Winds of change

FEW investors come in more belligerent form than Daniel Loeb, an American activist shareholder known for attacking lacklustre chief executives in the most personal of terms. Yet Mr Loeb has lately found a second home in Japan, a country where shareholders with opinions have hitherto been about as welcome as skunks at a garden party.

Late last year Mr Loeb’s fund, Third Point, took a stake in Fanuc, a secretive and highly profitable robotics firm which until recently seldom made direct contact with its investors, choosing instead to hoard a vast and expanding pile of cash. No one expected Mr Loeb’s gambit to succeed. In the past, successive waves of investors have tried to encourage Fanuc to change its ways, only to throw in the towel, usually at a loss. So the firm’s surprise news in March, that it would start talking to shareholders and return some of its cash to them, reverberated far and wide.

Mr Loeb has since taken tea with Fanuc’s president, Yoshiharu Inaba, at its headquarters in the foothills of Mount Fuji. He is receiving further encouragement from the very top of government. He has had private meetings with Shinzo Abe, the prime minister, with Taro Aso, the finance minister, and with Haruhiko Kuroda, governor of the Bank of Japan. “Can you imagine him getting in to see David Cameron or Angela Merkel?” remarks a friend in Tokyo. “Third Point loves it here.”

Such signals from the apex of the establishment, in a place where business heeds the government more than in perhaps any other big democracy, have not gone unnoticed among corporate leaders. And the government is offering more than gestures. On June 1st its new corporate-governance code came into effect, with the aim of shaking up companies’ slothful boards by, for instance, calling on them to appoint outsiders (many have none at present). This is the first time a Japanese government has laid down detailed rules on how firms should conduct their affairs.

Mr Abe’s attempts to make companies change their ways are one element of Abenomics, his grand plan to restore vim to the Japanese economy. The corporate reforms, along with monetary easing by the Bank of Japan, are the most tangible elements so far of the prime minister’s programme. His government has stood up to pressure from the Keidanren, Japan’s biggest business lobby, which tried its best to get the code watered down.

The code for companies follows another, for institutional investors, that came into force last year, which seems to be emboldening them to make demands on companies to improve their returns. The Tokyo Stock Exchange is also seeking to shame the laggards into action, with a new index of well-behaved firms. The reforms seem to have captured the public mood: books with titles like “Changing Japan, the Poorest Nation for Return-on-Equity” are flying off the shelves.

A prized skill for leaders in Japan lies in being able to “read the air”, or to sense what is important but unstated. What is in the air now, reckon foreign and Japanese investors alike, is nothing less than a revolution in companies’ attitude to both shareholders and returns. This, in turn, should prompt them to think hard about their strategies. The companies, like Fanuc, that have begun to change their ways are so far the exceptions rather than the rule, but their numbers are growing.

Dazzling no more

Change is undoubtedly needed. Japan’s post-war economic miracle produced firms such as Sony and Sharp that dazzled the world, yet today many of them have lost direction. In consumer electronics and appliances they have been left behind by the likes of Apple of the United States, Samsung of South Korea and Haier of China. For years, Japanese firms of all kinds have lagged behind those in the West on such measures as profitability and return on equity (see chart 1). Instead of investing their modest profits wisely, to expand their businesses—or at least handing them back to investors so they can reinvest the money elsewhere—many companies have sat on growing piles of cash.

To be sure, Japan can still produce firms such as Uniqlo, a seemingly unstoppable fashion retailer; and its strongest companies, such as Keyence, which makes high-precision measuring equipment, can still be world leaders in their industries. Yet the country’s few technology startups have underwhelmed. Indeed, there are few signs of entrepreneurship in the world’s third-largest economy. Only 4% of the working population was engaged in starting a business last year, compared with 14% in America, according to the Global Entrepreneurship Monitor, compiled by the London Business School and Babson College. The dearth of entrepreneurship inside large firms is no less of a problem.

Among established companies, a sense of crisis over mounting losses and tumbling global market share is already prompting some to think more clearly about their business portfolios. Panasonic has boldly shifted focus from consumer electronics, in which it was struggling, to supplying components for cars and energy-efficient homes. A bevy of firms have gone on overseas acquisition sprees.

More companies are abandoning a tradition of always appointing their next boss from among time-serving insiders, and looking outside—or even abroad. Last year Suntory, a drinks firm, made waves by appointing its first boss from outside the firm, choosing Takeshi Niinami, a Harvard-educated executive previously at Lawson, a retailer. And Takeda, a drugmaker, chose Christophe Weber, a Frenchman, as its new head. Foreign bosses are not unknown at Japanese firms: Nissan, a carmaker, is run by Carlos Ghosn, a Brazilian, and Sony was for several years run by Howard Stringer, a Welshman. But they are becoming less uncommon.

There is no firm that better embodies the results that reform can achieve than Hitachi. It was formerly one of Japan’s most conservative: the consummate “community” firm, at which employees and their families, and suppliers and their dependents, all took precedence over shareholders. In 2008 it notched up the largest loss on record by a Japanese manufacturer. Since then it has spun off its consumer-related businesses in flat-panel TVs, mobile phones and computer parts to refocus on selling infrastructure such as power plants and railway systems. More recently Hitachi has made efforts to change its internal culture. Last year it all but abandoned one of the central pillars of Japanese business: the seniority-wage system, in which salaries are based on age and length of service rather than on performance. The results of all this have been stellar. Its operating profits in the year to March rose by 12% to ¥600 billion ($5 billion).

Now, says Kathy Matsui of Goldman Sachs in Tokyo, stockmarket investors are all searching for the next Hitachi. Activists and private-equity firms are sensing an opening up of opportunities. Seth Fischer, an activist investor, says the government’s backing makes all the difference when it comes to shaking up firms. He is preparing to take on two industrial giants, Canon, a camera-maker, and Kyocera, an electronics and ceramics manufacturer, over their complex corporate structures.

The growing proportion of shares in Japan’s listed companies owned by foreigners (see chart 2) has undoubtedly added to the pressure on firms to change. But it is not just foreigners who are making the running. Early this year the country was transfixed by the spectacle of an elderly corporate patriarch and business founder seeking to oust his daughter from the top of the family’s furniture firm, Otsuka Kagu. Kumiko Otsuka had defied her father by bringing in outside directors to sit alongside family members on the firm’s board. There is no doubt, says Ms Otsuka, that her success in staying on as president was in part down to the altered attitudes on corporate governance. The institutional investors who backed her in the fight might otherwise have sat on their votes.

Stooping to conquer

Many companies that are not yet ready for an internal revolution are at least making some efforts to appease newly empowered investors, by buying back shares or lifting their dividends. The total value of share buy-backs rose to ¥3.7 trillion in 2014, the highest level since the global financial crisis in 2008. For several giants, including Mitsui, a trading house, and Toray Industries, a textiles and chemicals group, it is the first time that they have ever stooped to conquer shareholder approval in this way. Investors have responded by lifting the total value of companies listed on the main board of the Tokyo Stock Exchange to match its former peak in 1989.

The government’s aim is certainly far more ambitious than getting firms to distribute some of their vast cash piles. It wants to see Japanese industry regaining its global competitiveness. One important reason for the slippage has been quiescent boards. Although Japanese boards are no longer the charade they might have been in the past, says George Olcott, a seasoned director who currently sits on several of them, too few conduct a proper debate on the company’s strategy, and too many still see their main purpose as simply ratifying decisions already taken by management. The new corporate-governance code will oblige firms to employ at least two outside directors on their boards, and gives those boards explicit duties to scrutinise the work of managers and communicate with shareholders.

Just as important is the code brought in last year for pension funds and other institutional investors, which aims to transform them from supine rentiers into responsible stewards. The code, which is modelled on Britain’s, tells fund managers to engage in active discussion with companies’ boards about their strategy and performance, and to publish information on how they voted at shareholder meetings.

There are grounds for hope that big investors will do their bit. To give them further impetus, early this year Institutional Shareholder Services (ISS), an adviser to foreign fund managers and some Japanese ones, recommended that funds vote against the managers of any firms in Japan that had failed to notch up an average return on equity of at least 5% over the last five years. (It had planned to set the bar at 8%, but since the five-year average was just 4.6% last summer, when the measure was being discussed, companies fought hard to lower it.)

Some Japanese life insurers, which have hitherto been especially loth to speak out on poor performance, say they will adopt return-on-equity targets for firms they invest in. One of the largest, Nippon Life, says it will use ISS’s 5% benchmark. Since around a quarter of the 1,891 firms in the Topix index currently fail to achieve it, their bosses could face significant votes against them in the annual shareholder-meeting season, later this month. Many chief executives are feeling vulnerable, says Ms Matsui of Goldman Sachs.

Some institutional investors, most notably the vast Government Pension Investment Fund, say they will pay special attention to the “shame index” introduced last year by the Tokyo Stock Exchange, which includes the 400 best companies as measured by return on equity and some other factors. To avoid the embarrassment of being left out of the index, the bosses of some big firms have scrambled to enact changes. Amada, a toolmaker, promised to return its entire net profits to shareholders for the next two years.

But it would be deeply disappointing, says Mr Niinami of Suntory—one of the architects of Japan’s new corporate-governance framework—if companies restricted themselves to simply re-engineering their balance-sheets through such things as buy-backs, while failing to tackle the underlying reasons for their poor performance. One such is the tangle of stakes that companies hold in other companies, which help protect many ailing firms from takeover (as well as disadvantaging minority investors). These, and Japan’s hitherto hostile attitude to shareholder rights, mean that mergers are a lot less common than in countries like America and Britain (see chart 3). As a result, many industries are fragmented and inefficient.

Companies must rationalise their unwieldy structures and put their cash hoards to work, says Mr Niinami. If they have not embarked on these tasks by 2020, he says, their competitiveness may be eroded beyond the point of no return.

Perhaps the hardest reforms of all for Japanese firms will be those involving the way they manage people. Changing this is one of the main aims of the government’s new corporate-governance rules, says Yasuhisa Shiozaki, the minister of health and labour. Companies have long argued that it is unreasonable for the government to expect them to post dizzy shareholder returns while they are unable by law to lay off excess workers. Corporate Japan in effect forms part of the country’s welfare state, by keeping on more staff than are needed. Some of the “zombie” firms and subsidiaries kept alive through cross-shareholdings and keiretsu, or informal business groupings, exist mainly to provide places to park unneeded workers.

For all its reforming zeal in other areas, there is so far little sign that the government of Mr Abe will move swiftly to make it easier to lay off staff. And even if labour laws were changed, there would be a huge cultural barrier to overcome: since companies currently get rid of permanent staff only in the most dire circumstances, they will be reluctant to shed surplus workers in case their customers and suppliers get the impression that they are indeed in desperate straits.

Japanese firms have clung to their traditions of lifetime employment in a single workplace, and of paying and promoting people according to seniority, because they believe those traditions have merits. Indeed, they foster loyalty, and thereby encourage firms to invest in training graduates without fear of them being poached by rivals, argues Yoshito Hori, the founder of GLOBIS, a business school. However, it is no way to produce the sort of managers needed to lead modern, knowledge-based industries. “Imagine if you took managers at Apple, Google and Amazon and replaced them with people promoted on the basis of length of service rather than merit,” says Atul Goyal, an analyst at Jefferies, a stockbroker. “How long do you think those companies would last?”

Young and frustrated

The voice of Japan’s young workers, who are generally underpaid and underpromoted, recently found an outlet in a surprise hit television drama, set in a fictional version of Japan’s largest bank. Much of the country seemed to identify powerfully with the show’s talented hero, Naoki Hanzawa, a loan manager, who kicks back against the bank’s higher-ups and refuses to take the blame, as Japanese corporate culture dictates he ought, for the bosses’ many profit-destroying blunders.

Hitachi’s salarymen are similarly cheering the firm’s shift to performance-related pay and promotion. If you are in your late 40s you might be nervous, since the ascent of the corporate ladder now comes with some uncertainty, says one. But younger hires are ecstatic. It won’t even matter as much if you went to the wrong university as long as you work hard, exults another employee. Panasonic, Sony and Toyota are also moving towards more performance-related pay and promotion.

Those who plod their way to the top of Japanese firms tend too often to be conservative and narrow-minded. The way they are rewarded does not provide much incentive to try hard: not only is their pay smaller than that of their peers in other developed economies, it is less tied to their performance (see chart 4). When it comes to aligning the interests of bosses and shareholders, Japan is stuck roughly in the 1970s, says Jesper Koll, an economist and adviser to the government.

Although a few firms are beginning to change, it will take years for ambitious youngsters to thrust their way upwards through the layers of hierarchy. In the meantime, Japan Inc remains in the grip of lifetime salarymen who rose in the traditional way. And this is what advocates of better corporate governance, more investment and more risk-taking in Japan worry about most of all: roughly half of the present leaders of large blue-chip firms should be turfed out, argues one pro-reform boss.

It is not yet certain that corporate Japan has the will to take the drastic steps that are needed to restore its competitiveness. Grounds for scepticism are plentiful. The last great effort to open up firms to outside capital and takeovers, in the 1990s and early 2000s, petered out as the establishment closed ranks following the departure of Junichiro Koizumi, an earlier reform-minded prime minister. This time, at least, the government is having success in getting Japanese institutional investors and companies on board. However talented and determined Mr Loeb and other foreign activists are, it will be locals who decide whether the changed atmosphere on corporate performance is merely fleeting, or an irreversible change.