Almost three decades ago, the Texan oilman T. Boone Pickens attempted to charge into a Japanese boardroom. He had accumulated around one-third of the company – worth almost $1 billion at the time – yet a seat at the table eluded him. There was nothing to force the directors to accept him.
Japan Inc. has come a long way since Pickens took on Koito Manufacturing Co., a supplier of parts to Toyota Motor Corp. Backed by Prime Minister Shinzo Abe’s economic revival plan and corporate governance reforms, activist investors are circling. Tokyo buzzes with investors and advisers looking to capitalize as they open doors to once insular boardrooms. Yet the opportunity can still be as difficult to grasp as it was for Pickens.
Companies face a demographic crisis with risk-averse leaders, waning productivity growth and in many cases misallocated capital. Threats to their technology leadership are growing, and corporate scandals are multiplying.
The average return on invested capital at Japanese companies is around 7 percent, well below the 11 percent for their peers in the S&P 500 index. Despite increasing buybacks, companies’ cash-to-asset ratios (a measure of the liquidity they hold for a crisis) remain the highest in the world, making it hard to boost returns. One yen of capital doesn’t go as far as it used to.
The great Japan discount continues to hang over the Topix 500 index. The benchmark trades at a 30 percent discount to the S&P 500, based on forward earnings multiples. Japanese companies’ average return on equity is 9.6 percent, against 14.7 percent for those in the U.S. index.
The way out of this morass is to align executives’ incentives with companies’ goals. The current stasis is a symptom of Japan’s economic egalitarianism: Nobody wants to be seen getting too rich. The average Japanese CEO is paid less than $1 million, compared with more than 10 times that for the average American boss.
Low pay, and the fact that most CEOs started out as “salary men” (or women) rather than entrepreneurs, means there’s little drive to compete and take tough decisions. So while an American CEO’s compensation package may be more than 70 percent in long-term incentives, and a German leader might get 30 percent, in Japan it’s only around 20 percent.
That’s more than in the past: New rules on tax and disclosure plus governance reforms over the past two years have helped. But incentive pay remains below global norms. Meanwhile, executives must disclose compensation above $1 million under the regulations – but to avoid doing so, many are paid just under that threshold.
Behavioral science studies provide ample evidence of a deep relationship between pay and performance, present and future, showing the importance of having skin in the game. The U.S. may be an extreme example, where activists scrutinize pay and lobby to slash it, and short-termism becomes entrenched. But Japan is at the other extreme. There’s a happy middle ground, with Germany as an example.
This isn’t just about raising salaries. Executives may want to appear altruistic, but they need to be paid in the right way, including a performance component, to make money for shareholders – and themselves.
Data on the structure of compensation is spotty, but a proxy for directors’ vested interest is their share ownership. Where CEOs hold around $5 million-worth of stock, returns tend to be far higher, according to Zuhair Khan, a Jefferies analyst in Tokyo. At companies where the CEO holds less than $500,000, the performance tends to be dismal.
Japanese executives typically get a $1 million cash handout at retirement. With the downside capped at the end of their careers, no wonder incentives to change are limited. Companies are only now starting to award stock options with a 1 yen strike price. If the shares rise and the option is deep in the money, compensation increases. The opposite is also true, of course, but that’s how incentives work.
Companies started giving executives trust-like share grants to get around rules against restricted stock in Japan. Then the government amended those regulations (rather than removing them), and the process became more complicated with a credit system for executives to receive restricted stock. Creating a labyrinth only hinders progress. The tax laws, too, discourage companies from deducting the variable portion of compensation.
Fixing pay structures goes beyond narrowing Japan's valuation discount. By better aligning executives with their companies, there's an opportunity to boost the nation's stubbornly low wage growth and breathe some life into Abenomics. Officials, executives and activist investors should all be pushing for this.
The Bloomberg
