Part 4: More than a box ticking approach is needed in Japan

As we continue to dispel some of the most common myths and misconceptions of investing in Japan and highlight the opportunities for sustainable growth, today we explore how much more than a box ticking approach is needed. 

At FSSA, we seek to invest in quality companies, as defined by the strength of their management, financials and franchise. Our investment approach remains the same, irrespective of which market we look at. However, Japanese management philosophy is quite different to the Western style of management; and some of the key “quality” aspects that investors typically focus on may not apply.

For example, global investors often look for management to be financially aligned with minority shareholders. This usually helps to ensure that the executives managing a company act in the best interests of shareholders, by optimising capital allocation and making strategic decisions to maximise long-term shareholder returns.

However, some of the best Japanese companies do not prioritise shareholders’ returns – their first priority is to take care of their stakeholders, after which financial performance is assumed to follow.

There are many examples of good managers and leaders in Japan that are motivated by a deeper purpose rather than purely financial incentives Pan Ning, the CEO of Fast Retailing’s China business is a typical example of this viewpoint. Mr Pan is credited for building the China business from scratch; but he receives no stock-based compensation and owns few shares in the company, even though the Greater China region is the company’s biggest growth driver outside of Japan.

UNIQLO is consistently ranked the No. 1 apparel brand in China and the business is highly profitable, despite its strategy of looking after its stakeholders first. Instead of maximising profits, the management try to take a balanced approach, sharing profits with both consumers (through low product prices) and suppliers.

We spent time with the management of Fast Retailing/UNIQLO to understand how they could produce quality apparel at such competitive prices, without introducing operational risk or infringing on human rights. The company responded that UNIQLO has around 500 Chinese factory suppliers, but only around 200-300 unique items, which has helped to enhance manufacturing efficiencies and reduce unnecessary costs.

Each supplier is put through a strict evaluation process, but once they have been approved, they are treated like family members instead of being squeezed on margins. While UNIQLO had previously used a third party agency to rate the quality of suppliers, the company has since moved to an in-house team of textile professionals, who visit suppliers on a weekly basis to monitor compliance and quality standards.

Keyence Corp is another example of a company that may seem unattractive at first glance. Due to its conservative approach, Keyence holds around 85% of its balance sheet in cash and government bonds, yet its dividend distribution payout ratio is a paltry 18.4%. Investors point to this inefficient capital allocation and cash hoarding policy as signs that the company has little regard for shareholder returns.

Keyence is at the forefront of the automation industry with its sensors, laser markers and machine vision systems. Despite the “low“ rating, Keyence has delivered excellent capital growth for investors. The company generates stable free cash flow and high returns on invested capital; and both sales and net profit per employee are among the highest in the industry.

There are a few key reasons for its superior profitability metrics and longterm steady returns. Firstly, Keyence’s production is fabless (meaning it does not own factory plants) and its resources are concentrated in research and development (R&D), and sales and marketing. Due to its low fixed cost structure, Keyence generates high return on invested capital and earnings are typically resilient during a downturn. This also enhances its long-term competitiveness.

Secondly, Keyence’s direct sales model (as opposed to a distributor sales model), enables the company to benefit from a virtuous feedback loop with its clients. Its extremely capable and technical sales consultants often design products to meet a client’s requirements before the client even knows what they need! This strong ability to innovate on product design translates into high (more than 80%) gross profit margins for the company.

While Keyence’s total shareholder returns has been constrained by its capital management, it has still delivered an attractive 13% compound annual growth rate over the past 30 years, the equivalent of its book value per share with dividends reinvested. Additionally, there are encouraging signs that minority shareholders’ concerns are being heard, with the dividend payout – while still relatively low – increasing from 5.8% in FY2018 to 18.4% in FY2020.

Up next in chapter five of this six part series, we move on to explore how an ageing population is no barrier to growth.