In my previous post, I listed the reasons why Burgundy invests in Japan, but I also alluded to the risks that exist. Let me illustrate with the story of Olympus Corporation, a Japanese company which perpetrated a financial fraud for decades.
Olympus Corporation is better known for its cameras, but its biggest, most profitable and successful business is actually its medical device business. We had spent some time analyzing Olympus over the years and never considered it a potential investment candidate because it lacked some basic fundamental requirements we believe are necessary to be a Burgundy holding (e.g., the business wasn’t overly profitable, was heavily indebted and was in a very competitive industry with low returns). But at the same time, we really liked the medical device business and knew it wouldn’t take much to turn the company around.
Therefore, the announcement on April 1, 2011, that Michael Woodford, an Olympus veteran of 30 years, was unexpectedly being promoted to the post of company President and COO piqued our interest. Woodford had been responsible for building and running the company’s very successful European Medical Device business and was about to become the first non-Japanese executive in the long history of Olympus – and indeed one of the very few foreign executives in all of Japan.
While there were some questions raised at the time about the talents of this relatively unknown British national, not to mention his lack of Japanese speaking ability, by and large the market saw this appointment as we did: a positive indication that Olympus was finally serious about globalization, focusing on its best business and reforming its underperforming non-core parts. This view was further reinforced six months later when Woodford was appointed the CEO of Olympus.
All things seemed to be going well, but only two weeks after his CEO appointment, Mr. Woodford was summoned to an emergency board meeting where he was quickly and unanimously ousted from his job. Woodford was not allowed to speak nor vote in the meeting, which saw Olympus’s Chairman, Tsuyoshi Kikukawa, reinstated as company President and CEO. The reasons for this sudden departure and change of heart (again only two weeks after being appointed CEO) were explained as cultural insensitivities and differences in management style.
Woodford left Japan almost immediately but took a very different version of the story public. He claimed that his forced departure was linked to several prior acquisitions he questioned, particularly a US$2.2 billion deal in 2008 in which Olympus acquired a British medical equipment maker named Gyrus Corporation. While Gyrus was in a complementary field to the core endoscope business at Olympus, and seemed to make strategic sense, Woodford discovered that roughly US$700 million dollars, or 30% of the total value of the deal, was paid as advisory fees.
The typical fees for merger and acquisition advisory work are in the 1-5% range, so this US$700 million payment was, to say the least, excessive. The fact that these fees were never fully disclosed and were quickly written off only raised his suspicions of misconduct, as did the discovery that the advisory firm was based offshore in the Cayman Islands and whose owners were unknown and undetectable because the firm’s name had already been struck from the Cayman Islands business registrar. It was clear that something was amiss and the Olympus stock price fell precipitously.
Most frauds happen because of greed, and the Olympus narrative seemed like a classic example of deceit whereby some savvy insiders somehow created a scheme to skim money from the corporate coffers and, in the end, the pockets of the shareholders. But not so in this case. The findings of an independent investigation determined that this was not a story about stealing, but about hiding. A previous generation of Olympus management had made some ill-advised investments that went bad and, even though he had not been responsible for these decisions, Kikukawa had agreed to help conceal their losses. The aim of his deceit was to prevent others from embarrassment or “loss of face.” By hiding losses he thought he would preserve the reputations of a generation of executives that preceded him and the company’s reputation as well. He thought he was behaving righteously and with the company’s best interest in mind. In the end there was no greed, self-dealing or personal gain.
I have spent half my life studying Japan and investing in Japanese companies, and I have come to admire the Japanese for their work ethic, discipline, strong sense of unity and community, focus on continual self-improvement and quality, and their dogged perseverance especially in the face of challenges. All of these character traits have been on display over the past two years as the country quickly recovered from the devastating triple disaster of March 2011. But there are also cultural characteristics, which the Olympus story highlights, that are not flattering and from an investor’s standpoint are quite worrisome. This is a culture that resists change, favours insiders and lacks transparency. Furthermore, traditional Japanese business culture favours personal relationships over contracts. Boards of directors often lack independence and shareholders are not always treated as an equitable partner in a stakeholder system.
When investing in the capital markets there are many ways to lose money. The risk of financial malfeasance is just one of them. But this risk is real and, let me be clear, not just isolated to the Japanese market. Frauds happen all over the world and a lot more frequently than you would think – Bernie Madoff, WorldCom, Enron, Parmalat, and right here in Canada, Bre-X and Sino-Forest.
The point is not to scare you away from investing, but rather to highlight that risks exist and they should not be ignored. At Burgundy, they are always front and centre of our minds. By remaining cognizant of the risks, sticking to a time-tested philosophy that focuses on investing in quality companies when they are out of favour (no matter where they may be domiciled), and holding those companies for the long term, we believe we can reach our ultimate goal: to protect and build our clients’ capital.