Time to Short Japan’s ‘Bad Governance’ Stocks, Hedge Fund Says

The blistering rally in Japanese stocks has unfairly benefited companies that are flouting the bourse’s campaign to boost valuations, creating a major short opportunity, according to a top-performing hedge fund manager.

(Bloomberg) — The blistering rally in Japanese stocks has unfairly benefited companies that are flouting the bourse’s campaign to boost valuations, creating a major short opportunity, according to a top-performing hedge fund manager.

Reform efforts have been touted as one reason for Japan’s world-beating gains this year, but even some “bad governance” companies have been riding the wave, according to Zuhair Khan, a fund manager at Union Bancaire Privee who has been following the market for more than two decades.

“They’ve just gone up with everything, and people will start to realize these companies are way overvalued for how they’re going to behave,” Khan said in an interview. “They really want nothing to do with this corporate governance reform,” he said.

Pricey Japan Stocks Are Bargain in Top Fund’s Unorthodox Take

While up to 25% of Japanese companies are proactively improving governance, about 30% are reluctant to change, Khan said. His U Access Long/Short Japan Corporate Governance fund was launched more than three years ago to profit from this differential. It has returned 15% over the past year, beating 86% of its peers, according to data compiled by Bloomberg.

When deciding on stocks to short, Khan looks for companies where board members don’t own shares. He also cites firms without board committees, or are lacking enough independent directors with relevant backgrounds as targets. On the other hand, companies that can exit unprofitable business segments and transform, such as Hitachi Ltd. and Sony Group Corp., are examples of firms with good governance, he said. He declined to name specific investments.

Investors Reward Hitachi’s Transformation in Example for Japan

The Topix is up about 22% this year, with company reforms being one of the main drivers. In dollar terms, the return is just 6.8% as a weakening yen offsets the gains, though it still beats the gain of about 1% in a benchmark of Asian peers.

The Tokyo Stock Exchange’s push for better governance may enter a new phase after the bourse said last week that it is mulling disclosing a list of companies that have released improvement plans. Shareholder activism has potential to drive further change as well, creating more opportunities for long positions in “good governance” stocks, according to Khan. 

“Activism has now become very real again in Japan” after lying dormant for a few years during the pandemic, he said. 

Khan’s fund, which manages $61 million, looks to offset market and sector risks in order to focus bets on companies’ governance. He sees potential returns exploiting mispricing and widening governance gaps in sectors including financials, consumer goods and electronics. 

“Now everybody’s assumption is that governance in Japan is improving, and it is without a doubt,” the fund manager said. “But the gap between good governance and bad governance companies in Japan is actually getting wider and wider.”

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