Is Japan Really a “Buy”? The Corporate Governance, Cash Holdings and Economic Performance of Japanese Companies

• DOI: http://doi.org/10.1111/jbfa.12235
• Author: Douglas J. Skinner,Kazuo Kato,Meng Li
• Date: 01 March 2017
• Published date: 01 March 2017

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 44(3) & (4), 480–523, March/April 2017, 0306-686X

doi: 10.1111/jbfa.12235

Is Japan Really a “Buy”? The Corporate

Governance, Cash Holdings and

Economic Performance of Japanese

Companies

Kazuo Kato, Meng Li and Douglas J. Skinner∗

Abstract: We investigate whether Japan’s much-touted governance reforms improve its firms’

management of cash, economic performance and valuation. Consistent with an improvement

in governance since 2000, Japanese firms hold less cash and increase payouts to shareholders.

Improvements in performance are associated with reductions in (excess) cash, reductions in

the influence of the banks that traditionally sit at the center of horizontal keiretsu,andincreases

in the holdings of management and foreign investors. The market valuation of Japanese firms’

cash holdings was lower than for US firms during the 1990s but increased to levels closer to those

of US firms in the 2000s. Collectively, the evidence suggests that performance improves in those

Japanese companies that reform their governance practices. These findings have implications

for other Asian economies, such as China, India and Korea, where there are ongoing discussions

of whether improved governance can increase firm performance and valuation.

Keywords: corporate governance, Japan, dividends, repurchases

1. INTRODUCTION

At least since French and Poterba (1991), it has been clear that common valuation

metrics for Japanese firms often differ systematically from those of firms in other

countries. At the time French and Poterba first wrote their paper, Japanese equity

prices seemed too high based on P/E multiples. Since the “bubble” in Japanese

real estate and equity prices burst in 1990, Japanese equities have looked cheap by

∗The first author is from the Osaka University of Economics. The second author is from the Jindal

School of Management, UT-Dallas. The third author is from the University of Chicago, Booth School of

Business. The authors appreciate comments from Julian Franks (NBER discussant), Yasushi Hamao, Akihiro

Noguchi, Ronan Powell (JBFA Editor), Akinobu Shuto, Dan Simunic, Tomomi Takada, Arnt Verriest, two

anonymous referees, and workshop participants at Arkansas, Boston College, Harvard Business School (IMO

conference), the JBFA Capital Markets conference, Melbourne, Minnesota Empirical Conference, Nagoya,

NBER Japan Project, Southern Methodist University, Tilburg, and USC. Kato acknowledges financial

support from the Japanese Society for the Promotion of Science, Granted-in-Aid for Science Research

C21530485. (Paper received January 2015, revised revision accepted December 2016).

Address for correspondence: Douglas J. Skinner, Booth School of Business, University of Chicago, 5807

South Woodlawn Avenue, Chicago, IL, 60637.

e-mail: dskinner@chicagobooth.edu

C

2017 John Wiley & Sons Ltd 480

CASH HOLDINGS AND ECONOMIC PERFORMANCE OF JAPANESE COMPANIES 481

conventional measures. Over the last two decades, price-to-book multiples for Japanese

firms have often been well below those of US firms, with many below 1.1

Japanese firms are known for holding high levels of cash. Rajan and Zingales (1995)

examine the cash holdings of companies across the G7, and find that Japanese firms

held substantially more cash than their G7 counterparts in the early 1990s. Because

large holdings of cash are generally viewed as symptomatic of poor governance, this

evidence is consistent with the more general view that Japanese firms are poorly

governed.

Japan’s corporate governance problems have received a great deal of attention.2

Some argue that Japan’s poor governance was responsible for its economic perfor-

mance during the “lost decade” (Morck and Nakamura, 2001) and helps explain the

low relative valuations of its public companies. An important part of this argument

relates to the prevalence of Japan’s “main bank” (keiretsu) system, which originally

facilitated the monitoring of managers but that subsequently led to managerial

entrenchment by making it difficult for outside shareholders to replace managers

of firms that performed poorly. As Japan’s economic problems deepened during the

mid- to late-1990s, its government made a series of changes designed to remake its

corporate sector and financial system, including corporate governance reforms aimed

at providing better incentives for managers to act in the interests of shareholders,

which we describe in section 2. These included changes in the Commercial Code

that led to the use of stock options to provide incentives to corporate managers;

allowed the use of share repurchases to return cash to shareholders; lowered the

cost of various forms of corporate restructuring, including spin-offs, divestitures,

mergers and acquisitions (including hostile takeovers), and bankruptcies; improved

the effectiveness of auditing and the adoption of internationally accepted accounting

standards; and encouraged reductions in the size of boards of directors and increases

in the number of outside directors. A more general transition in Japan’s capital

markets reduced the importance of the banks and the associated bank groups, which

changed the ownership structure of Japanese firms and reduced the entrenchment

of managers. The jury is still out on whether these reforms have led to substantive

changes in Japan’s corporate governance practices.3

Our goal is to provide evidence on whether there has been any progress in

reforming the governance of Japanese companies and, if so, whether this translates

into improvements in economic performance. There is little systematic evidence on

these questions. They are important not just in Japan, but in other markets that

have adopted or are considering Western-style governance practices, including China,

Korea and India. To do this, we examine whether Japanese companies increased

their payouts and reduced their cash holdings, whether these changes are associated

with improved performance and valuations, and whether these effects are related to

1 Milhaupt (2006) cites data showing that in 2000, approximately 13% of 779 non-financial firms on the

Tokyo Stock Exchange were trading below their “bust up” values (measured as cash and cash equivalents

plus investment securities minus debt).

2 The scandal at Olympus again focused attention on the governance practices of Japanese companies

(for example, see “Pressure on Japan to probe Olympus”, Financial Times, 25 October 2011, and Woodford,

2012).

3 Milhaupt (2006, p. 3) writes that “(o)ver the past decade, the formal institutional environment for

Japanese corporate governance has been reformed significantly and at an accelerated pace . . . Yet, despite

substantial legal reform and a decade after Japan’s economic problems emerged, there has been no sea

change in Japanese corporate governance practices”.

C

2017 John Wiley & Sons Ltd

482 KATO, LI AND SKINNER

ownership characteristics likely to be associated with governance. We also provide

evidence on the valuation effects of these changes.

Our focus on cash provides a direct way of assessing corporate governance reform

in Japan. Although one can measure corporate governance using various metrics and

indices, these measures generally have limitations because, first, corporate governance

is multi-dimensional and so not subject to direct measurement and, second, different

corporate governance structures are likely to be optimal for different firms (e.g.,

Larcker et al., 2007). This is especially true in Japan, which allows firms to adopt

either a western-style model or a more traditional Japanese model, which makes it

especially difficult to characterize and measure board quality in Japan. Nevertheless,

there is evidence that the cash holdings of Japanese firms are negatively related to

other measures of governance quality (Aoyagi and Ganelli, 2014).

The corporate finance literature views managers’ tendency to hold excessive cash

as an important agency problem (Jensen, 1986; LaPorta et al., 2000). Evidence shows

that high levels of cash are more likely in countries with weaker investor protection and

that this has consequences for valuations. Activist investors frequently cite firms’ cash

balances as an example of poor governance, and engage with firms to force increased

cash payouts (Klein and Zur, 2009). The management of cash has become a common

focus of battles between activist investors and management over the last decade in

Japan.4

We find that Japanese companies, on average and in aggregate, reduce their cash

holdings and increase their payouts after 2000, but that there is a good deal of cross-

sectional variation. Japanese firms still retain a lot of cash. The median Japanese non-

financial firm held about 15% of assets as cash in 2011, similar to the numbers for

the early 1990s (the median is 13% over 1990–1992). However, using regressions that

control for the effect of firm characteristics on cash holdings, we find that Japanese

managers have, on average, reduced their holdings of cash since 2000, by 3% to 4% of

assets.

To provide a benchmark for assessing the Japanese experience, we also report on

the cash holdings of US firms. US firms increased their cash holdings substantially

over the last two decades (Dittmar and Mahrt-Smith, 2007; Bates et al., 2009; Pinkowitz

et al., 2016). Consequently, although Japanese firms have historically held more cash

than firms in other countries, Japanese and US firms now hold roughly comparable

levels of cash, with the median US firm holding cash of around 10–11% of assets over

2003 to 2011.5

Consistent with the idea that governance has improved in Japan, Japanese managers

now manage cash more like their western counterparts: Empirical models of cash

holdings that explain cash for US firms are increasingly useful for Japanese firms.

We find adjusted R-squareds of around 30% for US firms in the 1990s and 2000s; for

Japanese firms, the adjusted R-squared increased from 17% in the 1990s to around

32% in the 2000s. Coefficient signs and magnitudes are similar for US and Japanese

firms in the 2000s; this is not the case in the 1990s. This suggests that cash holdings

4 See “A Clash over Cash”, The Economist, 16 May 2002. For discussion of activist investing in Japan, see

Uchida and Xu (2008), Hamao et al. (2011), and Buchanan et al. (2012).

5 Our conclusions are robust to different treatments of marketable securities, including excluding mar-

ketable securities from “cash” for Japanese firms and including them for US firms. As we report in section 4,

US firms’ holdings of marketable securities increase significantly since the early 1990s while Japanese firms’

holdings of marketable securities, significant in the 1990s, essentially disappear around 2001.

C

2017 John Wiley & Sons Ltd