"I am strongly recommending that people do the courageous thing and invest in value in Japan at a time when people don’t want to hear about it. If you are truly an investor and not simply chasing performance, you need to be brave. You need to do something different from what the herd is doing. It is not easy, but that’s what has made many good, disciplined investors rich in the past. Here is the bottom line: investor apathy on the Japanese market has never been higher, and stocks have never been cheaper. Now is the time to buy Japan." (Thomas J. Niedermeyer)
Introduction
There is no doubt that Japan is off the radar of most investors and also of most value investors. Japan is not really a hated, despaired market or unloved, but rather are investors indifferent. As Amit Wadwhany puts it: „It is neglected it is disliked. It meets all the criteria that draw people - suckers - as us." Investors cannot be bothered with Japan anymore. 20+ years of underperformance and negative publicity has done that job.
Although "suffering" from the deep value investor’s disease of loneliness, I am not discouraged by this fact at all. When investing in Japan I hold it with the old Warren Buffett (1965) who once remarked: "(...) we derive no comfort because important people, vocal people, or great numbers of people agree with us. Nor do we derive comfort if they don't. A public opinion poll is no substitute for thought. When we really sit with a smile on our face is when we run into a situation we can understand, where the facts are ascertainable and clear, and the course of action obvious. In that case - whether conventional or unconventional - whether others agree or disagree - we feel we are progressing in a conservative manner (...)"
The Case for Investing in Japan
The investment community, and unfortunately the value investing community too, is neglecting and missing out on an extraordinary investment opportunity for the true value investor. Because if you were truly focused on the safe and cheap criteria when it comes to investing, you would have nothing but Japan in your portfolio. (Wadwhany) And that is what I am focused on and the reason why I confine my investment activities solely to Japanese stocks trading below intrinsic value. To many this might appear funky and crazy but as the old Warren Buffett (1965) once observed: "(...) truly conservative actions arise from intelligent hypotheses, correct facts and sound reasoning. These qualities may lead to conventional acts, but there have been many times when they have led to unorthodoxy. In some corner of the world they are probably still holding regular meeting of the Flat Earth Society. (...)"
But I am not totally alone when making the case for investing in Japanese value stocks. A few great and brave value investors dare venturing into the same investing sphere I do. And the best about them is that they appear to be witty and funny and persons of integrity. In short they are the kind of people I would enjoy having a beer with in a nice pub.
I do acknowledge that Japan is a rather tricky market. Patience and a strong stomach is always required when following a value investing approach. But in Japan it is even more important and daunting. Amit Wadwhany too cautions that: "(...) the question you ask - after years of some patience (...) - how we going to make money here? (...) japan is the place where you invest and wait and wait and wait, and suddenly you make money. Lots of it and very fast. It's almost this hockey stick phenomenon (...)." From those remarks one thing should become clear. Short termism is not going to pay out in Japan. Also Jiro Yasu seems to be well aware of this fact and remarks that: "(...) People (investing) in Japan (are) very short- term orientated. If the company has a good five year business plan nobody cares. I find those good investment opportunities for long term investors. With the (new business plan) they don't change their business, but the way they count money. If you can invest long-term and cope with the volatility (and mark to market volatility) I think there is great opportunity making money in Japan (...)." And Jean Marie Eveillard notes that: “(...) there is a trade off in Japan; you have to be very patient, but you can make 3-4 times on your invested capital in Japan (...)." I regard the necessity of extreme patience that is required when investing in Japan, in combination with high volatility an important reason why people do not dare venturing into Japanese equities.
In addition to the abovementioned there are many half-truths uttered by the media and so called "experts" regarding, for example, the poor macro- economic performance of Japan, supposedly poor operational performance of the majority of Japanese companies and the "widespread" disrespect of corporate Japan towards its shareholders.
Myths and Misconceptions about Investing in Japan
Misconception No 1; Corporate Governance: One reason why Japan is so cheap and neglected is the corporate governance discount, e.g. maybe investors recognizing the extraordinary cheapness of this market, but still they are not willing to invest, because the corporate governance framework is so distinct to the Anglo-Saxon model. Warren Liechtenstein (2008) observes that: „(...) Optimists are pointing to a “flight to value” as corporate pre-tax profits have risen for the last seven years while pessimists assert a “corporate governance discount. With SPJSF’s long history of value investing, we are clearly in the former camp. (...)"
In the first two years of investing in Japan I was concerned about corporate governance issues as well. But with the onset of my investment experience in Japan, I more and more came to the conclusion that a formal (Anglo-Saxon) corporate governance framework, i.e. a committee system with certain amount of independent directors, should be of minor concern when investing in a company. More important than the formal framework is how the management treats its shareholders: action speaks louder than words! Olympus and Daio paper were prominent cases where advocates of the Anglo-Saxon model of corporate governance were shouting out loud the supremacy of their framework over the Japanese one. They seem to have forgotten about the numerous scandals in their hemisphere the last +10years. I am pretty sure that in aggregate fewer corporate scandals have taken place in Japan than in the U.S.
Regarding performance and corporate governance framework, I haven't experienced any sort of positive correlation in my holdings so far. At most it is very weak. Mc Evelaine points out that: "(...) I break Japan in two components. One is the stuff with western corporate governance (...) probably 2/3 of my Japanese position. Second is stuff that is statistically cheap (...) I am not sure that the corporate governance is going to outperform the cheap stuff (...) the Jury is still out there. (...). Western corporate governance makes you feel better, but not necessarily the one you make more money. We'll see; ask me in two years (...)." He goes on to note that: "(...) initial mistake I made (investing in Japan) assume that the Japanese are doing it wrong, figure it out and do it the north American way. That is not going to happen in Japan. I am a little bit more accepting, ok that is what they do and accept it (...)."
Misconception No.2; Pay-out policy in Japan is dismal: Having pointed out that I cannot observe any positive correlation between the corporate governance framework and stock performance in my holdings, there is a strongly positive linear relationship between pay-out policy and stock performance. As more liberal the companies are with returning cash to the shareholders through dividends and/or share repurchase, as better the stock performance. The corollary is that: „(...) you have to find the right management. If we can agree on the value of the company (...) and the CEO agrees on the great undervaluation (...) good opportunity that he does something to close the value gap. There are a lot of managers in Japan that do not have any sense what the value of the business is. Even if the share price of a company is deeply undervalued sometimes it is not such a good idea to invest in it if management hasn't well an idea of the (market) value of its company. He might make stupid things, like overpaying for an acquisition. If management has a good sense for the value of its business and he sees the share price as deeply undervalued he might buy back some shares (...) sees why it is good for the shareholders (..). Two types of management here (in Japan), those who have a sense of stock valuation and those who don't. Many companies in Japan (who are undervalued) and you invest (...) maybe are undervalued for the next 20 years. If you find the right guy, right management who understand the undervaluation of the (companies') shares, I think it’s a good investment (...)." (Jiro Yasu). Concerning corporate governance in Japan Charles de Vaulx points out that: "(...) we do believe that a huge change in corporate activity is happening in Japan, what will make the Japanese market to go up despite the (already) huge rally. Japan still trades only at 1,1 tangible book". Also Mc Eveillard recognizes that: „ (...) Japan does a fair amount of share repurchase; in contrast to U.S and Canada usually when they say they repurchase shares they do it. (...) key to japan was to see corporations to realize that they have too much cash and give it back to the shareholders (via dividends or share buy-backs) (...)."
Misconception No.3; Expensiveness: Many "value investors" claim that the market is not cheap in terms of price metrics. Especially the value pretenders, such like Charles Sizemore, are in that camp:" (...) after roughly doubling in less than a year, Japanese stocks are no longer cheap. By Financial Times estimates, Japanese stocks trade for 19 times earnings (...).“
This comment is wide off the mark. Standard ratios do not give away the "true" state of a companies’ market valuation and operational performance to the interested value investor. In many instances P/ OCF and P/E overstate or understates the valuation and operational performance of a company by a wide margin. Although widely followed and eagerly marketed by the financial community and financial media (especially the P/E Ratio), they do not deserve this close attention. Especially the P/E ratio is a very flawed metric. In contrast to the P/OCF ratio, which is mainly distorted through the numerator (P), the P/E ratio can be so by the numerator and denominator. The distortion of the numerator mainly comes into play when not taking into account differences in the capital structure of a company, i.e. debt vs. equity financing on the passive side of the balance sheet and different asset composition on the active side of the balance sheet. The distortions on the denominator mainly happens through different accounting policies applied by companies and secondarily through differences in the financing of a company.
Especially in Japan those price metrics are severely distorted. Only a handful of value investors are aware of this fact. Jean Marie Eveillard states that: "(...) Japanese companies tend to sit on a ton of cash and with price/ earnings ratios you don't take cash into account; with EV to earning you take cash into account and on that basis there are (world class) Japanese companies that are reasonably valued (...)" And also Charles de Vaulx seems to be well aware of the flaws of standard price metrics: "(...) likewise from a valuation standpoint, when you look at a Japanese company from a pure and simplistic price to earnings basis as opposed to an enterprise value (adjusted for cash) that is how you notice how cheap these stocks are (...)."
Misconception No.4; Corporate Japan has an irrational cash hoard mentality: The fact that corporate Japan has accumulated a vast amount of cash is indisputable. And yes many companies are overcapitalized, especially domestic value stocks. Mc Eveillard puts it in the following way: „(...) Today Japanese company's balance sheets are way too strong. They sit on mountains of cash. Very little will ever been needed for business (...):" But is the cash hoard mentality in Japan irrational? I don't think so and neither does Amit Wadwhany. He notes that: „(...) for companies to hang on cash during a period of deflation is a very rational response. It's a logical safety blanket (...)."
Do not get me wron. I do think that corporate Japan’s cash hoard it is way too high. But accumulating high cash balances was by no means irrational. Especially if one is aware of the fact that although deflation was mild in Japan it was higher than the official numbers reveal. Stephen Yung-li Jen (NZZ 2013) asserts that the Japanese BIP-Deflator is lower than the official inflation rate reveals. This suggests, that the equilibrium yield of 10 year JGBs at a targeted 2% inflation rate is closer to 3% than 4%. The main reason for underreporting the inflation rate in Japan is that Japan does not use a hedonic price indices like the U.S, Europe and the UK. Thus, there has been no financial repression in Japan like in the western hemisphere, but rather the contrary. As long as the companies have not eaten into their current assets through losses, all money accumulated in the treasury is still there and in real terms has gone up in purchasing power. Furthermore, in contrast to the 1930's in the U.S, where a similar phenomenon was to be observed, the cash hoards in Japan have not been accumulated through stock offerings. It has been earned! "(...) If you see where the cash in Japanese balance sheets is coming from it has been earned; they are good businesses so that is why they have been accumulating cash. That is what Jean- Marie Eveillard told me. (Why) We look at cash rich companies is, because cash rich companies tend to have a good business (...)." (Jiro Jasu)
(Mis-) conception No.5; There is no market for M&A and corporate control in Japan: Unfortunately this is rather a fact than a myth. Wadhwany's main concern is: " (...) the lack of a M&A market in Japan. If there was an active M&A market you would certainly see a lot of change happening (...)." Mc Elvaine also hopes that in Japan: " (...) hopefully will be more (outside) corporate activity (friendly/ unfriendly takeover bids)."
But as I have mentioned several times before on this blog, it is my believe that activities to strengthen the M&A market and market of corporate control have to come first and foremost from within Japan. Jean-Marie Eveillard appears to be with me on this assertion. He says that: " (...) we are not more active towards Japanese management, because they just don’t want to listen to advice coming from a foreigner. Steel partners was very active in Japan, he is not around anymore. Well, we owned a stock were Warren Lichtenstein was successful. It (...) was a former textile company (that didn't operate in the textile business anymore). They owned real estate (redeveloped), owned tons of cash, had a business (not textile), had investment portfolio. It was extraordinary cheap. Lichtenstein suggested distributing extra dividends, which would be good for us and good for them. Because we will have been gone (after the special distribution) and that is exactly what happened. The stock went up, value had been recognized. Foreigners left and management stayed with a business/ real estate etc. They simply had less cash than before. I thought this formula would apply elsewhere, but it didn't for whatever reason (...)." (Just for the sake of clarification. The activist fund Eveillard is talking about was not Steel Partners, but the Murakami Fund)
Closing Remarks
Let’s close this post with the following observations:
„ (...) We know that after a 13 year bear market, many Japanese stocks are cheap. (...)" (SPJ; Sep. 2003) " (...) undeniable fact. Japan is undervalued. Valuations in Japan are trading at recent historic lows with the 2008 price/earnings multiple of 15x representing a 33-year low and approximately half the companies listed on the Tokyo Stock Exchange first section trading below book value. The average dividend yield of TSE first section companies has risen to 1.72% (higher than any year-end figure since 1977, 1.78%). Additionally, Japanese companies have repurchased over ¥4 trillion of common shares in 2007, a record high for the fourth consecutive year. On December 29, 1989, the Nikkei Stock Average stood at 38,915. As of February 29, 2008 it was 13,603 (...)". (Warren Liechtenstein, SP Japan; March 2008)
On December 29, 1989, the Nikkei Stock Average stood at 38,915. As of June 23, 2015 it was 20,809.
What an incredible compound rate of loss over time!
Source:
Investing in Japan: Only the 'cockroaches' survive
Arbeitsmarktreform Zentral für Japans Wirtschaftserfolg (NZZ)
Still Waiting for Japan’s Day of Reckoning (Charles Sizemore)
Wadhwaney on Investing in Japan
Mc Elvaine on Investing in Japan
Eveillard on Invesing in Japan
Jiro Yasu on Investing in Japan
Charles de Vaulx on Investing in Japan
Steel Partners Japan /SPJ); Letters to the partners; March 2008
Buffet Partnership Letters (BPL) (January 1965)
What an incredible post and summary! Thanks so much. Recently visited Japan for the first time and started to read a lot about it, glad I found your blog. Covacoro
ReplyDeleteThanks for the kind words.
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