MATTHEW BRETT

Companies across Japan have faced the same challenges since the turn of the 21st century: an ageing population, stagnant domestic markets, commoditisation of products and the threat from more nimble Asian competitors or multinational giants.

Many companies appear to be addressing these challenges in similar, predictable ways – with off-the-peg mid-term plans, or formulaic mergers and acquisitions in emerging markets, which will only incrementally bolster the top line. Sales are still regarded as an important measure of scale and total assets as a measure of power.

Additionally, Japanese management can suffer from structural weaknesses that we are wary of as investors, such as poor strategic decision-making, a lack of incentives, low financial literacy and diversity. Little or no reward for success for employees directly leads to a lack of ambition and can really harm company performance. We challenge these red flags whenever we spot them in our portfolio companies.

However, changes are happening in some organisations that should make investors sit up. The catalysts are partly demographics and partly evolving attitudes. The foundations of traditional Japanese human resources – lifetime employment, seniority-based pay and single-company trade unions – have been crumbling since the 1990s.

We are seeing offices become subtly less hierarchical, implying a more open mindset among middle management, often seen as the bottleneck of new ideas. A more ambitious and less uniform management culture appears to be emerging.

The opportunity we see in Japan comes from the signs of change across industries, primarily in three critical areas. Firstly, a closer alignment of management reward with company performance; secondly, an increased emphasis on governance; and thirdly, the changing nature of Japan’s corporate landscape.

We have long argued for a stronger link between pay and performance in Japanese management and at last this is starting to happen. Over two-thirds of Topix 500 companies now have share-based incentive plans.

Another improvement has been the empowerment of the chief financial officer (CFO). As the person meeting investors, the CFO fulfils a vital role in aligning management with performance goals, improving financial literacy and providing challenge in the boardroom.

Japan’s Corporate Governance Code has also undoubtedly made a difference. It gives powerful tools to activist investors and has transformed board dynamics by increasing the number of independent directors.

Japanese companies no longer exist forever, either. They are becoming more like their western counterparts, to be merged, bought, sold, split up or shut down as economic necessity demands. From the early 2010s, Japan’s IT start-up ecosystem has benefited from an effective pipeline of entrepreneurs, venture capitalists and angel financiers, promoting action throughout the ecosystem.

According to research commissioned by the Bank of Korea, 56 per cent of all global companies over 200 years old are Japanese and, until recently, Japan was home to the oldest known family enterprise in the world. The relative success of founder – or family – run businesses is not particular to Japan, but it highlights a source of competitive edge. Founder-run businesses typically exhibit better long-term thinking and a more strategic approach to risk taking.

We also believe they inspire greater entrepreneurialism, risk-taking and optimism than large, salaryman-staffed businesses. By investing in them, we stand to gain from better decision-making, strategic vision and alignment.

Many of the early-stage Japanese companies we are now coming across more closely resemble western counterparts in areas such as profitability, returns to shareholders and even issues such as board structure, performance-related pay and personnel promotions.

Much remains to play out, but the relationship between ownership and management structure with competitive edge is especially intriguing in Japan. With clearer reporting and alignment among many newer companies, it is easy to assume an edge, but there are obviously dangers of conflicts of interest between dominant and minority owners, and interference from self-interested shareholders. Nevertheless, new external and internal influences are transforming opportunities and making this a particularly exciting time to be investing in Japan.

Matthew Brett is manager of the Baillie Gifford Japan Trust PLC.