MW-43 -- Are Corporate Revitalization Plays a Short?

J@pan Inc Magazine Presents:
Weekly Financial Commentary from Tokyo

Issue No. 43
Tuesday, September 9, 2003

++ Viewpoint: Are Corporate Revitalization Plays a Short?

The Bottom Line
Top-Down: Bond yield/stock yield spreads normalize.
o With deflationary fears in remission and rising expectations
of both economic and corporate profit growth, the inverse
yield spread between bond yields and stock-dividend yields
that first emerged last September has been corrected. In other
words, stocks and bonds in Japan have resumed their normal
historical relationship.

o While Money Watch still suspects that stock prices and bond
prices are already discounting more economic growth than
Japan's economy can deliver, investor surveys indicate that
little importance is being given to short-term monetary
policy, implying that market participants do not believe the
Bank of Japan (BOJ) can have a significant impact on what is
happening at the long end of the yield curve.

o There are even suggestions that the rise in long-bond yields
is far from over. If Japanese government bond (JGB) yields
return to a "non-deflationary" state, they could rise to
around 2.5 percent, the level that prevailed in 1996 before
investors seriously began to worry about deflation. Going
forward, the stock market and the bond market will become even
more sensitive to economic announcements and to the signals
being broadcast by the BOJ regarding monetary policy, as the
changeover to "normal" rates will be very tricky, to say the

Bottom-Up: Good corporate governance pays, but you wouldn't know it by
year-to-date performance.
o There is long-term evidence that good corporate governance
pays in Japan as well. However, you wouldn't know it by
perusing the list of the biggest gainers in the fiscal year to
date. For example, all the negatives that were working against
bank stocks (who deserve an "F" for corporate governance) last
September are now looking positive, or at least neutral.
Moreover, rising expectations of corporate revival as the
Industrial Revitalization Corporation of Japan gets to work
has instigated rallies in domestic debt-ridden stocks long
considered on the short list for bankruptcy. Indeed, the
rising tide has lifted an unusually large number of very leaky

o But if higher bond yields are here to stay and are going much
higher, the higher interest burden on the heavily indebted
companies will decimate what profits they are now showing.
Moreover, many of these companies wouldn't make the benchmarks
the Industrial Revitalization Corp. has set as selection
criteria. Consequently, as there is no fundamental earnings
story and even the revitalization story is a stretch, many of
these firms look like good short candidates given the
disconnect in the rallying share prices of these stocks and
the rate expectations now being discounted in the bond market.

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++ Viewpoint: Are Corporate Revitalization Plays a Short?

On September 2, US treasury secretary John Snow officially recognized
what the Japanese stock market had already been discounting (and
foreign investors buying) for the last two months -- Japan's reform
programs were evidently "beginning to bear fruit" and the Japanese
economy was apparently beginning to turn. Indeed, some economists are
even suggesting that what we are now seeing is the beginning of the
end of Japan's deflationary malaise.

This is a 180-degree shift from last September, when bond yields fell
below stock dividend yields for the first time in memory. This was
definitely an abnormal situation, as dividend yields are typically
lower than bond yields because stocks ostensibly offer something that
bonds do not have: earnings growth. Moreover, bond yields had fallen
to the point that investors were discounting deflation as far as one
could see -- at least for the next 10 years -- while stock yields were
indicative of extremely low, if any, earnings-growth expectations.
Then, the selection of Heizo Takenaka as the new financial services
minister had investors convinced that Japan's reform efforts had taken
a turn toward the "hard landing" camp in terms of a forced liquidation
of bank nonperforming loans (NPLs). A forced liquidation of NPLs, it
was claimed by Takenaka's critics inside the government, would only
exacerbate the deflationary pressures on Japan's economy and push
Japan deeper into recession, or even a depression.

As the mood darkened in Tokyo and prospects for economic recovery were
further clouded by the Iraq War and SARS, the domestic media and
foreign investors, heretofore generally supportive of the "hard
landing" approach, began to sympathize with Takenaka's opponents
within the government.

The prospect of worsening deflation and potential turmoil in the
financial sector had investors seriously considering the possibility
that bond yields in Japan could even go negative, as the government
essentially became the domestic last resort for investors to maintain
a store of value for their funds. As domestic investors piled into
bonds and the BOJ added further fuel to the fire by raising the upper
limit of their monthly purchases of JGBs, 10-year JGB yields plunged
below 0.50 percent at one point, and the negative spread between bond
yields and dividend yields widened to 70 basis points. In other words,
between September of last year and August of this year, Japan's stock
and bond markets were discounting the worst of all scenarios.

But the stock market was already turning, first in discounting the
"successful" end to the Iraq War, then in discounting a more sanguine
view of financial-sector fragility with the de facto bailout of Resona
Bank in May, and then in discounting an economic upturn and an
ostensible improvement in corporate profits with a much-better-than-
expected June tankan (the BOJ's quarterly business survey), an upward
revision in Tokyo Steel's outlook in July, and finally with positive
news on the April-June GDP numbers in August.

With market participants now looking to GDP and corporate profit
growth, the yield spread has again reversed, with bond yields backing
up very rapidly. Barring a financial crisis and only nominal (as
opposed to negative-spiral) deflation, the bond and stock markets have
been restored to their traditional relationship. Investors now expect
growth in Japanese earnings and perhaps even some inflation. The
question is, how much growth has already been discounted, and how far
can JGB yields go before they start choking off the emerging recovery?

Money Watch would be concerned about potential overvaluation if stock
and bond prices were discounting any more than a "modest" cyclical
recovery. That being said, we are as much aware as any other investor
that: a) Japan has relatively more cyclical leverage to a global
recovery; b) global investors are now correcting what had been a
severe underweight vis-・vis their benchmarks in Japanese stocks; and
c) stock prices tend to do best at the early stages of a recovery.

Earlier in the year, the Japanese government released estimates that
called for nominal and real GDP growth of -0.2 percent and 0.6
percent, respectively, while the Organization for Economic Cooperation
and Development saw 1.0-percent growth. More recently, the Economist
Intelligence Unit bumped up its GDP forecast for Japan from
0.7-percent growth to 2.0-percent growth. This forecast was echoed by
the International Monetary Fund.

Yet the dramatic turnaround in investor sentiment downplays the fact
that the BOJ has poured more money into the currency markets in
support of the yen than the GDP of some Asian nations, while it has
also been supporting the bond market with trillions of yen of
purchases per month, and the stock market with purchases of stock held
by the banks. In other words, the BOJ is still in an "extraordinary
circumstances mode" as regards monetary policy, and the tricky part
will be when and how it moves away from its zero-interest-rate policy.

The BOJ is trying to play down such speculation, as it still remembers
what happened the last time it prematurely raised rates in August
2000, triggering a sell-off in stocks and prompting lawmakers to
demand BOJ governor Masaru Hayami's head. This "verbal intervention"
has so far worked. Current BOJ governor Toshihiko Fukui's insistence
that he would keep interest rates near zero until consumer prices
showed "consistent" gains prompted JGB yields to stage their largest
drop in four-and-a-half years. This is because the verbal intervention
has been backed by the supply of 1 trillion yen in cash into the money
markets. Market participants, however, doubt that these moves can keep
the lid on short-term rates if long-bond yields continue to rise.

With the Nikkei index at 10,000-plus, Money Watch believes that there
are high expectations regarding economic recovery already built into
stock prices. On September 4, the Finance Ministry's corporate survey
indicated the first improvement in perceived business conditions in
three quarters, but a major reason given was "rising stock prices." In
other words, stock prices are ostensibly rising because of improving
business sentiment, while business sentiment is improving because
stocks are rising. Consequently, Japanese stock and bond prices could
become very sensitive to economic announcements and to the signals
being broadcast by the BOJ regarding monetary policy. A recent survey
by Nikkei Quick of domestic bond investors gives "economic trends" and
"supply-demand," followed by stock prices, as the main factors
affecting bond prices.

Ironically, little if any importance was given to short-term monetary
policy, implying that market participants do not believe that the BOJ
can have a significant impact on what is happening at the long end of
the yield curve. Indeed, there are even suggestions that the rise in
long-bond yields is far from over. If JGB bond yields return to a
"nondeflationary" state, they could rise to around 2.5 percent, the
level that prevailed in 1996, before investors seriously began to
worry about deflation.

Does Corporate Governance Really Pay?
More and more studies are indicating that buying companies with good
corporate governance pays. A study of 1,500 large companies in the US
during the 1990s by Paul Gompers and Joy Ishii in February of this
year (Corporate Governance and Equity Prices, Quarterly Journal of
Economics, February 2003) found that buying stocks with the strongest
corporate governance scores and selling firms with the weakest scores
produced superior returns of 8.5 percent per annum.

A study produced in 2000 by global consultancy McKinsey found that 75
percent of the 200 institutional investors it surveyed regard board
practices as important as financial metrics for assessing companies.
The study showed that companies that moved from the worst to the best
governance practices could expect a 10-percent increase in market

At the same time, a veritable cottage industry has sprung up among
ratings agencies and consultants issuing corporate governance ratings.
Investors can turn to Standard & Poor's Corporate Governance Score and
Institutional Shareholder Services' Corporate Governance Quotient.
Both of them report and grade public companies' governance practices.
In addition, the Investor Responsibility Research Center, along with
corporate governance watchdogs like the Corporate Library and
Governance Metrics provide governance performance ratings.

But Japanese companies in general rank poorly in corporate governance.
Part of good corporate governance is the transparency of the process.
In 2001, PricewaterhouseCoopers (PwC) issued what it called the
"opacity index." Unlike a "transparency index," lower scores were
good, not bad. The US received a score of 36; the UK, 38; Singapore,
29; Chile, 36; Japan, 60; Peru, 58; Mexico, 48; and Greece, 75. PwC
calculated that Japan investors had to suffer a risk premium of 629
basis points over US benchmark levels because of Japan's high

In the IMD corporate governance ranking, Japan scored 49 (which is the
worst ranking) in shareholder value; it was nearly as bad in
adaptability and corporate boards.

Since bad governance ostensibly diminishes market value, and as
controlling shareholders ostensibly have the power to change things
with their proxy votes, one would expect them to be the one's pushing
capital destroyers to change. In Japan, however, the institutional
"strategic" and "cross" majority holders live in glass houses, and,
therefore, cannot afford to throw stones in the form of shareholder
activism. Thus the unwinding of crossholdings in Japan represents
corporate governance progress in that the relative importance of
pension funds (which are now voting their proxies against management)
has grown.

In Japan, companies dominated by a long-standing chief executive are
known as "one-man" companies. But a survey by the Nikkei indicates
that even "one-man" companies can perform well, provided they have a
solid basis in "good" corporate governance, as defined by an overall
evaluation of the following criteria:

1. Capital efficiency: return on equity (ROE), return on assets (ROA)
2. Market evaluation: Stock returns, Tobin's Q ratio
3. Stability: Stock price volatility, negative net equity
4. Structure of shareholders: foreign ownership, institutional
5. Board of directors (organization): number of directors, ratio of
outside directors
6. Directors (executive): value of shares held by directors
7. Shareholder returns: dividend-payout ratio
8. Information disclosure: speed of announcement of earnings
results, content of annual shareholders' meeting

As the first step, the Nikkei survey screened 2,353 listed companies
to find those that had recorded consistent consolidated profit growth
for the past five years. Only 49 firms made the cut. Moreover, only
nine firms managed to record consistent profit growth over the past 10
years. These firms also had relatively high corporate governance
scores, according to the Nikkei scoring system.

However, as Fujio Mitarai of Canon observed, simply importing a US
corporate governance infrastructure and overlaying it on a Japanese
organization will not produce good corporate governance.
Unfortunately, many Japanese companies have introduced an array of
superficial reforms that do not change the substance. Don't confuse
the methodology with the objective. Corporate Japan's problem is not
the system per se, but the managers themselves and the willingness of
major domestic institutional shareholders to tolerate poor

It is, however, becoming more common for investors to look beyond the
numbers for indications of future performance. Qualitative intangibles
-- such as quality of management, customer retention and innovation --
are examined. Among these, corporate governance, in particular, is
gaining weight. Studies show that corporate governance is now an
established investment criterion and that investors are willing to pay
a premium for a well-governed company. Perceptive investors look at
the core values of management and the company's commitment to reform.

Ironically, Hiroaki Niihara, a researcher at the Research Institute of
Economy, Trade and Industry, found in a recent study that none of the
core skills of the managers at superior Japanese companies had
anything to do with predetermined corporate governance
infrastructures. That said, Japanese corporate management that has
consistently destroyed value over the past several years also tend to
have low corporate governance scores.

Deeply Indebted "Dogs"
There have been many deeply indebted market "dogs" that contributed to
the rally in Japanese stocks by soaring on investor hopes that they
would get a new lease on life because of the bailout of Resona Bank
and the establishment of the Industrial Revitalization Corp. For
example, the 20 companies with the largest debt-equity ratios as of
the end of March posted interest-bearing debt-weighted performances of
74 percent. Companies that make up Topix and the Nikkei 225 rose 26
and 29 percent, respectively.

Those 20 companies have total interest-bearing debt of 3.9 trillion
yen, a weighted average debt to equity of 277.5x and a median
debt-to-cash-flow ratio of 19x. The effective interest rate on these
debts is 2.5 percent. If their effective interest-rate burden
increased by 100 basis points because of soaring JGB yields, interest
payments would rise by 14 percent, or from 40 percent of operating
cash flow to 57 percent. Moreover, this rise in interest payments
would reduce their aggregate ordinary profit by 68 percent. In other
words, the rally in these heavily indebted losers to date has no basis
in earnings fundamentals, but only in the hope of revitalization.
Considering that one of the main criteria for revitalization by the
Industrial Revitalization Corp. is that the target firm can ostensibly
achieve a debt-to-operating-cash-flow ratio of 10x or better in three
years, most of these firms would not even be eligible for

As the rallies in these stocks have no basis in earnings fundamentals
and the revitalization story ostensibly driving stock prices is also
tenuous, Money Watch views this list as a list of potential short

In particular, Nippon Yakin Kogyo has surged 8.2-fold since late 2002.
It has avoided net negative equity by gaining debt relief from its
major banks. Part of the reason the stock has soared is because the
corporations that own their debt -- Mizuho and the Development Bank of
Japan -- have shifted their credits to a corporate turnaround firm.

Arai Gumi is up 6.3-fold during the same period despite an unusual
statement by Chuo Aoyama Audit that the ability of the firm to reach
its restructuring goals in three years will largely determine the
company's fate. Its stock has been boosted by debt waivers from
Sumitomo Mitsui and the fact that Konoike has become a stockholder,
along with a 5-percent position by Goldman Sachs.

Towa Real Estate is up 5.4-fold during the same period, having staved
off net negative equity with debt waivers, while its auditor, Chuo
Aoyama Audit, felt compelled to spell out the waiver details when
reviewing the company's accounts. Tomen is up some fourfold while it
also has received debt forgiveness from UFJ and has seen support for
its stock with the listing of Japan Wind Development and the interest
this generated in wind-power-generation-related companies.

-- Darrel Whitten

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Written by Darrel Whitten

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