Musings on Corporate Retained Earnings
On July 27, NHK’s “Close-up Gendai” aired a special titled “360 Trillion Yen! Who Does the Company’s Money Belong To? The Battle Over Retained Earnings”.
In light of the recent trend towards “constructive dialog” based on corporate governance reform and introduction of the stewardship code, I had been looking forward to a fascinating program, but unfortunately my impression was that the program was based on the intention to put on a formerly well-known activist investor and highlight confrontation. It seemed somewhat unreasonable to me to try to cram such an epic theme into 30 minutes. To push back further against this confrontation-based approach would not lead to any constructive resolution of the matter, so we’ll take advantage (?) of this good opportunity and briefly explain what we are thinking about this situation. First, the stance we take on the question of who retained earnings belongs to is that it belongs to the shareholdersi.
The reason is that corporations belong to the shareholders. We can view publicly traded companies as belonging to society, which in a broad sense is undeniable. Yet it is the shareholders who pay their own money and stay closes to the company, providing support within our society. If, for whatever reason, no-one wanted to buy the company’s shares, its stock price would drop to something near zero. A stock price near zero would lead to a crisis of confidence and threaten the company’s ongoing existence. Concerning the question of to what extent retained earnings should be returned to shareholders, we need a non-emotional, balanced discussion, based on economic principles, not some black-and-white argument about this is the Western way or that is the Japanese way, or this is right or that is wrong (the program does not seem to have addressed it, but there were some indications that Mr. Murakami tried to have such kind of discussion). We think the important issues can be boiled down to the following two.
① How much retained earnings is appropriate to really be ‘retained’?
On the first topic, how much retained earnings is appropriate, of course companies require working capital and retained earnings would fund them. The question is how many years’ worth of working capital would companies require preventing a lack of confidence as an ongoing concern— two years’ worth, or even ten years’ worth (depending on the stability of earnings, of course)? There should not be any problem if the reasoning is made explicit and is convincing to the shareholders. In addition, of course funds are required for things like capital investment, acquisitions, and strategic joint ventures, and rather than depending on banks in a pinch, the natural approach is to want to as much freedom as possible to make your own decisions, which is one important reason that retained earnings are needed. Another idea, as the program indicated, is of course doling it out as an increase in salaries and wages.
In light of all these variables, we see no problem in management explaining things openly to shareholders, and appealing to shareholders who will understand this and will stick around giving their long-term support. Of course shareholders who are unconvinced may sell their holdings, or make their voices heard, but that is the fate of a public company, and the most important part of constructive dialog. For example, a company with ample, stable cash flows continuing to pile up retained earnings on its balance sheet, with no logical explanation or feasible long-term strategy, brings on itself an increased risk of long-term impacts such as a stagnant stock price and changes in the makeup of the shareholders (with more opportunistic and/or noisy shareholders), not a desirable set of circumstances for management.
Second, on the topic of what kinds of shareholders the company wants to attract, although it may be repetitive as to the discussion made above, it goes without saying that a public company is free to have a “long-term IR strategy” of what kinds of shareholders it wants to be interested in it, even under the axiom that a public company cannot deliberately choose its shareholders, and we think this is an important perspective. Most of the companies we invest take this view, so although their short term performance may significantly fluctuate as much as many others, when the stock price drops the shareholders (who quietly follow the name) generally view it as a buying opportunity and take actions – which works to support the share prices.
Nowadays many companies do possess such strategy and so have in place a certain level of dividend payout ratio or dividend to equity payout ratio as publicly notified guidelines. With such guidelines in place, companies will be able to appeal to shareholders with long term perspective because of heightened visibility of stable cash return in a generally unfriendly volatile market environment. Moreover, if company has a long term vision and has disciplined capital allocation that are coherent with such vision and are willing to sincerely communicate that with existing and potential shareholders then, without doubt, typical and orthodox shareholders with longer time horizon will become fans of the stock rather than the so-called ‘short-termists’ who tend to turn over the portfolio in a few days or a few months. Of course, each and every serious institutional investor has their own criteria on what to buy at what kind of valuations, so it is hard to tell whether your stock will be preferred at some certain timing or not. However, we see a generalized phenomenon when at some certain shocks occur such as Brexit, shrewd institutional investors suddenly become new shareholders taking the chance in stocks they have quietly been following for many months or years. It is obviously quite hard to quantify such actions into measurable facts, but we see the impact of managements’ communication to the market as well as enthusiasm by Investor Relations person to be fairly large and meaningful in inviting ‘good’ ‘long term’ shareholders.
We learned in class rooms that the society in general will be better off with efficient equilibrium derived by having variety of participants and liquidity in the market place and we intuitively agree in such statements living in this world of inefficiency and chaos. Having said that, even when assuming such is the ideal direction of future markets, when it comes to individual companies, it is important to strategically attract those shareholders who cares about the business of what they invest in (not just about the stock prices and daily P&L) and in order to achieve that, discussion about the retained earnings, dividends etc will work as strong ammunition for the companies to drive the situation, by understanding and taking advantage of institutional investors’ judgment procedure mechanisms.
The other thing to convey, which we all tend to forget time to time, is the fundamental structure of this complicated capitalism world. Shareholder who you face every day, especially those large global institutional investors supposedly with power and sometimes are pathetic and annoying, are actually not your true shareholders, but they are just acting as the agent or fiduciary of the ‘real’ money which typically are pensions and endowments – a pool of money for the future wellbeing of mankind. If, in a viewpoint where you consider company to be owned by the society rather than shareholders, and consider who to fulfill such nobles-oblige of companies as public corporations, paying out to shareholders start to have a real meaning because those pay-outs will be part of capital that will be used to serve your own future and society in a way. Interestingly, if you go beyond the current walls of institutional shareholders and identify the true owners you may find future of your own self. You are not confronting the shareholders but your future self which start to make all of this confrontational argument sound silly.
I may have been mumbling things that are hardly necessary to mention but, nevertheless, by speaking things out and loud, I hope it will be of any help to feed a constructive and meaningful discussion between the managements and shareholders of ambitious forward looking Japanese companies.
i We refer to the concept of shareholder along a continuous time axis proceeding from the past, to the present, and into the future, not some particular shareholder at a point in time. Management and employees both change over time, and so do shareholders, but as long as the notion of the corporation endures, so will that of the shareholder.