Japan’s Nikkei index broke through its 1989 high  for the first time in February 2024. It took an astonishing 35 years for the index to get back to the levels seen at the peak of the Japan bubble in the 90’s. Behind these lost decades is a fascinating story about the enormous stock market bubble that popped, but also a valuable lesson on the impact of capital allocation decisions on shareholder returns. 

Capital allocation is a topic that is very important to us, and worth discussing in more detail. In this letter we will first look at how capital allocation plays a role in investing. Second, we will explain how a change in capital allocation practices in Japan was an important driver for the strong recent performance of the Japanese equity market. Third, we will discuss the (potential) changes in capital allocation policies that are taking place in Korea now, and what the investment implications are.  

Options for Capital Allocation
One of the three core principles of our investment philosophy is capital allocation, along with 'cash flow generation' and 'valuation'. When a business produces cash flows, management must choose how to use these cash flows. Generally speaking, management has four choices.
The first option would be to invest the cash back into the business. For example, building an additional production facility, opening a new office, rolling out a new service. 

The second option is to use cash flows to acquire other companies. The reasoning behind acquiring other companies is frequently to expand the scale of operations, realizing cost synergies and increasing profits. 

The third option is to use cash to strengthen the balance sheet by paying down debt or building a cash buffer. 

The fourth and final option is for management to hand the cash back to shareholders. They can do this through dividends and through share repurchases. Dividends have the advantage of putting cash into the hands of shareholders. Management teams can also decide to use excess cash to buy the company’s shares in the market, thereby reducing the number of outstanding shares. 

It is important to stress that there is no one-size-fits-all approach to capital allocation, as the opportunity set that management has available differs per company. However, in all cases they should critically assess the returns they expect to make on their plans and should allocate capital to the highest returning opportunities. 
Companies with attractive reinvestment opportunities should reinvest in the business. What is crucial is that the expected return on such an investment is high, otherwise the expected profits from the endeavor will be below the cost of the investment and management will have destroyed value. 

Other companies might lack the possibility to reinvest in their own business but have ample M&A opportunities. Here, management should be wary whether the expected boost in profitability really warrants the steep premium that an acquirer usually must pay. 

In some cases, strengthening the balance sheet is the best use of capital. This can either be because the business is overleveraged and/or because the company pays a high interest rate on its debt.  

When returning capital to shareholders, management should decide what the pathway is. While we like to receive dividends, when the shares trade at a discount to their intrinsic value, buying back shares can create substantial value for the remaining shareholders. Share repurchases have the added value of signaling to investors that the management team believes that their shares are undervalued. Dividends have a similar signaling function. As management teams usually aim to continue to pay a similar (or greater) dividend going forward, a commitment to dividend distributions signals their confidence in the long-term prospects of the business. 

When we look at a company, analysis of the options that a company has available, and assessing management’s capital allocation plans and track record is of key importance. 

Lessons from Japan

Now back to Japan, where the importance of capital allocation can be seen over the last decades. During the 1980’s, the Japanese economy was rapidly growing, led by strong export numbers and buoyant real estate markets. The excessive optimism resulted in strongly inflated real estate and equity markets. After the initial correction of the excessive share price valuation of the Japanese bubble in 1990, the Nikkei share index continued to underperform as poor capital allocation practices put a lid on the recovery. In the end the index lost about 80% of its value over the course of two decades. 

The poor capital allocation started during the bubble, when new projects were funded based on overly bullish assumptions, and Japanese companies used borrowed money to finance huge acquisitions and to acquire ‘trophy assets’, such as Van Gogh paintings and New York office buildings. The lack of interest in their shareholders was reflected in low dividend payouts. 

When the bubble burst, many of these projects turned out to be worthless resulting in substantial write downs. The painful deleveraging process left such a scar with some management teams, that they vowed to avoid financial leverage going forward. Instead, they went into overdrive to build excessively strong balance sheets, holding no debt and large cash positions. despite record low interest rates. In many cases they refrained from returning cash to shareholders. 

Another example of poor capital allocation was cross-shareholdings. This is the practice of Japanese corporates to be invested in each other’s shares as a token of commitment to the business relationship, rather than to make a good return. This practice effectively prevented outside shareholders from having a say in the company’s management. Because of the latter, investors became unwilling to fully value cash balances or equity investments that Japanese corporates owned as they felt that the value would never be distributed to shareholders. 

With the establishment of the Corporate Stewardship Code in 2014, a decade-long process of corporate governance reforms was started. In the early years, the reforms were aimed at improving shareholder’s rights. In the last couple of years, Japanese regulators and the Japanese Stock Exchange (TSE) have been actively pushing listed companies to either reform or risk being delisted from the exchange. In a 2023 plan by the TSE, Japanese companies that are trading at a price/book ratio below 1 are required to communicate plans to increase the ratio to above 1. 

As an engaged shareholder, we applaud the efforts of the TSE to push for change. Because of these initiatives, companies started to pay higher dividends, and actively bought back shares. According to NikkeiAsia, Japanese companies repurchased a record amount of 9.6 trillion JPY (~65 billion USD) in 2023. Consequently, the Japanese Nikkei index has nearly doubled over the last 5 years. 

We have had many conversations with the management of the companies held in the portfolio and other Japanese companies about their capital allocation practices. In our funds for example, we have benefited from these developments with shareholdings in companies such as certain insurers . Recently, the financial regulator (FSA) urged Japanese insurers to speed up the sale of their investments in listed companies. The sale will bring in cash that is likely to be used to repurchase shares. On the back of these developments, the shares of some of these companies have performed very well over the last months. This Japanese example clearly shows that improving capital allocation can lead to strong share price performance.

More on the horizon
Interestingly, the success of Japan has sparked a discussion in another market that has suffered from poor capital allocation practices, namely Korea. Korea shares similarities with Japan, going from boom to bust, complex cross holding structures and low shareholder distributions. As a result, the Korean equity market has generated an abysmal return since the peak in 2007 and trades at one of the lowest valuations compared to global peers. 

On the back of the valuation opportunity some are now pushing for change. In 2023, a domestic activist shareholder started a campaign to push the Korean banking sector for higher shareholder returns. More recently, the Korean Corporate Governance Forum also wrote an open letter to the Financial Services Commission (FSC) and the incoming CEO of the Korea Exchange to act. At the end of February, the FSC came out with a first draft of their ‘Corporate Value-up’ program. Although it lacked concrete measures, it is a positive sign that the issue is starting to be addressed. In Korea we have been actively involved in conversations with the management of the companies held in the portfolio and prospective companies on their capital allocation and see the developments as a potential catalyst for share price re-rating. 

The improvement in capital allocation in Japan, and the subsequent strong share price performance, supports our view that capital allocation matters. It is and will remain an important pillar of our investment philosophy. We are excited to follow the developments in Japan and Korea and aim to benefit from the ongoing improvements through diligent stock picking.

(Data on Nikkei Index from Nihon Keizai Shimbun)