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Goldman sees 'revolutionary' shift in Japan Inc

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Japanese corporates are notorious for hoarding cash, but there's a revolutionary shift underway, with shareholder returns set to reach their highest level ever this fiscal year, according to Goldman Sachs.

"Faced with growing pressure to improve capital efficiency, Japanese companies have become increasingly conscious of corporate governance and the need to deliver higher returns to shareholders as their earnings have recovered," Goldman Sachs wrote in a note published over the weekend.

Annual dividends are forecast to reach a record high of 9 trillion yen ($76 billion) in the fiscal year ending March 31, up from 8 trillion yen last year. Japanese companies have announced share buybacks totaling 2.5 trillion yen between April and December 2014, up 116 percent on year.

A corporate sector that is more proactive about shareholder returns is "quite revolutionary in Japan's context," Kathy Matsui, managing director and chief Japan strategist at Goldman Sachs, said in an interview with CNBC on Monday.

The government, under Prime Minister Shinzo Abe, has taken it upon itself to drive a shift in corporate behavior.

Corporate governance reform is a part of the so-called "third arrow" of Abenomics – Abe's three-pronged strategy to revive the economy – alongside other a host of structural reforms including increasing labor market flexibility and opening up the agricultural sector to foreign competition.

What's needed to sustain Japan's growth

In January 2014, the JPX-Nikkei 400, dubbed the "shame index," was launched by the Japan Exchange Group and Nikkei, receiving endorsement from the Government Pension Investment Fund (GPIF) soon after.

The index, reportedly the brainchild of the ruling Liberal Democratic Party, is unique in that stock selection criteria emphasize high return on equity (ROE) and good governance. The GPIF, which manages around $1.1 trillion, has adopted the index as a benchmark for some of its domestic equity portfolios.

In February 2014, the Japanese Stewardship Code – new government guidelines on shareholders' involvement in the firms– was introduced. The new guidelines are designed to encourage shareholders to challenge executives on issues such as low dividend payouts and a lack of independent directors.

Later this year, a new "corporate governance code" will be rolled out to establish best practices for governance behavior. A key focus area of will be the role of board of directors.

"One of the most overlooked areas of PM Abe's reform agenda remains corporate governance," Goldman said.

Encouragingly, firms are beginning to respond to calls for better governance with concrete actions, the bank said, citing firms like Aoyama Trading and Marui Group, which announced share repurchases in the past month, driving their stock prices higher as a result.

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Shares of Aoyama Trading soared 17 percent the day after the apparel retailing company announced a buyback on January 28, while department store operator Marui Group shares gained 16 percent after a buyback on February 10.

"We expect a continued focus on such moves for the remainder of FY2014 as the corporate governance code announcement fuels interest in returns to shareholders as a component of governance," the Goldman said.

The case for Japan stocks

Progress on corporate governance is one aspect driving Goldman's bullish outlook on Japan stocks this year.

Higher ROE, supportive valuations and increased buying by domestic investors against a backdrop of accommodative monetary and fiscal policy are other factors it expects will trigger further gains.

While macro events may dominate headlines, equity investors should focus on micro corporate sector developments, the bank said.

Gross domestic product (GDP) data published on Monday showed Japan emerged from a recession in the fourth quarter although the growth figures came in much weaker than expected.

GDP grew an annualized 2.2 percent, helped by a rebound in exports, but the figure missed a Reuters poll expecting a 3.7 percent gain.

The bank, however, remained upbeat on its outlook for the market. Mitsui has a year-end target of 20,000 for the Nikkei 225 and 1,650 for the Topix – representing and upside of 11 and 13 percent, respectively, from current levels.