Japan’s Corporate Governance Reform: A Powerful Driver of Earnings Growth A Shift in Corporate Priorities. For decades, Japan’s corporations were managed to

protect market share, headcount and influence, all at the expense of profits. Today,driven by a shift in corporate priorities, pretax margins are at record highs even aseconomic growth has been lackluster.

Two Phases of Reform. Even before some recent government initiatives largely aimedat boosting ROEs, a shift in corporate priorities got underway around 2009 andcontinued until the 2011 earthquake (“Phase 1”). The natural disaster proved to beonly a temporary interruption of reforms that resumed in 2012 (“Phase 2”).

The Yen: a Catalyst not a Cause. A key catalyst for reform during Phase 1 was Yenappreciation that undermined the competitiveness of the export sector. However, inPhase 2, Yen weakness has not been the predominant driver of profitability, as marginsof domestic services industries have also surged.

Recent Catalysts for Enhanced Corporate Governance. Separate from steps bycorporations to increase margins, the government has recently promoted initiativesthat should improve ROEs to the benefit of shareholders.

Japan remains top ranked in our strategy model. Since its introduction in April2014, the Cornerstone Capital regional strategy model has been Overweight Japan.

@Zloyel / Crystal Graphics

Michael Geraghty Global Markets Strategist

Figure 1: Japan’s Corporate Governance Payoff Pretax Profit Margin and Capacity Utilization in Japan

Source: Ministry of Finance, Ministry of Economy, Trade and Industry, Cornerstone Capital Group

Global Markets Strategy December 16, 2015

2 Please see important disclosures at the back of this report.

Recent Trends in Revenues, Margins and Earnings Growth in Japan

Since its introduction in April 2014, the Cornerstone Capital regional strategy model has been Overweight Japan. (See, for example, the most recent Regional and Sector Strategy: Monthly Update of December 1, 2015.) In this model, valuation and earnings factors are equal-weighted. Not only has Japan consistently ranked relatively highly in terms of valuation, its earnings growth has significantly exceeded that of the other major geographies — Figure 2.

Figure 2: Index of MSCI EPS: 2012 = 100

Source: MSCI, Cornerstone Capital Group

As we discuss in detail below, higher margins are largely to thank for Japan’s remarkable EPS growth — Figure 3.

Figure 3: Pretax Profit Margin of Japan’s Non-Financial Corporate Businesses (Domestic and Offshore)

Source: Ministry of Finance, Cornerstone Capital Group

3 Please see important disclosures at the back of this report.

To be sure, sales have grown too, but not nearly at the same rate as earnings — Figure 4.

Figure 4: Indices of Sales and Pretax Income of Japan’s Non-Financial Corporate Businesses (Domestic and Offshore) 2012 = 100

Source: Ministry of Finance, Cornerstone Capital Group

With the Yen falling significantly against the dollar since 2012, some observers have pointed to foreign exchange related gains as the recent driver of profits in Japan. However, currency does not seem to be the predominant factor behind the improvement in profitability lately given that margins of domestic non-manufacturing businesses (largely services) have also surged — Figure 5.

Figure 5: Pretax Profit Margin of Japan’s Domestic Non-Manufacturing Corporate Businesses

Source: Ministry of Finance, Cornerstone Capital Group

4 Please see important disclosures at the back of this report.

A Structural Shift Higher in Profit Margins

As is the case with other countries — such as the U.S. — profit margins in Japan have tended to fluctuate with capacity utilization. However, in recent years, margins in Japan have made a structural shift higher, continuing to rise even as capacity utilization declined in tandem with the domestic economy — Figure 6.

Figure 6: Pretax Profit Margin of Japan’s Non-Financial Corporate Businesses and National Capacity Utilization

Source: Ministry of Finance, Ministry of Economy, Trade and Industry, Cornerstone Capital Group

As we discuss in detail below, the structural shift higher in profit margins got underway around 2009 and continued until the 2011 Tohoku earthquake (“Phase 1”), with the natural disaster proving to be only a temporary interruption of reforms that resumed in 2012 (“Phase 2”).

The Dataset

As part of this analysis, we have relied on data from the Ministry of Finance Japan. The Surveys for the Financial Statements Statistics of Corporations by Industry are intended to ascertain the financial status of commercial corporations — public and private — whose head offices are located in Japan. The surveys have been conducted on a quarterly basis since 1950. Currently, the survey covers over 1 million corporations. Specifically, we analyzed a dataset that excludes the “finance and insurance” industry in order to avoid anomalies caused by issues specific to that sector.

Our analysis reveals that, since the second phase of reform got underway in 2012, the primary drivers of pretax margin expansion have been reductions in “Cost of Goods Sold” and “Selling, General and Administrative” (SG&A) expenses — Figure 7 — which combined accounted for over two-thirds (69%) of the increase in profitability (with factors such as lower interest expense accounting for the remainder). We discuss in detail below some of the reforms that have contributed to these cost reductions.

5 Please see important disclosures at the back of this report.

Figure 7: Cost of Goods Sold and SG&A as a Percentage of Sales

Source: Ministry of Finance, Cornerstone Capital Group

The fact that Japanese corporations have significantly cut their cost structures means that operational leverage is very high, so that even just modest sales growth (Figure 4) translates into substantial profit gains.

The Push of Weakening Competitiveness; the Pull of Activist Shareholders

In a recent report, Gauging Governance Globally: 2015 update, September 2, 2015, we highlighted that, based on certain measures of governance, Japan was one of the few countries that experienced an improvement in corporate governance in 2015 versus 2014, with the percentile ranking of the vast majority of the other countries in a governance composite declining on a year-on-year basis.

Even before some high-profile government initiatives largely aimed at boosting ROEs were introduced by Prime Minister Abe following his election to office in December 2012, Japanese corporations had been restructuring their operations for several years. This restructuring reflected a profound shift in corporate priorities: For decades, Japan’s corporations had been managed to protect market share, head count and influence, all at the expense of profits.

As we outline below, two key catalysts for corporate restructuring were the push of Yen appreciation that seriously undermined the competitiveness of Japan’s key export sector, and the pull of shareholders — including an increasing number of foreigners — who demanded greater recognition as stakeholders.

Currency as a Catalyst for Restructuring

After reaching a cyclical peak of 4.1% in Q2 2007, pretax margins began a steady decline, ultimately reaching a trough of 1.9% two years later in Q3 2009. While a number of factors contributed to the sharp decline in corporate profitability — including a moribund global economy — Yen appreciation played a significant role (Figure 8). Between 2007 and 2009 the Yen rose 37% against the U.S. dollar, a factor that weighed heavily on the export sector, which had been a driving force of Japan’s economy.

6 Please see important disclosures at the back of this report.

Figure 8: Year-on-Year Percent Change in Yen-Dollar Exchange Rate and Pretax Margin

Source: Bloomberg, Ministry of Finance, Ministry of Economy, Trade and Industry, Cornerstone Capital Group

In order to improve their profitability, Japanese companies embraced reform, including consolidation via M&A as well as restructuring. Although Japan’s homogeneous society is often cited as a reason for the slow pace of change, the upside of homogeneity is that, once change starts, the speed of uptake can be quite fast. In the context of corporate governance reform and how corporations are managed, this meant that pressure from peers forced many of Japan’s longtime underperformers to take steps to improve profitability.

Successful mergers and acquisitions can be difficult in Japan because of the legal and cultural impediments to firing employees, to name one reason among many. Even still, Japan embarked on major consolidation in virtually every industry in recent years, with the number of players often reduced from seven down to three. Figure 9 illustrates that announced M&A activity with Japanese involvement has exceeded $100 billion in every year since 2009.

Figure 9: Announced M&A Activity with Japanese Involvement (in U.S. $ Billions)

Source: Thomson Reuters

7 Please see important disclosures at the back of this report.

The bulk of M&A was either driven by the need to restructure mature industries with low returns, or in response to severe financial difficulties. Industries of note here include chemicals, steel, materials, consumer electronics and pharmaceuticals, all of which experienced significant consolidation and, subsequently, meaningful improvements in profit margins.

In terms of restructuring, many Japanese companies looked to improve break-even points by reducing fixed costs or, alternatively, withdrew from underperforming businesses completely. On the subject of cost reduction, a 2013 Bloomberg article1 noted that:

Japanese companies that made tough decisions about exiting businesses, closing factories and revamping management led a doubling of corporate earnings…to the highest level since 2007. Companies showing profit surges include Panasonic Corp., which has cut 71,000 jobs; Mazda Motor Corp., which is shifting car production to Mexico; and Toyota Motor Corp., which overhauled management and halted new factory construction.

Figure 10 illustrates that the number of employees at Japan’s non-financial corporate businesses has declined since 2012. While the headcount reduction has been modest, it stands in contrast to a prior emphasis on protecting employees.

Figure 10: Number of Employees at Japan’s Non-Financial Corporate Businesses In Millions

Source: Ministry of Finance, Ministry of Economy, Trade and Industry, Cornerstone Capital Group

With regard to exiting unattractive businesses, the Bloomberg article observed that:

Panasonic has undergone one of the more dramatic makeovers, shifting its focus from consumer electronics to alternative power products such as solar panels and batteries. The company, once a leading television maker along with Sony and Sharp Corp., plans to stop making plasma TVs…

1 Japan Inc. Profits Double as Cost-Cutting CEOs Pace Recovery, November 17, 2013

8 Please see important disclosures at the back of this report.

Similarly, a recent Barron’s article2 pointed out that:

Mitsubishi Heavy…is its nation’s largest aerospace and defense company, with a hand in power plants, ships, industrial and construction machines, and much else. Management has been pulling out of unattractive businesses, selling, for example, a lithium-ion battery division [in 2014]…It has also announced plans to restructure its struggling shipbuilding business and focus on liquid natural-gas vessels.

A Heightened Focus on Shareholders

We noted above that, for decades, Japan’s corporations worked to protect market share, headcount, and influence, all at the expense of profits. In addition to the push of Yen appreciation that undermined the competitiveness of Japan’s exports, another key catalyst for a change in the way corporations were managed was the pull of shareholders who demanded greater recognition as stakeholders.

By way of example of one company that has radically changed its attitude to shareholders since 2009, the Economist recently observed3 that:

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 [2015] rose by 12% to ¥600 billion ($5 billion)…[italics added]

The Economist article also pointed out that “the growing proportion of shares in Japan’s listed companies owned by foreigners has undoubtedly added to the pressure on firms to change” — Figure 11. (Note that one reason why foreigners have increased their ownership stakes might be that more shares have become available reflecting a reduction in cross-shareholdings. Today 21% of Japanese companies’ shares are owned by other corporations, which is down from a peak of 30% in 1987.)

2 Time to Buy Japan’s Blue Chips, July 18, 2015 3 Winds of change, June 6, 2015

9 Please see important disclosures at the back of this report.

Figure 11: Foreign-Owned Shares on Japanese Exchanges as a Percentage of Total

Source: Japan Exchange Group

Just as many of Japan’s longtime underperformers were forced by peer pressure to improve profitability by way of M&A and restructuring so, too, have many companies increased their commitment to shareholders in order to pre-empt such demands.

Finally, in addition to striving to improve profitability, Japanese firms have also been enhancing shareholder value by way of dividend hikes and share buybacks. The percentage of companies increasing dividends in 2015 is close to a record high, while share buybacks for all of 2015 are on track for a record year.

Recent Catalysts for Enhanced Corporate Governance

Our discussion thus far has focused on the steps Japanese corporations have taken to increase margins. More recently the government of Prime Minister Abe has promoted corporate government initiatives that should improve Return on Equity (ROE) to the benefit of shareholders.

Just prior to the government’s initiatives, the JPX-Nikkei Index 400 was launched in January 2014. One of the criteria for inclusion in the Index, which consists of 400 large cap companies, is a relatively high ROE.

The investor Stewardship Code was introduced by the government in February 2014. The Code encourages investors to play an active role in the companies they invest in.

In June 2014, an amendment to the Companies Act was passed in the Diet, with one of the requirements being the need to explain if companies do not appoint outside directors.

The Corporate Governance Code went into force in June 2015. The Code encourages companies to set return on capital targets, have two independent directors and have a duty to explain failures to deliver on medium-term plans and capital policies.

If successful, these initiatives should further enhance corporate governance, which would likely result in an additional boost to shareholder returns.

10 Please see important disclosures at the back of this report.

11 Please see important disclosures at the back of this report.

Michael Geraghty is the Global Markets Strategist for Cornerstone Capital Group. He has over three decades of experience in the financial services industry including working as an investment strategist at UBS and Citi. michael.geraghty@cornerstonecapinc.com

12

Cornerstone Capital Inc. doing business as Cornerstone Capital Group (“Cornerstone”) is a Delaware corporation with headquarters in New York, NY. The Cornerstone Flagship Report (“Report”) is a service mark of Cornerstone Capital Inc. All other marks referenced are the property of their respective owners. The Report is licensed for use by named individual Authorized Users, and may not be reproduced, distributed, forwarded, posted, published, transmitted, uploaded or otherwise made available to others for commercial purposes, including to individuals within an Institutional Subscriber without written authorization from Cornerstone.

The views expressed herein are the views of the individual authors and may not reflect the views of Cornerstone or any institution with which an author is affiliated. Such authors do not have any actual, implied or apparent authority to act on behalf of any issuer mentioned in this publication. This publication does not take into account the investment objectives, financial situation, restrictions, particular needs or financial, legal or tax situation of any particular person and should not be viewed as addressing the recipients’ particular investment needs. Recipients should consider the information contained in this publication as only a single factor in making an investment decision and should not rely solely on investment recommendations contained herein, if any, as a substitution for the exercise of independent judgment of the merits and risks of investments. This is not an offer or solicitation for the purchase or sale of any security, investment, or other product and should not be construed as such. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations to purchase or sell such securities. Investing in securities and other financial products entails certain risks, including the possible loss of the entire principal amount invested. You should obtain advice from your tax, financial, legal, and other advisors and only make investment decisions on the basis of your own objectives, experience, and resources. Information contained herein is current as of the date appearing herein and has been obtained from sources believed to be reliable, but accuracy and completeness are not guaranteed and should not be relied upon as such. Cornerstone has no duty to update the information contained herein, and the opinions, estimates, projections, assessments and other views expressed in this publication (collectively “Statements”) may change without notice due to many factors including but not limited to fluctuating market conditions and economic factors. The Statements contained herein are based on a number of assumptions. Cornerstone makes no representations as to the reasonableness of such assumptions or the likelihood that such assumptions will coincide with actual events and this information should not be relied upon for that purpose. Changes in such assumptions could produce materially different results. Past performance is not a guarantee or indication of future results, and no representation or warranty, express or implied, is made regarding future performance of any security mentioned in this publication. Cornerstone accepts no liability for any loss (whether direct, indirect or consequential) occasioned to any person acting or refraining from action as a result of any material contained in or derived from this publication, except to the extent (but only to the extent) that such liability may not be waived, modified or limited under applicable law. This publication may provide addresses of, or contain hyperlinks to, Internet websites. Cornerstone has not reviewed the linked Internet website of any third party and takes no responsibility for the contents thereof. Each such address or hyperlink is provided for your convenience and information, and the content of linked third party websites is not in any way incorporated herein. Recipients who choose to access such third-party websites or follow such hyperlinks do so at their own risk.