Japan's Digital Transformation

JAPAN’S DIGITAL TRANSFORMATION

Donald Farquharson and Thomas Patchett

THIS PAPER IS INTENDED SOLELY FOR THE USE OF PROFESSIONAL INVESTORS AND SHOULD NOT BE RELIED UPON BY ANY OTHER PERSON. IT IS NOT INTENDED FOR USE BY RETAIL CLIENTS.

CM16057 Japan’s Digital Transformation WP IC 0721.inddRef: 53662 PRO AR 0191

Baillie Gifford

RISK FACTORS

The value of an investment, and any income from it can fall as well as rise and investors may not get back the amount invested. Past performance is not a guide to future returns.

Risk Factors

The views expressed in this article are those of Donald Farquharson and Thomas Patchett and should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect personal opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.

This communication was produced and approved in July 2021 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.

Potential for Profit and Loss

All investment strategies have the potential for profit and loss, your or your clients’ capital may be at risk. Past performance is not a guide to future returns.

Stock Examples

Any stock examples and images used in this article are not intended to represent recommendations to buy or sell, neither is it implied that they will prove profitable in the future. It is not known whether they will feature in any future portfolio produced by us. Any individual examples will represent only a small part of the overall portfolio and are inserted purely to help illustrate our investment style.

This article contains information on investments which does not constitute independent research. Accordingly, it is not subject to the protections afforded to independent research, but is classified as advertising under Art 68 of the Financial Services Act (‘FinSA’) and Baillie Gifford and its staff may have dealt in the investments concerned.

All information is sourced from Baillie Gifford & Co and is current unless otherwise stated.

The images used in this article are for illustrative purposes only.

– Japan’s Digital Transformation

JAPAN’S DIGITAL TRANSFORMATION

BY DONALD FARQUHARSON AND THOMAS PATCHETT

JULY 2021

In the following four essays they explore Japan’s digital journey.

Personal reflections on an emerging opportunity

The rise of entrepreneurialism: From kaizen to kakushin

Japan’s digital disruptors

Japan’s increasing appeal: from sakoku to kaikoku

Unique and surprising, the ‘DX’ or digital transformation of the world’s third largest economy offers exciting openings for investors.

Donald Farquharson, head of Baillie Gifford’s Japanese equities team and Thomas Patchett, Japanese Equity Specialist explain why.

3

July 2021

PERSONAL REFLECTIONS ON AN EMERGING OPPORTUNITY

I first encountered Japanese bureaucracy in the early 1990s. Shortly after moving to Tokyo, trying to clear a container of personal effects through customs, I was told to report to the port in person.

Bags and footwear (leather being a protected industry) and the metallurgy of certain items such as lamps were particularly closely scrutinised. The Port Authority of Yokohama needed clearance from the Bureau of Port and Harbor under the Tokyo Metropolitan Government’s jurisdiction and the Ministry of Foreign Affairs in Tokyo. Proof of prior ownership, residence and work visa were required at every stage. Finally, at the end of a process

requiring visits to four separate departments and no fewer than 12 personal and corporate hanko signature stamps,my goods were released.

This was at a time when Japan still ruled the global indices. Fourteen of the 20 largest companies globally by market cap were Japanese and half of these were financials. Today the only Japanese company on that list of 20 is Toyota Motor, one of only three Japanese companies in the top 100. This simple observation is both an illustration of Japan’s 30-year stagnation and its own unique and arduous pathway towards digital transformation.

Challenges in Japan ICT is positioned as a cost rather than an enabler in transformations

ICT investments, nominal; 1995 = 100

Source: OECD Statistics.

0

50

100

150

200

250

300

350

20171995 2000 2010

Japan UK US France


4

Japan spends far less than its peers on information technology. Rather than narrowing over the past 30 years, the gap appears to have widened. Just 1 per cent of Japan’s workforce comprises technology professionals, compared to 3 per cent in the US, a difference of 3.8m people.

Fourteen of the 20 largest companies globally by market cap were Japanese and half of these were financials.

July 2021

5

Returning to my observations of Japan after the 1980s Bubble Economy, features that shaped the corporate landscape then continue to influence it now, though with diminishing effect.

The first of these was the central importance of the banks, both as the main provider of capital and an instrument of governance. Much of the enforced deleveraging of the 1990s and early 2000s came through their instruction. If companies did have an external director, he (it was almost always he) was almost certainly from the main bank. Japan retreated into a cocoon of risk-aversion in the Bubble’s aftermath. Thankfully, this influence has waned following the Global Financial Crisis and introduction of the Corporate Governance Code in 2015. Around the major banks, keiretsu or interlocking business groups controlled many aspects of business life, ensuring that affiliation came before innovation.

In the early 1990s, Japan was still greatly admired for its industrial prowess and managerial style. Words such as kaizen (continuous improvement) and horenso (an acronym for effective business communication, also a play on the Japanese for spinach) were synonymous with its success. Drawing from Brian Arthur’s influential paper ‘Increasing Returns and Path Dependence in the Economy’ (1994), Japan was captured by the vision of English economist Alfred Marshall, where products are largely substitutable and competitiveness determined by accruing the small advantages of good planning, control and hierarchy.

But the country turned out to be surprisingly ill-suited to an increasingly knowledge-centric world, one of ‘increasing returns’ from technology, where psychology, cognition and adaptation proved more important. Just 20 years ago, over 60 per cent of Japan’s entire IT spend was still going on hardware and, even today, the number remains at close to 40 per cent. As Microsoft was building Windows, Japan still boasted ten major PC makers.

...the insularity of much Japanese technology...doomed it to eventual extinction.


6

July 2021

7

Japan’s IT industry has an unusual structure of prime contractors who delegate to second and third-tier vendors. According to McKinsey, 28 per cent of Japan’s IT engineers are employed by the users, with 72 per cent working for providers. In the US, the number is 65:35 in favour of IT users. An absence of in-house IT talent and understanding has become an obstacle to digital adoption. The same McKinsey report identifies the four biggest blocks to progress as senior management; lack of understanding; lack of talent and organisational structure.

The new businesses that are transforming the landscape are often founder-run and built with entirely different approaches in mind.


8

‘Galapagos Syndrome’ is the term used about Japan’s 3G ‘feature phones’, a smartphone precursor that never caught on outside Japan. The term now serves for the insularity of much Japanese technology, which doomed it to eventual extinction. Many companies rely on their own R&D rather than adopt an external solution that could effect a step change. Lack of diversity and wariness of ideas from abroad are symptoms of the syndrome. There are exceptions, of course. For example, Hiroshi Mikitani, founder and CEO of ecommerce company Rakuten, declared that, “language will open your eyes to the global,” demanding that employees used English, despite Rakuten operating almost exclusively in Japan.

From an investment perspective, the Japan opportunity feels genuinely exciting. The new businesses that are transforming the landscape are often founder-run and built with entirely different approaches in mind.

While the vested interests protecting traditional Japanese ways of doing things remain formidable, the potential prizes for innovating around them are considerable – though hard to measure given that the markets often don’t yet exist. Japanese entrepreneurs are going to have to think creatively, and for the long term, if they are going to capture all the opportunities on offer.

July 2021

9

...kakushin (transformative change through radical technological innovation) offer Japan contemporary answers to the analogue culture


10

THE RISE OF ENTREPRENEURIALISM: FROM KAIZEN TO KAKUSHIN

Although Japan’s vaunted lifetime employment system can cultivate a sense of safety and stability for the salaryman, it has arguably come at a cost. It has promoted occupational segregation by creating a stark status difference between ‘regular’ and ‘non-regular’ employees; stymied specialised expertise, as generalists can be more easily reassigned within a company; and contributed to Japan’s shūshoku hyōgaki (or Ice Age Unemployment). As hiring is often frozen during periods of economic uncertainty – to protect lifetime employees – unlucky age groups can find themselves permanently locked out of the system.

Such a crisis can galvanise action, and in Japan it has proved particularly helpful in creating new and less conventional career paths for Japan’s budding entrepreneurs.

The idea of entrepreneurialism – breaking from the mould – is a serious undertaking in a society famous for conformity: ‘The nail that sticks up gets hammered down’ is a famous Japanese proverb, ‘the hawk with

talent hides his talons’ is another common refrain. However, the increasingly obvious effect of digital disruption, accentuated by Covid-19, is transforming attitudes. Even conservative blue-chip companies are offering capital to start-ups operating in this space in a bid to avoid taking on the risk themselves.

Companies like Recruit and Kakaku, have also fostered ‘intrapreneurship’, incubating their own internal ventures. Overall, the start-up scene is beginning to show signs of Silicon Valley swagger, with VC deals rising several-fold in recent years, reaching a sum of $5bn in 2019. Access to risk capital allows entrepreneurs to circumvent traditional channels and avoid the suicidal hara-kiri of a premature listing, where growth prospects are often sacrificed in the pursuit of profitability.

The pandemic also helped legitimise this otherwise unorthodox career option. The psychological barrier for would-be entrepreneurs – from the fear of failure and social alienation – is beginning to break on the back of a

series of homegrown success stories: Companies like Mercari, an online portal for selling used goods and Japan’s first ‘unicorn’ (an unlisted business with an estimated value of $1 billion or more); Mixi a leading mobile gaming company; WealthNavi a digital robo-wealth management platform; Freee, an accounting software provider and BASE, Japan’s version of Shopify, saw significant progress in the pandemic, and have become increasingly popular from wider press coverage.

Companies such as these, that embrace kakushin (transformative change through radical technological innovation) offer Japan contemporary answers to the analogue culture exposed by Covid.

July 2021

11

JAPAN’S DIGITAL DISRUPTORS

Japan’s meteoric rise in the 1970s and 80s provoked a tide of literature on the perceived mysteries of Japanese management. The popular discourse of Nihonjinron (theories of Japaneseness) arguably began with the anthropologist Ruth Benedict’s wartime book, The Chrysanthemum and the Sword, and was quickly followed by best sellers such as

Chie Nakane’s Japanese Society, and Takeo Doi’s Anatomy of Dependence. These cultural studies morphed into fashionable business books, such as William Ouchi’s Theory Z: How American Business Can Meet the Japanese Challenge, which claimed to understand the secrets of Japan’s success.

© Getty Images Europe.


12

Although inviting, many were accused of being ahistorical and essentialist, by presupposing that ‘The Japanese’ shared standard characteristics. This pigeonholing approach discounted the inherent diversity and complexity of Japanese society. A similar blanket approach to Japan’s digital opportunity would be equally reductive. Alleged loyalty to the fax machine notwithstanding, there are plenty of examples of innovative and ambitious companies embracing digitalisation. Gaming companies are the most conspicuous and represent a standout success story in Japan’s DX journey. As this is an industry where performance fluctuates wildly from one title to the next, companies such as Nintendo have responded by adopting a fully flexible, fabless model that embraces open innovation. By relying on its partners, in areas outside of its core competence, Nintendo can rapidly respond to the capricious needs of its audience.

There are copious examples of – domestically orientated – companies that are also embracing innovation. In healthcare, Sony-backed medical platform provider M3 wants to cut the fat from the pharmaceutical industry, by offering a transparent, accessible alternative to a plethora of intermediaries. In hospitality, Infomart is replacing a system of faxes, phone calls and paper records, by allowing restaurants to manage their fragmented supplier base online, with the additional appeal of online ordering and invoicing (a burgeoning opportunity in a country that boasts the highest number of restaurants per person, at 1 per 266 people). There is also ample room for innovation within the industrial space, as MonotaRo illustrates. It undercuts sub-scale physical store operators by selling over 18 million products online. In 2003, 70 per cent of its business was placed via fax machine. That number fell to 3 per cent last year, with over 95 per cent of orders placed online. BASE is another company benefiting from a rising tide of online consumerism, by streamlining the setting up of a virtual operation. With 98 per cent of its clients made of SMEs of five or fewer people, BASE is intent on capturing the long tail of companies set to grasp Japan’s nascent online opportunity.

Companies such as these are addressing the inefficiencies and demographic issues that beset Japan’s SMEs. This market accounts for 99.7 per cent of all businesses, and 70 per cent of the country’s employment and offers several inimitable opportunities.

Nintendo has responded by adopting a fully flexible, fabless model that embraces open innovation.

July 2021

13

JAPAN’S INCREASING APPEAL: FROM SAKOKU TO KAIKOKU

In this increasingly interconnected digital world, cultural and cognitive diversity are rapidly becoming essential to success. Researchers Takahiko Masuda and Richard Nisbett highlighted trans-Pacific cultural diversity in a simple experiment where Japanese and Americans were asked to view the same underwater scene. Americans described it in detail, focusing on the three fish in the scene. The Japanese, conversely, noted the river and water first and the fish as an afterthought. For them, context came first. While the American approach was individualistic, the Japanese showed a more interdependent perspective.

According to Matthew Seyd, in his 2019 book Rebel Ideas: The Power of Diverse Thinking, “Both offer valuable frames of reference [that when combined] create a more comprehensive grasp of reality”. The merits of cognitive diversity have become indisputable. Companies that embrace creative tension and foster fresh thinking are far more likely to remain relevant to a broader base of consumers and users.

This potentially paints a bleak picture for Japan, where an island mentality, centuries of sakoku (a ‘closed country’ rule) and a post-war ethno-nationalism have contributed to the pervasive presumption of a homogenous society unwelcoming to foreign workers: “One nation, one civilisation, one language, one culture and one race.” as a leading politician put it recently. Deep-seated attitudes regarding the subservient role of women in society, discrimination against indigenous groups and keinihon-jin (those born and raised in Japan but not seen as Japanese), along with extreme working hours and even karoshi (death from overwork), create an unwelcome advertisement to outsiders, and partly explain why only around 2 per cent of the population is foreign-born, compared with levels ranging from 10–25 per cent in western Europe and North America.

But Japan is now fostering a more inviting image. Amendments to immigration laws make it easier for gaijin (foreigners) to join Japanese companies that are themselves becoming increasingly inclusive. This is thanks in part to the progressively ambitious – and triennially revised – targets of the corporate governance code. The latest iteration raises the bar on diversity and encourages companies to embrace English. Even the Bank of Japan, the epitome of tradition, has an action plan to boost the number of female managers and double the taking of parental leave.

Covid-19 has arguably accelerated these trends, compelling companies to incorporate flexible working and family-friendly hours. Such adjustments are likely to make conventional companies more accessible, encouraging broader inclusion and diversity, from home and abroad. Of course there are companies leading the charge, like Cybozu, a software-as-a-service provider for SMEs which refuses to bow to Japan’s corporate handbook. Employees can declare their own working hours and can take up to six years’ worth of parental leave. Mercari is another example, with an increasingly cosmopolitan workforce, incorporating diversity “as a result of a quest for a better product, rather than seeing it as a goal in and of itself.” Companies like these, that clearly consider the merits of human capital, were propelled by the pandemic, and epitomise the country’s continuing pursuit of kaikoku (‘opening up to the world’).


14

Companies that embrace creative tension and foster fresh thinking are far more likely to remain relevant to a broader base of consumers and users.

July 2021

15

IMPORTANT INFORMATION

Baillie Gifford & Co and Baillie Gifford & Co Limited are authorised and regulated by the Financial Conduct Authority (FCA). Baillie Gifford & Co Limited is an Authorised Corporate Director of OEICs.

Baillie Gifford Overseas Limited provides investment management and advisory services to non-UK Professional/Institutional clients only. Baillie Gifford Overseas Limited is wholly owned by Baillie Gifford & Co. Baillie Gifford & Co and Baillie Gifford Overseas Limited are authorised and regulated by the FCA in the UK.

Persons resident or domiciled outside the UK should consult with their professional advisers as to whether they require any governmental or other consents in order to enable them to invest, and with their tax advisers for advice relevant to their own particular circumstances.

Europe

Baillie Gifford Investment Management (Europe) Limited provides investment management and advisory services to European (excluding UK) clients. It was incorporated in Ireland in May 2018 and is authorised by the Central Bank of Ireland. Through its MiFID passport, it has established Baillie Gifford Investment Management (Europe) Limited (Frankfurt Branch) to market its investment management and advisory services and distribute Baillie Gifford Worldwide Funds plc in Germany. Similarly, it has established Baillie Gifford Investment Management (Europe) Limited (Amsterdam Branch) to market its investment management and advisory services and distribute Baillie Gifford Worldwide Funds plc in The Netherlands. Baillie Gifford Investment Management (Europe) Limited also has a representative office in Zurich, Switzerland pursuant to Art. 58 of the Federal Act on Financial Institutions (“FinIA”). It does not constitute a branch and therefore does not have authority to commit Baillie Gifford Investment Management (Europe) Limited. It is the intention to ask for the authorisation by the Swiss Financial Market Supervisory Authority (FINMA) to maintain this representative office of a foreign asset manager of collective assets in Switzerland pursuant to the applicable transitional provisions of FinIA. Baillie Gifford Investment Management (Europe) Limited is a wholly owned subsidiary of Baillie Gifford Overseas Limited, which is wholly owned by Baillie Gifford & Co.

Hong Kong

Baillie Gifford Asia (Hong Kong) Limited 柏基亞洲(香港)有限公司 is wholly owned by Baillie Gifford Overseas Limited and holds a Type 1 and a Type 2 license from the Securities & Futures Commission of Hong Kong to market and distribute Baillie Gifford’s range of collective investment schemes to professional investors in Hong Kong. Baillie Gifford Asia (Hong Kong) Limited 柏基亞洲(香港)有限公司 can be contacted at Suites 2713-2715, Two International Finance Centre, 8 Finance Street, Central, Hong Kong. Telephone +852 3756 5700.

South Korea

Baillie Gifford Overseas Limited is licensed with the Financial Services Commission in South Korea as a cross border Discretionary Investment Manager and Non-discretionary Investment Adviser.

Japan

Mitsubishi UFJ Baillie Gifford Asset Management Limited (‘MUBGAM’) is a joint venture company between Mitsubishi UFJ Trust & Banking Corporation and Baillie Gifford Overseas Limited. MUBGAM is authorised and regulated by the Financial Conduct Authority.

Australia

Baillie Gifford Overseas Limited (ARBN 118 567 178) is registered as a foreign company under the Corporations Act 2001 (Cth) and holds Foreign Australian Financial Services Licence No 528911. This document is provided to you on the basis that you are a “wholesale client” within the meaning of section 761G of the Corporations Act 2001 (Cth) (“Corporations Act”). Please advise Baillie Gifford Overseas Limited immediately if you are not a wholesale client. In no circumstances may this document be made available to a “retail client” within the meaning of section 761G of the Corporations Act.

This document contains general information only. It does not take into account any person’s objectives, financial situation or needs.


16

South Africa

Baillie Gifford Overseas Limited is registered as a Foreign Financial Services Provider with the Financial Sector Conduct Authority in South Africa.

North America

Baillie Gifford International LLC is wholly owned by Baillie Gifford Overseas Limited; it was formed in Delaware in 2005 and is registered with the SEC. It is the legal entity through which Baillie Gifford Overseas Limited provides client service and marketing functions in North America. Baillie Gifford Overseas Limited is registered with the SEC in the United States of America.

The Manager is not resident in Canada, its head office and principal place of business is in Edinburgh, Scotland. Baillie Gifford Overseas Limited is regulated in Canada as a portfolio manager and exempt market dealer with the Ontario Securities Commission (‘OSC’). Its portfolio manager licence is currently passported into Alberta, Quebec, Saskatchewan, Manitoba and Newfoundland & Labrador whereas the exempt market dealer licence is passported across all Canadian provinces and territories. Baillie Gifford International LLC is regulated by the OSC as an exempt market and its licence is passported across all Canadian provinces and territories. Baillie Gifford Investment Management (Europe) Limited (‘BGE’) relies on the International Investment Fund Manager Exemption in the provinces of Ontario and Quebec.

Israel

Baillie Gifford Overseas is not licensed under Israel’s Regulation of Investment Advising, Investment Marketing and Portfolio Management Law, 5755-1995 (the Advice Law) and does not carry insurance pursuant to the Advice Law. This document is only intended for those categories of Israeli residents who are qualified clients listed on the First Addendum to the Advice Law.

Oman

Baillie Gifford Overseas Limited (“BGO”) neither has a registered business presence nor a representative office in Oman and does not undertake banking business or provide financial services in Oman. Consequently, BGO is not regulated by either the Central Bank of Oman or Oman’s Capital Market Authority. No authorization, licence or approval has been received from the Capital Market Authority of Oman or any other regulatory authority in Oman, to provide such advice or service within Oman. BGO does not solicit business in Oman and does not market, offer, sell or distribute any financial or investment products or services in Oman and no subscription to any securities, products or financial services may or will be consummated within Oman. The recipient of this document represents that it is a financial institution or a sophisticated investor (as described in Article 139 of the Executive Regulations of the Capital Market Law) and that its officers/employees have such experience in business and financial matters that they are capable of evaluating the merits and risks of investments.

Qatar

The materials contained herein are not intended to constitute an offer or provision of investment management, investment and advisory services or other financial services under the laws of Qatar. The services have not been and will not be authorised by the Qatar Financial Markets Authority, the Qatar Financial Centre Regulatory Authority or the Qatar Central Bank in accordance with their regulations or any other regulations in Qatar.

July 2021

17


18

THOMAS PATCHETTIntermediary Client Manager/Japan Product Specialist

Thomas is a Japanese Equity Specialist with responsibility for Japanese equity clients. Thomas maintains a close relationship with the Japanese Investment Team, participating in stock discussions and portfolio meetings, as part of his Specialist Client Service role. Prior to joining Baillie Gifford in 2015, he worked as a Private Banker at Barclays Wealth & Investment Management. Thomas graduated BSc (Hons) in Business Management from Kings College London and is also a CFA Charterholder.

DONALD FARQUHARSONHead of Japan

Donald heads the Japanese Equities Team and has been a member of the International Alpha Portfolio Construction Group (PCG) since 2014. He joined Baillie Gifford in 2008 and became a Partner in 2017. He has 32 years’ investment experience dedicated almost entirely to Japanese Equities. Donald spent 20 years working for Schroders as a Japanese specialist, latterly as Head of the Pan Pacific Equity Team. Between 1991 and 1995, he headed Schroders’ Research Team in Tokyo. Donald graduated MA (Hons) in Arabic Studies from the University of St Andrews in 1987 and is a CFA Charterholder.

ABOUT THE AUTHORS

19

July 2021

Copyright © Baillie Gifford & Co 2015.

Calton Square, 1 Greenside Row, Edinburgh EH1 3ANTelephone +44 (0)131 275 2000 / bailliegifford.com

CURIOUSABOUTTHEWORLD

bailliegifford.com/thinking

Japan's Digital Transformation

Documents