Is the Japanese Cash Equity Market about to get an overhaul?

Reading the Japanese financial markets press in recent weeks, one can discern that in addition to steady improvements in corporate governance, transparency and total shareholder returns, major structural changes for Japan’s equity markets are in the works. The Japan Exchange Group (JPX), which operates the Tokyo Stock Exchange (TSE), has been soliciting feedback from market participants as part of its review of the TSE cash equity market structure. As yet, JPX has not made any official statements regarding the contemplated restructuring but asset managers and listed company boards are already wringing their hands over the potential fallout. We have been calling for changes to the market structure since we started investing in Japan in 2003, in hopes that a properly thought-out revamping of the market would be the key to unlocking hundreds of billions of dollars in value trapped in Japanese companies.

We have had numerous consultations with exchange representatives and various regulators to try to grapple with what the potential changes might be and how they could impact the markets and our investment activities. JPX just released materials summarizing the comments they received from market participants. It appears that JPX is moving forward in its formulation of a plan to radically reshape the market. Although there are no specifics available, it seems that JPX is moving towards restructuring the cash equity market into three groups. Temporarily they are referring to these groups as; Market Segment A, Market Segment B, and Market Segment C. Market Segment A would be well-known companies for all investors, including institutional and retail, Market Segment B would include companies with high growth potential, and Market Segment C companies for a "broad range of investors," including international institutional investors. While Segment inclusion criteria could be based on governance structure, liquidity, earnings and market capitalization, the segmentation, it seems, is designed more to match specific investor groups. Although it is still unclear exactly how the TSE will define these new market segments and unlikely that they will be named A, B and C, we will explain what we understand so far for the anticipated changes. The proposed changes are designed to bring the TSE into alignment with its global counterparts, such as the London Stock Exchange and Euronext. The motivation is clearly a desire to accelerate market reforms and to make Japanese equities more attractive, especially to international institutional investors.

As envisioned, a vast majority of companies in the TSE First Section (“TSE1”) will be moved (relegated down) from Market Segment C to Market Segment A or B. Despite this being nothing short of a demotion, JPX is trying to characterize this as a “shuffle” so as not to embarrass its members. Currently, membership to the TSE1 is the highest honor a listed company can achieve. Also, all TSE1 members are included in the TOPIX index, which is widely used by ETFs and institutional investors. Being dropped from TOPIX or having the index reconstituted with far fewer constituents could have a negative effect on liquidity and share price. There have been no discussions about how to revise these crucial indices yet but as part of the review of the market structure, "the continuity of the TOPIX index as well as the demand for a benchmark index functioning properly as an investable index" would be taken into consideration. This is critical as an increasingly large percentage of the market is held by passive index ETFs.

The rationale for making these changes seems straight-forward. Under the current rules, companies in the TSE2 or the Mothers market can “step-up” to the TSE1 under certain conditions. One criterion is market capitalization, with the hurdle being only ¥4 billion. This provocatively low hurdle has enabled a vast number of small companies to move up to the TSE1, thereby reducing the median market capitalization of Japan’s “elite” exchange to a lowly ¥48 billion. By comparison, the median market capitalization for the LSE Premium (504 companies) is ¥140 billion and the Deutsche Boerse Prime (307 companies) is ¥96 billion.

Subsequently, the number of listings on the TSE1 has doubled to 2,141 over the past 30 years.

The large number of TSE1 listings has also led to a preponderance of illiquid, under covered, mispriced stocks. Many of these companies are ignored by professional investors because of their size and lack of liquidity. The problem for the market however, is that this group constitutes the overwhelming majority of listed companies. Nearly 82% of listed companies have a market capitalization of less than $1bn. Conversely, trading activity is dominated by the remaining (18%) large-cap companies where 68% of the 3-month average trading volume occurs.

The changes under consideration will see the minimum market capitalization required to stay listed on Market Segment C raised to ¥25 billion ($225 million), from the current TSE1 minimum of ¥2 billion. Approximately 30% of the listings could be demoted. JPX expects to see investor capital shifted away from these demoted companies and back to Market Segment C listed names. The pressure on smaller companies to quickly adopt more shareholder-friendly and share price positive policies is increasing.

Additionally, JPX will require Market Segment C companies to release earnings reports in English, and pressure companies to adhere to strict corporate governance rules. We expect liquidity requirements will be included in the new rules as well.

JPX is considering merging the markets for smaller companies into Market Segment A. This should help clarify some of the confusion around what the differences are between the various array of markets like TSE2, JASDAQ Growth, JASDAQ Standard, and Mothers.

JPX will probably offer guidelines regarding the new rules in the next few months complete with an implementation timeline. As is often the case in Japan, a period of a few months is allotted for public comment before the rules become finalized. Implementation is anything but imminent!

When the plan is officially proffered, the transition will certainly take three to five years to implement. This will alleviate pressure on both market participants and those companies being demoted. But it will also give companies the opportunity to remedy their shortcomings and increase their market capitalization.

Companies trading at large discounts to assets will likely take aggressive steps to raise their market capitalizations ahead of the transition. There should be a dramatic increase in the number “corporate events” in the coming years including M&A transactions, MBOs and asset sales. If the reshuffling of listed companies into three new markets proceeds as discussed, we see a tremendous investment opportunity ahead. Many of the companies slated to be demoted will act to either increase their market cap or delist entirely.

Great companies, with small market caps, that get relegated out of Market Segment C will most likely be sold by ETFs as indices get redefined. The additional pressure on share prices would create a unique opportunity for savvy investors. Many corporations could be the focus of unwanted attention from shareholder activists or even corporate raiders.

From Symphony’s vantage point, if JPX goes ahead with the restructuring of the cash equity market as described above, the opportunities to generate extraordinary returns in Japanese equity will abound. Not only will we have companies scrambling to get their share price up through corporate actions, but we will also have price insensitive sellers (ETFs) pushing down the prices of good companies and making them potentially vulnerable to less friendly shareholders.