We do discuss their ESG score, but today companies recognize it’s not just about the score – they need to improve their business activities or management strategy itself.
What led to the coaching approach?
Sometimes a person’s inner opinion differs from their outer opinion. The Japanese people do not like tough negotiation, so if we speak too strongly to a business leader they may choose to close their mind and hide their inner opinion. I underwent an executive coaching program for me to be more effective with Japanese management teams and in the process learned many tools that we now apply. For example, if we ask them a very open question and then listen carefully and acknowledge their answer before providing feedback, then we can build a very good relationship that allows us to better understand how the business is doing.
Why should a European investor consider it important to include Japanese companies and their sustainable strategies in their portfolios?
For starters, diversification and impact. Our Japan Sustainable Equity Strategy should be a good diversifier to mitigate risk of investing only in, say, “ESG Developed” region like Europe. Also, many European countries are very advanced in terms of ESG, so investing in Japan, which may be called “ESG Emerging” country, can help the world move forward toward greater sustainability.
Putting ESG aside for a moment, the Japanese stock market is relatively less efficient, so it adds a non-correlated pursuit of alpha. Our strategy’s alpha is mainly generated by stock selection. We do not bet based on sectors or size, which means you can enjoy unique alpha potential that is the result of our bottom up research capability.
What companies might investors be surprised to find in the strategy?
If you simply look at a sector or a business on the surface, some companies may not have a great ESG image. But we take a much more holistic view to understand the relevant trade-off. To illustrate, let’s take an air conditioning manufacturer that we are investing. First of all, they have an environmentally friendly technology. Second and perhaps a subtler consideration is the role air conditioner plays to solve global economic inequality by increasing the productivity of regions with tropical and subtropical climate. There is also an increasing risk of loss of lives as heat waves become more severe with global warming. This company fully recognizes its social and economic benefit, while minimizing the cost to the environment.
What do you see as the big differentiators for SPARX and the Japan Sustainable Equity Strategy?
We are based in Japan and we speak Japanese, so we are very good counterpart for companies we invest in. Our client base is global, and we have implemented global standard strategy quality, especially regarding ESG. We have been disclosing the strategy’s ESG score for greenhouse gas emission on a monthly basis, for example. And we’ve analyzed the future scenarios of climate-related risk in line with the TCFD format. Our team working on the strategy is very diverse. Nearly half of our team are women. Nor is everyone on the team Japanese. We believe that helps with better idea generation and decision making.
Another big advantage is that we’re independent investment company. In Japan, a lot of investment firms are either part of a larger financial group, or they have some type of shareholding or interest that might not be clear in the forefront, but it’s there in the background. So being independent like us and being around for 30 years, it’s a very slim number of asset managers if any. The foundational philosophy of our firm is that each individual should come up with their own investment hypothesis and seek investments that correspond to that in an active, high-conviction manner. Each portfolio manager has full discretion to invest as they see fit within the portfolio they manage – there’s no top down pressure to buy or sell. Our strategy is also an all cap strategy, and our colleagues manage other all-cap funds, and we have team meeting on a daily basis. But the weight commonality is less than 20%, which demonstrates our people are really thinking and acting independently. On this aspect, we think that we’re more entrepreneurial than any other Japanese asset managers.
What’s your goal as the leader of the strategy?
We want to be the bridge between Japan and overseas investors. To pursue that goal, we make every effort to build a high-quality Japanese equity strategy in line with the European standard for ESG. It’s not only about the performance, but also the reporting. We are writing monthly reports showing the data and explaining our activities, such as going into great detail on dialogue with the companies in the strategy. We also published the strategy’s annual report, which is very unusual in Japanese asset management. We are very open-minded and receptive to feedback from asset owners and the leadership at companies which we invest in. Ideally, we’d like more and more asset owners to read our reports and give us feedback, so that together with global investors we can contribute to global ESG development from Japan.