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Japanese companies cannot ignore advance of activist shareholders

Groups need to reshape before the arrival of hostile investors

| Japan
Legendary activist investor T. Boone Pickens in Japan in 1990. Shareholders like him are not as rare any more.

Activist shareholders, often detested by management as "locusts," are a permanent, if controversial, fixture of American and European stock markets.

Japan, the most developed stock market in Asia, has never been completely shielded from activism. But after retreating from Tokyo in the 2008 financial crisis, the activists are back.

To cope with the pressure, Japanese managers must do what most don't want to do -- and have very rarely done before -- think like activists. They should focus on their core strengths and cut away functions and operations that destroy value. In a land where many company presidents still love to run conglomerates this will not be easy.

International shareholder activism first appeared in Japan in 1989 when American investor T Boone Pickens tried to shake up Koito Manufacturing and attempted -- unsuccessfully -- to secure a board seat. More recently U.S. activist fund, Steel Partners fought raucous proxy fights in the 2000s with Sapporo Holdings, the No.3 domestic beer giant, and Aderans, a wig maker, with mixed results.

Almost every time, the assaults have represented a rude awakening for Japanese managers, for whom the annual shareholders' meeting had meant a sleepy ritual and not a boxing match with hostile investors.

With the 2008 financial crisis now nearly a decade old, the activists have returned to Tokyo, albeit in a more subtle way than before. They are not grabbing headlines but their numbers are growing: 2017 saw 28 Japan-headquartered companies publicly targeted by activists, up from 20 in 2016. That puts Japan behind the U.K. on 36, but ahead of Germany with 19, according to Activist Insight. Activist funds which have either bought into Japanese companies or expressed interest in doing so include Hong Kong-based Oasis Management and ValueAct Capital, of the U.S.

The renewed interest is fueled by the combination of ample risk money, cheap valuations in the Japanese stock market and by the side-effects of the policies of the government of Prime Minister Shinzo Abe to boost corporate transparency.

How can Japanese managers be better prepared than they were in the past? The quickest way to answer the question is to think like activists. The easiest targets for activists are complacent managements with no explicit growth strategy which do little to boost a lackluster stock price.

The first thing that activists generally want is for hoarded cash (piled high in many Japanese corporate treasuries) to be returned to shareholders by share buybacks or dividend increases or both.

On this score, Japanese corporations have visibly improved. For Japanese public companies, the average return on equity (ROE) -- a key yardstick for shareholders returns -- last year surpassed 10% for the first time and inched closer to the U.S. average of 12.8%.

Next, activists press managers to be more aggressive. Again, Japanese executives are doing rather better than before. For example, overseas acquisitions, a useful proxy for go-ahead managers, are no longer exotic. Volumes have grown over the past decade and hit 7.5 trillion yen ($70 billion) last year, 2.6 times the level of 10 years ago, with a record 672 deals, according to Recof, an M&A advisory firm.

But even the most entrepreneurial Japanese managers struggle to contemplate what is often a key activist demand -- corporate breakup. These investors typically argue that -- particularly in a large diversified group -- the enterprise value of the whole entity is less than the sum of the parts of the business portfolios. They complain that they are being forced to pay a conglomerate discount. When investors can customize their investment portfolios, why should they let managements run complex business portfolios with an often mediocre record in allocating resources? This is the logic activist investors have applied in targeting big U.S. corporations such as General Electric and DowDuPont.

The list of Japanese groups with assets at least as diversified as these American groups is legion, thanks to long-standing traditions of establishing companies to supply parts and services combined with the practice of forming cross shareholdings with key partners, including banks.

Even mid-sized companies may end up covering a wide range of industries. Once this approach may have been justified, for example to secure suppliers of scare components in earlier decades of industrialization . But managers must ask themselves the question -- if I were rebuilding the company from scratch would I include all the business lines that I have? Are not some of them better divested, and the funds funneled back to fortify the core business or, say it softly, returned to shareholders?

An A.T. Kearney analysis of mid-sized companies in the Topix Mid 400 (excluding the financial sector) shows that, ranked in the order of operating margin, the top 20 groups on average list 2.4 business segments compared to 5.3 by the bottom 20. In fact, 9 out of top 20 are "one-trick ponies" with only one business segment reported in their investor relations documents.

This does not mean that all companies should be single-sector businesses. But most should rationalize down to a few core businesses. This in my view is the single most important task for Japanese management today. It is not just a matter of satisfying hostile shareholders or raising financial returns, though these matter. It is about defining the identity of the corporation in a globalizing world.

However, it must be done well. Companies which choose to focus can still get their decisions disastrously wrong. For example, when Toshiba, the sprawling electrical conglomerate, decided to concentrate on two main businesses it made a huge error in picking nuclear power alongside its successful semiconductor memory operations. It invested heavily in nuclear by purchasing a controlling stake in Westinghouse, a U.S. manufacturer, paying $5.4 billion in 2006. Sadly, we know today that an American atomic power plant business neither fitted well into Toshiba nor was it a good investment when the world turned away from nuclear power, especially after the 2011 Fukushima disaster.

Meanwhile, Hitachi, Toshiba's long-term rival, successfully restructured the sprawling portfolio of its 900+ group companies in 2009-2012 under the leadership of Takashi Kawamura. He redefined Hitachi's core business as "social innovation," combining hardware, operations and IT as packaged solutions such as in energy management schemes for German cities or in high-speed train systems in the U.K. For Kawamura this was a future-oriented direction which fitted well with Hitachi's strengths which originated in hardware manufacturing but also included IT skills garnered through providing software services. This decision redefined the center of gravity for Hitachi. Other businesses such as consumer electronics under subsidiary Hitachi Appliances moved away from core orbit of Hitachi even though this business had made Hitachi a household name.

Japanese managers must not be put off by the Toshiba example. They must draw the right lessons from both companies' experiences.

The whole process of unloading and sifting of the portfolio reminds me of the cooking technique called deconstruction. In deconstruction, you take a traditional dish, say bouillabaisse, tear it apart and treat all key ingredients -- seafood, potato, saffron-flavored broth -- independently until finally reassembling them on a plate. The idea is that the finished dish produces a more pronounced harmony of flavors than its pre-deconstructed mishmash.

The art of deconstruction in management, is about sharpening the definition of what you stand for and shaping your business portfolio around it. It is high time that the executives of Japan Inc. took lessons from the chefs. Deconstruction should be a creative process pursued at a time of a company's choosing. It will never be as enjoyable when done in response to activist shareholders.

Nobuko Kobayashi is a partner at A.T. Kearney in Tokyo.

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