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Opinion

Japan Inc. ripe for post-COVID consolidation

Japan remains the global hotbed for activist investors behind the U.S.

| Japan
The trading floor of at the Tokyo Stock Exchange: the share of underperforming stocks is much higher in Japan than anywhere else in the world. (Photo by Kento Awashima)

Jochen Legewie is the Tokyo partner and Asia Chairman of strategic communications consultancy Kekst CNC.

While most global stock markets including Japan's Nikkei Stock Average have almost fully recovered their COVID lows, the crisis has left certain sectors and companies looking rather battered and bruised.

What is most interesting about Japan is that the share of underperforming stocks is much higher here than anywhere else in the world.

This will likely lead to significant restructuring driven by foreign and domestic capital, from activist and strategic investors alike. And over the next two years, I expect to see a major consolidation in the Japanese industrial sector.

Hostile takeovers will play a major part, as shown by restaurant chain operator Colowide, which successfully leveraged shareholders' frustration with Ootoya Holdings' sluggish share price to take effective control despite fierce opposition from Ootoya management.

Already in 2019, the number of hostile takeover attempts had risen to five from the one or two Japan usually sees each year. Expect that figure to keep rising, with underperforming stocks being the primary targets.

Around two-thirds of companies in the Nikkei Stock Average are trading at least 10% lower than at the start of 2020 compared to less than 40% in Germany and the U.S. Even more remarkable, more than 42% of the Nikkei Stock Average's 225 component companies are down more than 20% -- far more than anywhere else. Japan also features the smallest share of actual winners: only 12% of Nikkei Stock Average listed companies are trading at least 10% higher than at the beginning of the year, compared to 23% in Germany and 38% in the U.S.

Just one company out of the Nikkei Stock Average, M3, is up more than 60% -- compared to four out of 90 German DAX and MDAX companies, and nine U.S. S&P 500 companies. Interestingly, Germany -- with a similar industrial structure built around a strong manufacturing sector and which is also seen as a laggard when it comes to digitalization -- clearly has more stock winners and less losers than Japan.

Let us have a closer look at the most affected sectors. Only three out of Japan 33 Topix sectors are up by more than 5%: precision instruments, info and communication -- both up by 6% -- and other products, which is up by 11%.

By contrast, seven indexes are down by more by than 20% year-to-date, meaning they have barely moved from their COVID lows: from mining, which is down 48%, through to iron and steel, air transportation, real estate, textile and apparel, oil and coal products, to banks, which is down 21%.

The message is clear: international investors do not appear to fancy Japan Inc.'s prospects of prevailing in a post-COVID world. The pandemic has exposed specific sector and company weaknesses, many of which have been there for years.

First of all, many Japanese companies are lagging behind their peers in digitalization, now a major disadvantage. Many Japanese companies are also judged to be very vulnerable to supply chain disruptions. This even made the Japanese government subsidize the reshoring of production from China and other places.

Other structural weaknesses include a declining population and shrinking domestic market with clearly too many domestic players in a number of sectors such as steel, heavy industry, automotive, or office equipment. Companies fitting these descriptions have to watch out.

Back in April and May, many activists increased their positions on the back of substantially more attractive valuations than before COVID-19, globally as well as in Japan. These opportunities are now more rarefied. But companies in the sectors mentioned above, which have not recovered, continue to be at risk from activist forays.

It is therefore not a surprise that, according to Activist Insight data, Japan remains the global hotbed for activist investors behind the U.S. By the end of August 2020, 57 companies were subject to activist demands, a figure likely to increase to a full-year record.

And it is only logical that the focus of this activism will be companies in those sectors suffering most. Oasis's investment in construction company Hazama Ando -- down 21% year-to-date -- or RMB's investment in apparel company Sanyo Shokai -- down 56% year-to-date -- stand out.

At the same time, the need for consolidation in these battered sectors will lead to a surge of friendly and hostile takeover bids by various strategic players. And there is a strong link between both kinds of raiders. Maeda Corp.'s successful hostile bid for Maeda Road Construction in March, with activist Oasis involved in the background, provides a blueprint.

Merger-related consolidation will likely be driven more by Japanese companies rather than foreign players. Publicly listed companies in Japan hold an all-time record of more than $6 trillion in cash. These cash positions provide would-be Japanese buyers with a powerful ready-to-use tool for friendly, as well as hostile, takeover bids.

Japan Inc. is up for far-reaching restructuring and industrial alignment. Japanese companies will be the main drivers, but with heavy involvement of foreign activists who speak up primarily -- though not exclusively -- for foreign institutional investors.

This combination of Japanese and Western capital at play will shape the structural reform of the Japanese economy for years to come and will hopefully contribute to the eventual raising of Japanese companies' global competitiveness.

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