(Bloomberg) -- When the Tokyo Stock Exchange unveiled a campaign to whip poorly managed companies into shape two years ago, investors responded by piling into companies with the lowest valuations.
The investment thesis was that management could easily improve valuation metrics with very little effort.
For a while that strategy worked. The top quintile of value companies — the bottom 20% of firms based on a combination of valuation metrics — outperformed their more richly valued peers over the next year and a half. The mere announcement of a buyback plan was often enough to trigger a rally.
But the market’s historic crash in early August has changed the dynamics, as the unwinding of yen-funded trades ended the outperformance of value stocks and made investors more demanding. Cheap valuations alone don’t make the cut and investors are showing a preference for companies that are making real efforts to improve corporate governance.
“Low quality stocks had floated higher on vague pledges to do something. That stage is over,” said Shuntaro Takeuchi, portfolio manager at Matthews International Capital Management in San Francisco.
Takeuchi said the market is in the second stage of the governance-themed trade, where investors try to identify companies that have strong fundamentals but have a lot to gain by improving capital allocation.
Expectations of corporate governance reforms, sparked by the TSE’s name-and-shame campaign aimed at getting companies to focus on shareholders, have been a major driver of the rally in Japanese stocks over the last two years. The price-to-book ratio of Topix 500 companies has risen to 1.47 from a 2 1/2-year trough of 1.17 hit in January 2023.
Data show almost all the gains were a result of “re-rating” as investors drove up stock prices of these companies on the belief that management would lift governance standards.
But there was little on-ground evidence.
Return-on-equity, a measure of how efficiently a company is generating profit using shareholders’ funds, has risen only marginally since the launch of the TSE’s reform drive. The ROE of Topix 500 firms stood at 9.3%, still below their international peers.
That is exactly why some global investors, such as Harris Associates and Baillie Gifford, largely stayed out of the market.
“While low PBR stocks have outperformed, they are low quality businesses and the improvement in their ROE is not big enough to justify their outperformance,” said David Herro, deputy chairman of Harris, a Chicago-based value investment fund. “We need to see improvement in the low ROE stocks to get interested.”
At the heart of problem, many analysts say, are bloated balance sheets of Japanese companies which are sitting on piles of assets that have low returns — cash, cross-holdings in affiliated companies and real estate.
As shareholder pressure mounted, Japanese companies responded by increasing buybacks. The amount of share buyback plans announced so far this year has reached a record 18.2 trillion yen ($120 billion), more than doubling from 8.9 trillion yen last year.
Investors like buybacks because they reduce the company’s base of outstanding shares which helps lift earnings per share and potentially its stock price. But this form of financial engineering does little to enhance the company’s income-generating ability.
“There’s a bit of a simplistic view out there that you have to buy back shares to lift ROE,” said Keiichi Ito, chief quants analyst at SMBC Nikko Securities, noting that companies should focus more on measures to make their core business grow, such as stepping up capital expenditure and spending more on research and M&A.
“Of course you cannot boost the profitability of core business overnight. But investors won’t be happy unless you do that,” he said.