INSIGHTS: Catalyst for Change: a Q&A with Nezu Asia

[Bobby] I'm here today with David Snoddy, the founder of Nezu, a Japan based alternative asset manager that has over 25 years of investment experience in Japan. David's also the PM of the recently launched Nezu Engagement Fund, which has a very unique approach to the activism space in Japan.

David's agreed to take a few minutes of his time to give us more insight into their differentiated way of working with corporates in the region. So David, thanks for joining us today.

[David] Thank you very much, Bobby.

[Bobby]  Let's start off with the macro. How is Japan's current macro and policy environment, particularly the recent regulatory pressures, creating challenges for corporates, and how has this backdrop shaped your opportunity set and your approach to activism in Japan?

[David] The backdrop is quite favorable for what we're doing. On the one hand, you've got the very long-term demographic pressures of the aging of society, which means that the number of workers per retired person continues to drop. That means that financial income has to improve or living standards go down. In other words, capital efficiency has to get better.

On the regulatory side, you've had, obviously the stuff from the TSE, which a lot of people are familiar with, and in the press, but you've also had changes in the M&A rule set and other governance issues which have become much more shareholder favorable and are good for what we're doing.

At the micro level, these changes have created a number of market cap fears in the corporate sector, and I think the most important ones are first Index. The TSE has said that by 2030 they're going to start kicking a lot of people out of the prime index and the topics index, which are the most prestigious socially and the most useful commercially, not just for companies, but also for the employees. So that means that companies that have what they think are substandard numbers haven't been released; the cutoffs haven't been released, but what they think may be substandard market caps are very anxious about increasing their market cap to clear that hurdle and maintain those social and commercial advantages.

You've also got incipient sector consolidation in financials and IT, in machinery and a number of other sectors. Japan has about the same number of listed companies as the US, with a third amount of GDP. So there's a lot of listed companies that are subscale and they are going to merge or delist. And when they're going to merge, the merger ratios are going to be determined by relative market cap, and that's a big reason to increase your market cap. The index thing is going to settle out by 2030 and will be less of an issue. But sector consolidation is an issue that's with us for a long time.

The next one is takeover risk. There are a lot of companies, and Seven & i is only the most recent example in the very large cap space. But there are a lot of companies which don't have market caps which are sufficient to deter suitors from trying to take over the whole thing. And companies obviously want to maintain as much independence as they can. They may be willing to merge, but they're not necessarily willing to disappear, and so takeover risk is another big source of market cap anxiety.

And then the fourth one, which I think a lot of people haven't thought enough about, is talent risk. Increasingly, companies are using options and other forms of equity link compensation as a way to not only incentivize existing employees, but to get good new ones, and to the extent that you have a healthy stock and a healthy stock price, that makes that a lot easier and creates a virtuous circle, if you will, for the ones that win and a vicious circle for the ones that lose.

So there's a lot of sources of fear right now about market cap in the Japanese corporate space, and that's a really good opportunity for us. 

[Bobby]  So, amidst that, the macro that you just explained, what's the core investment thesis behind Nezu’s activist strategy?

[David] Our thesis is pretty simple. There are a large number of companies who want to raise their market cap and have the wherewithal to do so, and we partner with them to make that more successful and more cost effective. Sometimes there's more will than wherewithal. Sometimes there's more wherewithal than will. We want both, and we also want from the corporate a willingness to kind of break out of their historical pattern of what they've done before and be willing to experiment more to achieve higher market cap.

One of our most successful slides that we use with corporates compares the ticket prices for Economy Class round trip to New York from Tokyo to Business Class, on the same flight, both on JAIL. Economy Class is about 300,000 yen. Business class is about 1.5 million. And I say to the companies, both of these seats are going to get you to the same place at the same time on the same plane. Why does one cost five times more than the other? They said, well, being in Business Class is a much better experience, and that is the core of cost of capital that we're trying to impart. Experience is partially volatility, and it's a lot of shareholder return. And how that is distributed - it's not one yen is one yen; one yen is not one yet. Different ways of distributing shareholder returns give you different outcomes, and we want to help companies understand that and do it more efficiently.

My partner, Hiro Kawakita and I are both well known as experts in improving corporate value. Me more from the kind of quantitative side, and him more from the governance side. But companies know us, and they want to hear what we have to say, and that's our entry point.

[Bobby] So David, how does your collaborative approach to activism differ from the more confrontational or western style activist strategies that have historically faced resistance in Japan, and what does collaborative engagement actually look like in practice?

[David] The companies that we want to start a conversation with are selected because, on paper, quantitatively, they have the types of tools and the types of cash that are necessary to produce much higher market caps. When we meet with them the first meeting or the first few meetings, we know the numbers already. And so really, it's more about trying to ascertain: number one, what is their goal, what kind of market cap do they want for their enterprise?

And number two, what methods are they willing to use to achieve that? And it's based on that, that we decide to work with them or not to work with them. Our ticket, from their perspective, is our expertise in our intellectual property and where they want to utilize that. That's where we have an entry, and that's where we have an opportunity.

I think that contrasts pretty heavily with the sort of more traditional, combative approach to activism, because a lot of the activists, the combative activist ideas, are really good ideas. But since they're embedded in the context of a fight, they're suspect from the get go, as far as the corporate is concerned. And that kind of leads to the second problem of non-collaborative activism, which is in order to get some of these things done, the stakes have to get bigger and bigger and bigger. So the corporate action that you're pushing for becomes not only just an action to help the corporate and to help the stock price, but it's also about getting you out of that position. It becomes a very digital event. Since we're working with companies that want to work with us, we don't need to own 25% of the stock to get them to do things. And our approach is a lot more analogue than it is digital.

We want a number of medium sized and some large sized actions, which are embedded in a narrative that the market can understand. And the market can say, I see where this is going, and I like this. And those result in, one, a much higher market cap, but two, a much better supply demand situation for the equity which makes it easier for us to get out. 

[Bobby]  Great. Thanks, David, you've spoken about the difference between companies that want to grow market cap and those that you can actually help to drive that growth. What defines the latter group and how do you identify them?

[David]  We start from the premise that everything they're currently doing is in the press. So we're not buying stuff because it's cheap and we think it should be more expensive. What we're doing is buying stuff where we can create a list of incremental actions that they can take to make the stock price significantly higher.

We have a broad range of back tested tools. We have lots of statistics that we can provide corporate showing if you do this- this is your median outcome, this is your average outcome, this is standard deviation of outcomes. And most people don't have that kind of data, and certainly corporate stuff. And for some of these tools, like shareholder perks, we're definitely the domain experts. So then it's basically putting together a model showing how you can get the stock to be 50 to 100% higher, and how that can be sustainable.

And in some cases, you've got multiple routes to the same destination. That's a nice thing to have, because the corporate may want to choose route C as opposed to route B or route A, and that is a very valuable part of what we provide them. But where we have a company where we can see incremental things that they can do that, can raise the price by 50 to 100% and secondly, when we talk to them, they're willing and wanting to do that, then I think we have somebody that's worth talking to.

[Bobby]  Great Thanks, David. And last question for today, and I guess, to summarize all you've said, what gives Nezu an edge in executing this strategy successfully, whether it's team experience, access, relationships or whatnot, and what would you say sets you apart in the activist space in Japan? 

[David] Our core edge in executing the strategy successfully is intellectual credibility. A lot of corporates and a large part of the equity market know us, not only as fund managers, but also as writers, as presenters, as thinkers and creators of innovative ways to create more market cap, and that's our core edge with corporates. I think our next edge is ease of use and ability to communicate that. A lot of people who have intellectual credibility are also really hard to understand.

And our data is designed to be pretty simple. It's designed to be robust, obviously, and easy to communicate.

Hiro and I have been visiting hundreds of companies a year since the 1990s and that experience has taught us how to communicate well in that particular forum. In addition to that, for the last two or three years, I've been doing a lot of corporate consulting, trying to help them with their dividend policy or their shareholder perk policy or whatever it happens to be. And I've been for a little bit more than a year now on the Board of a very traditional Japanese listed company. And one of the things that that experience and that set of experiences has taught me is that every Board has got an experimental wing.

The spectrum moves from company to company. Some companies are much more experimental on average than others, but every Board has got an experimental wing and a conservative wing. And to get anything done, you usually have to get the conservatives on board, and sometimes the best way to do that is with fear rather than greed.

And we've obviously thought carefully about the data that we present to also appeal to those people.

The market cap anxiety that so many Japanese companies have now is a huge follow in for us, and that is basically what's leading the horse to water, but you still have to get them to drink, and combination of communication skills and intellectual property is how we get these horses to drink. 

[Bobby] Well, great, David, thank you very much. This has been a very engaging conversation. Pun intended. Really appreciate your time and look forward to doing this again soon..

[David] Thanks a lot. Bobby, really appreciate it. Thanks.