Finding rising ESG stars in Japan’s under-researched SME market: Q&A with Neuberger Berman
Japan may boast the third largest equity market in the world, but its 3.5 million small to medium sized businesses, which account for 99.7 per cent of its companies, are still under-researched.
This is where fund managers at Neuberger Berman are applying their expertise to find quality companies that are committed to improving their ESG impact, in the recently launched Neuberger Berman Japan Equity Engagement fund.
Speaking to Institutional Asset Manager are Keita Kubota, head of Japanese Equities at Neuberger Berman and manager of the Neuberger Berman Japan Equity Engagement fund, and Kei Okamura, director of Japan Investment Stewardship of the Japanese Equity team at Neuberger Berman.
What is the current climate in Japan towards ESG investing, and how has this developed in recent years?
We believe the overall climate for ESG investing has continued to improve in Japan and the trend has become more noticeable in the last seven to eight years. Before the Global Financial Crisis, ESG was still a relatively niche focus for investors. For our strategy, we didn’t necessarily call it “ESG” back then, but we certainly looked at the same material issues focusing first and foremost on governance followed by environmental issues like energy efficiency and opportunities in clean technology, and social responsibility themes like diversity and employee turnover. This was part of our bottom-up and fundamental analysis of investment risks and opportunities. Hence, ESG integration, as it’s called today, came naturally to us.
In Japan, we believe the majority of investors’ focus still remains heavily focused on governance while a minority have expanded their scope to include environment and social issues. Part of the reason for this trend is the current government led by Prime Minister Shinzo Abe that placed improving corporate governance at the heart of its economic reform strategy. More importantly the government recognised that reforms would be meaningless without the commitment of both companies and investors, which is why the Stewardship and Corporate Governance Codes were launched in 2013 and 2015 respectively to encourage the two parties to achieve higher corporate governance standards. On environment and social, the Government Pension Investment Fund’s (GPIF) decision to sign the UN PRI in 2015 was a wake-up call to the Japanese investor community to address material ESG risks in their portfolios while companies should expand beyond CSR and think about sustainability challenges through an ESG lens.
In the last four to five years we have witnessed the wider investment chain including sell-side brokers, consultants, proxy voting advisors, index and data providers jump on this trend. More importantly, we are beginning to see the wider Japanese public beginning to recognise the importance of addressing ESG issues. The increasingly frequent and extreme weather patterns as well as the rapidly ageing demographic have raised the public’s awareness of these issues. And as a result, it’s no longer unusual to see ESG stories on the front page of local newspapers and office workers with UN SDG badges on their jackets.
What are the unique challenges and opportunities of doing ESG investing in Japan?
The biggest challenge and opportunity to ESG investing in Japan is management commitment to addressing material ESG issues and integrating sustainability into the business model. In many cases among Japanese companies, we often find that this is the most crucial component that is missing. During the last half decade, we have witnessed a surge in Japanese companies placing ESG and sustainability in their investor and corporate communication. As a result, Japan has become home to the highest number of companies in the world publishing integrated reports and supporting Task Force on Climate-related Financial Disclosures (TCFD) reporting. However, many of these reports are missing core elements of the integrated reporting framework such as how the business will create value over time through its financial and non-financial capital allocation. Similarly with TCFD, of the more than 260 companies and organisations that have pledged their support, only two companies have disclosed the quantitative impact that climate change may have to its business as part of the scenario analysis (Nikkei, 11 July 2020).
We are somewhat concerned about this trend that sustainability and material ESG issues are becoming merely PR tools for companies to re-brand Corporate Social Responsibility (CSR) as ESG. At such companies, management has shown little willingness to embrace sustainability into the business and therefore it comes as no surprise that none of the so-called “ESG initiatives” to address the material risks have filtered through the organisation. On the other hand, there are a handful of companies that are the exception. One musical instruments maker held in our portfolio is run by a CEO who has a firm understanding of the importance of integrating sustainability into its business model. For instance, the company identified that raw material costs and sustainable supply chain management were key risks to its mid-term growth strategy. As a result, in its new mid-term strategy, the company has set out to expand its bulk procurement of certified timber to stabilise procurement costs as well as reduce the risks of illegal logging. This would help reduce volatility in cost of goods sold while helping to secure a stable supply base of high quality timber for its acoustic instruments in the long-run.
How do you assess a company’s ‘willingness to change’? Why do you take this into account when choosing where to invest?
We consider a company’s willingness to change as a crucial component of our investment process because we see ourselves as long-term owners of the business and expect to grow corporate and shareholder value together with management. The types of small to mid-size companies we own are highly profitable thanks to an attractive business model that’s protected by a strong moat. They have clear earnings visibility in industries and markets with good growth potential. They also tend to have robust cash flow generation and solid balance sheets that can weather macroeconomic headwinds like the one we face today with the Covid-19 pandemic. More importantly, they are run by an experienced management team that has a track record in achieving stated goals while acting in the best interests of all minority shareholders like us.
Identifying such companies is no easy feat and requires combing through years of financial statements, media clippings as well as cross-checks with competitors, suppliers and customers. But what’s most important is meeting the company, preferably with a management level speaker. During these introductory meetings, we try to gauge if management can speak candidly about not just the strengths of its business but also its weaknesses as well as possibly the material ESG risks that could hinder its sustainable long-term growth. This is usually a good starting point to understand if management is willing to listen to shareholders and more importantly capable of embracing change. If we sense that management has no intention of accepting change or simply playing lip service to investors, we may consider not investing in the business as we may run the risk of wasting our time and resources engaging on deaf ears.
How does it apply to stocks already in your portfolio?
For each of our carefully selected 30-50 companies in our portfolio, we have a set of key material ESG risks we’ve identified using the Sustainability Accounting Standards Board (SASB) framework as well as any issues pertaining to business fundamentals such as capital management. And for each topic, we have a set of engagement objectives and strategies, which we manage using a milestone system. In general, engagements can span an average of two to three years and in some cases more than five years to achieve the goals. As a result, we have adopted a system that will allow us to set periodic goals, or “milestones” that will help us remain on track but also act as an indicator of when to escalate the engagements if necessary (i.e. meet the external director, send a letter to the board, consider collective engagement with other investors as well as proxy voting). Our team has a strong track record in engaging companies that has provided us with crucial know-how on how to manage engagement campaigns effectively.
For example, on the topic of cash hoarding, we recently recorded a significant engagement win with a regional telco company that is a listed subsidiary of one of Japan’s three main mobile carriers. The company is highly profitable thanks to its dominant market position and continues to accumulate cash on its balance sheet as capital spending remains well below its cash flow generation. We have built a strong relationship with the open-minded management whom we regularly exchange views on capital efficiency. Management often agreed with our view that more can be done to raise capital efficiency but admitted that the decision needs to be made in accordance with its parent. As a result, we expanded our campaign to include the parent to discuss the importance of raising its subsidiary’s capital efficiency from a long-term growth perspective. And earlier this year, our regional telco holding announced its first ever share buyback coupled with an increased dividend. In the subsequent meeting with the CEO, he cited our all-rounded engagement with the company as a key catalyst that resulted in the change in capital management policy.
On material environment and social risks, we had engaged Japan’s top fabless distributor of PC accessories and IT equipment that has been aggressively gaining store shelf space among top electronics retailers. Early in our investment phase, we identified key social risks such as human capital management as a result of its relatively high employee turnover vis-à-vis peers due to it its unique sales culture. We suggested the company consider reviewing its evaluation system for sales representatives and consider more long-term and sustainable KPIs. The company was naturally concerned that such an approach may lead to reduced sales and loss of market share to rivals. But we pointed out the risks of inventory mismanagement and potential impairment losses if the company continued aggressive sales tactics in the event of a market downturn. Earlier this year, we learned that the company did just that by overhauling its KPIs for sales managers to include sell-through rates to end-customers. Management noted that sales remained brisk and that the changes were warmly welcomed by their staff who said they were able to focus more on long-term goals and the needs of their end-users.
What are the benefits of engaging Japanese small and mid-cap companies on material ESG topics?
The biggest benefit to engaging small to mid-size companies is that you get to reap the benefits of your engagement much better than large cap companies. In other words, the “return on engagement” is higher as long as you’ve identified the right quality business run by management that’s willing to listen to shareholders and change if necessary. But the reason why not every investor can implement this strategy is because finding these so-called “hidden gems” is not easy.
Japan’s small to mid-cap market is one of the most liquid of its kind in the world and yet it remains one of the most under-researched among developed markets. Roughly 25 per cent of this space has zero sell-side analysts with nearly 90 per cent of companies having less than five. That compares to 36 per cent in the US and 6 per cent in Europe. The situation is more severe in ESG research as less than half of the companies we hold in our portfolio are being rated by major ratings agencies. And even if these companies are being researched, it’s often the case that the ratings only capture the surface of their sustainability profile as most of these companies do not disclose relevant ESG data and the information is almost always provided only in Japanese.
However, we consider this as an advantage from our strategy’s standpoint. That’s because as long-term investors that conduct its own fundamental analysis and ESG research, we believe we have a better understanding of the true underlying value of the business. And as a result, that gives us a much better sense of how to advise management on which material issues they should address first in order to maximise corporate value. This type of constructive feedback is usually well received by our investment companies that don’t have the same resources as their large-cap peers and need to know what ESG risks to focus on. Over time, as these companies improve their sustainability profile and disclosure according to internationally accepted standards such as SASB, GRI and TCFD, we anticipate the ESG ratings agencies will be able to better assess these companies and possibly make them eligible as investment targets for other long-term and sustainability focused investors. This is sometimes a painstaking process that requires time and patience to see the intended results but we believe this is a crucial step to helping these companies realise sustainable growth and ultimately achieve our portfolio’s outperformance over the long-term.