Summary

  • The Nikkei Stock Average closed at 38,915.87 yen on December 29, 1989, and it took 34 years and two months to surpass this level.
  • During that long period of stagnation, Japanese companies' ROE remained at a low level by international standards. The Ito report did not simply attribute the cause to economic conditions or demographic trends, but pointed to problems with corporate capital allocation and governance.
  • The report's “ROE of above 8%” has become a common starting point for companies and investors when discussing capital efficiency.

34 years to recover to 1989 high

On December 29, 1989, the Nikkei Stock Average closed at 38,915.87 yen and the TOPIX closed at 2,881.37. Both indexes then remained below this level for more than 30 years. The last time the Nikkei average exceeded its closing price at the end of 1989 was in February 2024. Around the same time, TOPIX finally approached its high price.

In the 1990s, the bursting of the bubble, the bad loan problem, and deflation were cited as the main causes of slumping stock prices. In the 2000s, there was a growing emphasis on demographic trends such as the decline in the working-age population. All are important factors, but they have common limitations. Rather than focusing on how Japanese companies' business performance and capital allocation affected market valuations, the explanation focused on the external environment surrounding the companies.

Around the end of 2012, when the second Abe administration was inaugurated, the Ministry of Economy, Trade and Industry became aware of a different problem. The reason behind the low rate of return of Japanese stocks is the low capital efficiency of Japanese companies. Funds pile up on balance sheets and go toward businesses and investments that don't generate sufficient profits, and cross-shareholdings and boards of directors made up mostly of insiders make it difficult to enforce discipline from the outside. Based on this diagnosis, what is needed is not just monetary and population policy reform, but also corporate governance and capital allocation reform.

ROE gap in numbers

In 2014, international comparisons clearly showed the low profitability of Japanese companies.

region Average ROE (2004–2013) Average ROIC (McKinsey) Foreign stock ownership ratio (2014)
Japan Less than 5% About 8% Approximately 30%
united states 14–15% About 21% n/a
Europe (Stoxx 600) 10–11% About 15% n/a

Source: Ministry of Economy, Trade and Industry, “Ito Report” §1, §3 (2014); McKinsey & Co., Closing Japan's valuation gap by changing corporate traditions.

There are two major issues highlighted by the Ito report.

  1. Lack of awareness of cost of capital. Only about 40% of listed companies answered that they were conscious of their cost of capital, and less than 10% actually disclosed it. Without understanding the cost of capital, it is not possible to compare the profitability of investments and business continuity using the same criteria.
  2. Internal management and explanations to investors were separated. While ROE and shareholder value are explained to overseas investors, management is managed internally using other indicators such as sales, operating income, and personnel. Without a logic that connects the two, explanations aimed at the capital market will become divorced from the reality of management.

“Japanese companies' ROE has fallen below 5%.Despite this, the cost of capital is significantly higher than that.This is a structural problem.”

  • Ministry of Economy, Trade and Industry, “Competitiveness and Incentives for Sustainable Growth - Building Desirable Relationships between Companies and Investors Project Final Report (Ito Report)” (August 2014)

Kunio Ito's awareness of the problem was also on the same point. Although Japanese companies have superior technology, patents, human resources, and positions in the world market, they have not been able to sufficiently translate these into profits that exceed the cost of capital. What the Ito report showed was this gap between technological capabilities and profitability.

Why was it “8%”?

The Ito report did not arbitrarily decide on 8%. The project surveyed global investors from 2013 to 2014 to ascertain the cost of capital required for Japanese stocks. The responses were concentrated around 7%, and ROE of 8% was indicated as a guideline for exceeding the cost of capital expected by approximately 90% of the investors surveyed.

A representative passage from the report is as follows.

“In order to be recognized by global investors, each company should commit to achieving an ROE of above 8% as a first step.” ― Ito Report §1.3

There are three points to keep in mind here.

  • 8% is not the final goal, but a guideline to exceed first. Higher standards may be required depending on the industry and business characteristics.
  • Based on global investors. The starting point is whether or not a company is recognized as an investment target in the international capital market, rather than a comparison with the national average.
  • The aim is a sustained management commitment rather than a temporary result. This does not mean that the rate of return exceeds 8% by chance during good times, but rather that the company consistently manages to exceed the cost of capital.

This standard has permeated subsequent policy and market practice. It has been used as a common yardstick when considering capital efficiency, including dialogue between institutional investors who have accepted the Stewardship Code, disclosure based on the Corporate Governance Code, GPIF's evaluation of asset managers, corporate analysis by securities companies, and even the Tokyo Stock Exchange request in March 2023.

Two changes that supported the reform

The low ROE itself had been going on long before the publication of the Ito report. Nevertheless, the reason that awareness of the issue took hold as policy from 2013 to 2014 was because the shareholder structure and corporate supervision structure had changed significantly.

First, the presence of foreign investors has increased. Foreign ownership rose from a small percentage in the early 1980s to around 30% by 2014. The proportion of foreign investors in daily trading value has increased, and the price formation of Japanese stocks has come to be strongly influenced by international investment standards. Rather than being "fair" compared to the domestic average, questions are now being asked about whether the company is sufficiently profitable compared to overseas companies.

Second, supervision by main banks has weakened. Banks' ownership of listed stocks declined from over 20% in the 1980s to less than 5% in 2014. In the past, banks had three roles: shareholder, lender, and management monitor. As banks sell off their stocks and lending relationships change, a new issue has become who will take over their supervisory functions.

Column - Why was the problem difficult to see from within the company? In major manufacturing companies, operating profit margins improved throughout the 2000s, and net interest-bearing debt decreased, so it appeared to managers that their financial standing was improving. However, if internal reserves accumulate more than the increase in profits, equity capital, which is the denominator of ROE, will expand. Even if the profit margin improves, if the increase in equity exceeds the increase, ROE will not increase. The 8% ROE standard and subsequent cost of capital disclosure made this problem visible.

numbers changed the debate

Before the Ito report, companies with an ROE of 6% could be described as being “on par with the average Japanese companies.” After the announcement, it became necessary to explain why the same 6% did not reach the 8% indicated by the Ministry of Economy, Trade and Industry. Since it has become a standard set by Japan's industrial policy authorities, rather than an evaluation axis used only by foreign investors, it has gained more weight as a management issue.

It is also significant that the issuing entity was the Ministry of Economy, Trade and Industry. For Japanese companies, mainly in the manufacturing industry, the Ministry of Economy, Trade and Industry is a familiar government agency responsible for industrial policy. With the Ministry of Economy, Trade and Industry taking up capital efficiency as an issue of corporate competitiveness, it has become difficult to dismiss ROE as an issue only for the IR department.

The major developments since then can be categorized into the following three categories.

  1. The 2015 Corporate Governance Code requires listed companies to use capital effectively and increase corporate value over the medium to long term.
  2. GPIF's stewardship activities encouraged external asset managers to engage in dialogue about the capital efficiency of their portfolio companies. ROE of 8% became a level that was repeatedly referenced in those conversations.
  3. March 2023 TSE request requires listed companies on the Prime Standard Market to analyze their cost of capital and return on capital at their board of directors, and disclose and implement improvement measures. The awareness of the issues expressed in the Ito Report has become concrete as ongoing management issues for each company.

From the Ito report in 2014 to the TSE request in 2023, the question at the heart of reform has remained consistent. Does the company generate more returns from the invested capital than is required for that capital? ROE of 8% became the first standard for management and investors to share this question.

Implications that IR personnel should keep in mind

  1. Do not make 8% a uniform final goal. What the Ito Report indicated was "above 8% as a minimum." If you aim for around 8% in your medium-term management plan, explain the relationship with your company's cost of equity and why that level is appropriate.
  2. Indicate the basis for calculating capital cost. In addition to the numbers, explain the assumptions used and the differences in perception with investors. If a company only sets an ROE target without disclosing the cost of capital, it is difficult to judge whether it is at a level that allows it to create value.
  3. Connect internal KPIs and shareholder value. Shows how daily management indicators such as operating profit margin, personnel productivity, and segment profit are linked to corporate value through ROE and ROIC.
  4. Explain ROE by breaking it down into factors. The reasons for not achieving the target are shown separately for net profit margin, total asset turnover, and financial leverage. What investors are looking for is not an excuse for the numbers, but an understanding of the causes and improvement measures.
  5. Clarify criteria for capital allocation. Explain the relationship between expected rate of return and cost of capital for capital investment, M&A, dividends, and share buybacks.

Source/reference materials

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