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NOV 25, 2008

The “Lost Decade” Represented Ten Years of Learning and Strategic/Structural Reform

By Yoshito Hori

Recently, I have occasionally noticed commentaries in American and European newspapers and other media discussing whether the US and European countries will face a “lost decade” similar to the one Japan experienced. However, was the lost decade really lost?

To begin with, conditions leading up to Japan’s bubble collapse in the 90s were different than those leading up to the recent bursting of the sub-prime bubble, the consequence of which Western countries are now facing. So there is no simple comparison. Also, the definition of lost decade is unclear in the first place, so I think trying to compare these two is meaningless.

First, what is the bursting of a bubble? It is often explained as a rapid surge in asset prices, including stocks and real estate, as a result of excessive liquidity and a frenzy of stock market speculation. Falling asset prices lead to a credit crunch, deflated assets and stagnating consumption.

While this explanation may be accurate in terms of economic theory, it does not take human factors into consideration. As mentioned in my previous column, I tend to view economics as the combination of human psychology and human behavior rather than just numbers.

Those who have studied economics are impelled to view this field in terms of numbers and models. On the other hand, those who have studied management, as I have, and manage their own companies are apt to view economics with people at the center. This doesn’t imply that one view is better than the other, but people have different approaches.

Here’s what I think. First, the incorrect perceptions of managers (errors in management) gave rise to Japan’s bubble. Second, the “lost decade” after the bubble burst was actually ten years of learning and strategic/structural reform.

I have come up with the following three causes for the Japanese bubble.

1. “Money management” was conducted without any concept of the cost of capital.
2. Excessive capital investments were based on overconfidence in the continued growth of the market.
3. There was no concept of strategy, which lead to “lockstep” management.

This may sound harsh, but the bubble itself was entirely the result of the ignorance of management in the area of business administration at the time. Naturally, companies lead by ignorant managers went bankrupt or were merged and are no longer around today. Even for those that survived, their management teams and shareholders have entirely changed.

Let’s take a quick look at these three errors in management.

1. “Money management” was conducted without any concept of the cost of capital.
I still clearly remember an article from the Nihon Keizai Shimbun stating that equity finance was cheap because it only required the cost for dividend yields with no obligation to pay back the money, as if this was simply how things worked. It seemed most managers in Japan at that time believed this to be true. This is why they repeatedly engaged in “cheap” equity financing and took on as much “debt” as possible. These managers then used these funds to invest in stocks, bonds and real estate as well as excessive capital investment and the purchase of overseas companies, referring to this as “money management.”

In this way of doing things, there was no concept of the cost of capital. I began my studies at Harvard Business School in September 1989, at the peak of the bubble. At the beginning of the finance class for first-year students, I was taught the concept of the cost of capital. I learned that equity finance costs more than debt finance. Stock prices will fall unless a company produces a higher return than the cost of shareholder equity.

The moment I learned this, I predicted that Japan’s stock market would go into a tailspin. Since even newspapers at that time were writing about “cheap” equity finance, the public perception was the same. Due to the ignorance of management and media outlets in the area of business administration, equity finance was used over and over again, and the ROE of Japanese companies plunged. In addition, as profits per share dropped, a stock price correction kicked in, and the Japanese bubble was on its way to collapse.

This is my conclusion. The creation and burst of Japan’s bubble was caused by a lack of knowledge and general ignorance in its business administration. Not many people make this point.

2. Excessive capital investments were based on overconfidence in the continued growth of the market.

3. There was no concept of strategy, which lead to lockstep management.

I don’t feel it’s necessary to discuss these two errors in detail because I believe many readers of this column already see them as causes of the bubble economy. Particularly the third error, lockstep management was only found in Japanese companies at that time. When Professor Michael Porter came to Japan, he often used the term “rat race.” His main point was that Japanese electronics makers were following the same strategy. Hitachi, Toshiba, and Panasonic were no exception. As a result, they entered into similar fields. Despite high sales, their profit ratios were extremely low. This is because they were in lockstep in the “rat race” and heading into the river. He was stating a harsh truth. And then the bubble collapsed.

What have Japanese companies done in the decade following this collapse? They have been single-minded in their pursuit of learning.

During my studies overseas, other Japanese would often ask why I was studying in the States since there was nothing to learn from America anymore and there would be no point in getting an MBA. But after the bubble burst, Japanese companies reflected on the road to the collapse and quickly learned the up-to-date knowledge of business administration.

GLOBIS was established in 1992 after the bubble burst. I still vividly recall how surprised I was to see we were providing training for a leading bank at the time. The bank simply had no concept of cash flow or IRR.

Today, however, concepts such as the cost of capital, cash flow and strategy have spread throughout many companies. I believe GLOBIS’ corporate training program, school, and publication business, including the GLOBIS MBA Series, have somewhat contributed to this change.

As a result, in terms of the first of these three errors, Japanese companies have completely shifted their management style to that which enhances ROE. Furthermore, they have reinforced their capital base and reduced unnecessary debt. Currently, a couple dozen top Japanese companies collectively maintain more than 40 trillion in cash.

In relation to excessive capital investment, Japanese companies have established a flexible production system that allows them to adjust capacity by disposing of superannuated equipment and eliminating waste and work overloads, for both personnel and equipment. In short, these businesses have carefully strengthened their facilities and equipment. (Although this cautious stance was sometimes criticized, they steadily moved forward, one step at a time).

To address lockstep management, companies have implemented a select and focus approach. Electronics manufacturers have withdrawn from DRAM (dynamic random access memory) production and other areas and sold off or streamlined business units. They have worked to narrow their business operations to their fields in which they can emerge on top in global competition. Things have changed. 

Ten years have passed after the collapse of the bubble in Japan, and now, several years later, the sub-prime bubble has burst in the U.S. Maybe it’s time for American, European, Chinese, and Indian companies to reflect and learn. Chinese companies in particular will face many aftershocks from excessive capital investment made under the assumption that markets would continue to grow. In addition, European and American financial institutions and companies will have to pay for enhancing—to an extreme degree—capital efficiency through leveraged financing.

The reason I wrote in my previous entry that people will change their opinions about Japanese-style management in the future was that during the lost decade, Japan single-mindedly continued to learn and made a sustained effort to improve strategy and structure. I can say this because we at GLOBIS have been a partner with client businesses and have together been making such efforts in developing human resources.

Although this is not widely known, corporate training for leading Japanese companies accounts for more than half of GLOBIS’ sales. Lecturers and staff from the corporate education division at GLOBIS have dedicated their efforts to developing human resources for businesses in Japan (including foreign-owned companies in Japan).

From now on, although the Japanese economy may slow down, Japanese companies will remain relatively strong. It is said that Toyota faces a drop in profits of more than 70%; however, the company is still generating 500 billion in profit. On the other hand, most Western companies are projected to be in the red. (American businesses will especially face a sea of red ink.)

What should Japanese companies do now?

The answer is clear. Japan should continue to relentlessly pursue learning and steadfastly strive to further improve their strategies and structures. Personnel who are able to play an active role globally will be in particularly high demand in the future, for this is a time in which Japanese companies can also purchase foreign businesses at bargain prices. Japanese companies can recruit. Sufficient funds are available. All that is needed is human resources.

What I learned after the Japanese bubble burst was that at the end of a crisis, strong companies become stronger and weak companies die out. Strong companies are relentless in their efforts. They nurture human resources, maintain strong organizational cultures and focus on their core businesses to confidently achieve success. I believe a positive cycle starts with the development of human resources.

After all, people are ultimately the only resource Japan has. I believe Japanese companies will continue to become stronger by always cultivating this resource.

Yoshito Hori
November 7, 2008
at home

P.S. Our International MBA program, an MBA curriculum in English, is scheduled to commence in April 2009. I encourage those who aspire to become global leaders to by all means give this program a try. (http://imba.globis.ac.jp/)