Slightly dated, but interesting conversation with Timothy Foley, co-founder of Edwall Management. He discusses the opportunity in Japanese stocks, evidence that things are finally changing in Japan and why value can be unlocked, the growing trend of hostile takeovers and the role shareholders activists are playing in the market. I have included some of my own paraphrased notes below (please note these are for personal reference only and any mistakes in transcription are my own).

Introduction: they are not activists themselves, but believe that activism in Japan can generate alpha. So they will invest with activist managers, invest in stocks that activists own etc. They think that in a world of factor investing, this is one factor that hasn’t really been commoditized yet and so they try to align themselves with interesting and forward thinking shareholder activists in Japan. They focus on Japan because it is a dream for value investors. You have hundreds of companies that trade at valuations that are unseen elsewhere in the world, e.g. ~850 companies that trade at P/B of 0.7x or less, few hundred companies that trade at negative EV and so on.

On why there are so many listed companies in Japan: some people say you have to be a listed company in Japan to attract and retain good staff, but not sure there is proof of that. You also have this history of big conglomerates spinning off individual business units, which is somewhat related to the issue of employee retention. In a system of lifetime employment, you need a place for accomplished executives who are not going to run the mothership to be placed elsewhere. Many of these listed companies are trading at very cheap valuations. Lots of them have little to no analyst coverage or engaged shareholders. Basically, part of the stock market is broken and this has been a big problem for Japan for a wide variety of reasons.

On the evidence that things are changing and value can be unlocked: the exchange, the government and proxy advisers have all tried to address these issues. There has been some progress. One is the increasing number of delistings, as a result of either parent-subsidiary consolidation, management buyouts or PE takeovers. 2021 was a record year for delistings (over the last decade or so) with 86 in total. The parent-subsidiary situation is pretty consistent, there have been somewhere been 10-30 transactions a year since 2014 or so. There are about 200 remaining publicly listed subsidiaries. Second, M&A is up. Part of that is the future pressure around what it means to be a listed company in Japan. There are clear benefits to being a listed company and it shouldn’t be free. Not necessarily meant in dollar terms, but things like increasing free float, appointing independent directors, publishing reports in English etc. should be the cost of being publicly listed. Some companies are now looking at that and saying it does not make sense to be public. Third, tender offers are at relative high for the last decade or so. And then there are hostile or unsolicited bids – over the past 3 years, been about 10 per year, 5 on average have been successful. The underappreciated story is that more of these are coming from Japanese companies, which makes sense because they are the ones who know the assets better (e.g. the target may be a customer or supplier) and they have the most synergies with those assets. That’s where he thinks will see the most increase in deals.

On why this is happening more now: there are a few reasons. One is a more engaged shareholder base which is demanding better returns on equity, shareholder returns etc. The big change is that it is coming increasingly from domestic shareholder activists. GPIF is is asking their asset managers to vote and vote more consciously. Some of the other pillars that have enabled entrenched management to stay in power and ignore shareholders in the past are now also crumbling. For example, cross-shareholdings are coming down, and the number of poison pills every year is lower. Finally, the number of independent directors on boards is increasing (although many are still ineffectual due to lack of training, serving on too many boards etc.).

On why engaged shareholders or activists aren’t being more demanding of the big companies: a lot of the changes have in fact been at the large cap level, and many now look better on paper. The reality is that for smaller companies, it’s often a pretty easy suggestion – e.g., your stock is trading at less than the value of the cash on your balance sheet, that’s a problem, you need to change it. Doesn’t take that much time to express it to the management team. With a large cap company, however, you are often talking about reorganizing businesses, shutting or spinning off divisions, and it ends up being more of a long-term engagement that takes a lot of effort (e.g. the Toshiba case has been going on for years and has worked out well for some of the investors, but it has not been quick or easy). If you are a smaller fund, you just have many more smaller targets to choose from.

The other part of it also comes from the problems of running an activist strategy. Your investors usually expect you to be fully invested and if you have success, you will gain more assets and be forced to take on bigger and bigger targets, or to increase the number of names in the portfolio. In his experience, however, a reasonable team of activist investors in one fund can probably do 2-3 campaigns at one time. They are very time consuming, expensive etc. You can’t really do that many, so you have to run a concentrated portfolio. If you are successful and raise more assets, you will have to move up the market cap scale. Or expand the number of companies in your portfolio which will probably dilute your returns. So there is an issue with just the structure of activist funds globally. In his view, activism in Japan is not a US$10bn strategy, it is a couple of hundred million dollars strategy, and you have to keep recycling capital to interesting names.

Why not just focus on investing in good companies? Investing is all about valuation. There are a lot of great companies, but if they are priced as great companies, there aren’t much opportunities. At the same time, there are levels of “badness” that are acceptable for most activist investors. They will typically screen for companies that are cash generative, not losing money, and they want to verify the validity of the assets. But if a company is trading at 0.7x book value, if you can bring that to book value over ~2 years, that is ~50% upside, which is a good return. The company doesn’t need to be growing that much. If it is stable, profitable and it is more of an issue with capital allocation, you can still make a decent return. Some companies just need more “pep in their step,” to think about the future, what shareholders are going to want and then get after it.

On companies not being willing to speak or engage with shareholders: some of this is about having a sense of duty to shareholders, that is what being a public company entails. Shareholders are not the only stakeholder and they may not be the most important to everyone, but certainly it should be high on the list in terms of wanting to generate value for your shareholders. But if that is not something that is a priority for corporate management team, think the question is should it be a publicly traded company (or should there be changes to management)? Often, you don’t need to bring in people from outside, the talent is already there. A lot of Japanese companies are operationally good. They make good products, think carefully about their customers and suppliers, but they might not think about capital allocation. The CEO might have come from the operational side, so perhaps the CFO is someone who could be in charge. You want someone running the company who ideally knows the business, is loyal to the company etc. 

On the challenges of appointing independent directors: Japan has gone about corporate governance reform by putting it in the hands of shareholders. Was a smart way to do it, but not the fastest way to get things done. They haven’t often said explicitly that you need X amount of independent directors. More about we think you should have this many, it is ok if you don’t, but then explain to your shareholders why not. And if shareholders are satisfied with the answer, then fine. Independent directors is only one metric. Some of the best performing companies in the US have voting rights consolidated to the founders. But the shares perform well and and investors are happy. If the company’s CEO and chairman are the same person, and the entire board is composed of former employees, but they are putting shareholder returns near the top of the list, he doesn’t think it is much of an issue. The goal of shareholder activists is not to get board directors appointed. The goal is to get a higher share price or higher valuation, increase the payout ratio or monetize some dormant assets. 

How does Japan differ from other markets when it comes to change of control? If you take the typical small cap, deep value company with entrenched management, the best owner is likely another Japanese corporate. They probably have the highest synergies, overlapping labor pool etc. Talked earlier about the prestige of a public listing – that can be maintained, and employees will probably stick around.  The issue historically is that Japanese corporates have been averse to anything hostile or unsolicited. Also, companies sometimes may not have the means to finance a deal themselves. So there needs to be a catalyst – and this is where activist investors can play a role in highlighting places of deep valuation discount to the best suited buyers, causing them to run to each other.  

On factors holding back takeover activity: financing is one, but that is also starting to change. In order to launch a tender offer, you must prove to the regulator you have sufficient cash (or access to it) to close the deal. In the US, every bank has an LBO desk or some sort of high yield desk. In Japan, banks will not finance anything that is hostile or unsolicited, so you have to go somewhere else for funds. So what activists are doing now is either they are big enough to to fund the deals themselves (albeit very few) or they are raising the money from overseas.