Bloated Balance Sheets in Japan

Excessive cash and cross-holdings contribute to discounted valuations
 

By: Naoki Ito

Japanese companies have balance sheets that look very different from what US investors are used to. The median Japanese company holds 33% of its market cap in cash and 16% in long-term investments, while these figures are nearly negligible for US companies. The charts below illustrate these ratios for companies by country, excluding those in the finance, insurance, real estate, and utility sectors.

Figure 1. Distribution of Cash Equivalents and Long-Term Investments to Market Cap

Source: Verdad analysis, Capital IQ. Whiskers of the box plots indicate 5th and 95th percentiles.

Astonishingly, more than 5% of Japanese companies have more cash equivalents than their market cap. The discrepancy is especially acute in smaller companies. Yet even the largest Japanese companies own an extraordinary amount of both cash and long-term investments compared to US companies.

Figure 2. Median Cash Equivalents and Long-Term Investments as % of Market Cap

Source: Verdad analysis, Capital IQ. Small Caps: Market cap < $1B; Large Caps: Market cap ≥ $1B. For each bar, medians of cash/market cap and long-term investments/market cap are calculated separately and then combined.

The most common reasons for Japanese companies to have accumulated large amounts of cash are risk aversion and self-insurance. This attitude originated in the asset bubble burst in the late 1990s, which triggered almost two decades of economic stagnation with deflation. Companies drastically slowed growth-oriented capital investment and focused on long-term survival by maintaining substantial cash reserves as a buffer against unexpected downturns like COVID-19. Ineffective corporate governance and limited shareholder activism reduced pressure to distribute profit.

Long-term investment primarily comprises companies’ cross-shareholdings. Cross-shareholdings began in the 1960s, following the dissolution of the zaibatsu (large conglomerates) as a defense against foreign acquisitions of Japanese companies. Its use peaked during the bubble economy of the late 1980s, where it also absorbed large amounts of equity finance. In 1990, a whopping 35% of the total market cap in Japan was held through cross-shareholdings, according to Nomura Institute of Capital Markets Research. However, after the bubble burst, the drawbacks of having other companies’ stocks became evident. This led to the dissolution of many cross-shareholding groups, reducing cross-shareholdings to 20% of the total market cap by 2000. Since then, the percentage has gradually decreased, but the practice has continued to play a role in maintaining and strengthening ties between companies. By 2023, total cross-shareholdings had been reduced to about 8%.

We believe that fixing these balance-sheet inefficiencies is critical to improving Japan's depressed valuations. We estimate that if every Japanese company reduced cash and long-term investments to US levels, it would reduce the number of companies trading at less than 1x price-to-book ratio by approximately 40%. 

The government understands the role these bloated balance sheets play in Japan’s undervaluation and is pushing for a nationwide change. To facilitate sustained growth and increase corporate values, the Tokyo Stock Exchange (TSE) published “Action to Implement Management that is Conscious of Cost of Capital and Stock Price” in March 2023. In this guideline, the TSE urged management to improve price-to-book ratio by considering the “cost of capital and profitability based on the balance sheet, rather than just sales and profit levels on the income statement.”

We have seen significant improvement. From March to December 2023, around $4.5B (4x of March to December 2022) of cross-shareholdings were sold, according to Nikkei. Our analysis reveals that, over the past three years, 78% of Japanese companies with P/B below 1x have reduced cash equivalents, with a median reduction of 20%. Additionally, 71% have cut long-term investments, with a median reduction of 13%.

Japanese companies still have a long way to go to reach US levels of balance-sheet efficiency, but the tide finally seems to be turning. Investors might not have to wait much longer to see significant improvement.