Fund managers share their insights on finding rising ESG stars in Japan

21 Jul, 2020 00:16
source: Singularity Financial

Singularity Financial Hong Kong July 21, 2020 – 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.

According to Keita Kubota and Kei Okamura, head of Japanese Equities team at Neuberger Berman,  this is where they 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.

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. However 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. ” said the Japanese team of Neuberger Berman during a conversation with Institutional Asset Manager.

Management commitment is the biggest challenge

But the team also pointed out, 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. ”

A company’s willingness to change is a crucial component for investors

According to the insights shared by Neuberger Berman Japan team, “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.”

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.

“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. ”

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.

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