Will Japan Sink Into The Pacific Ocean?

The following is our answer to a client who recently questioned our optimism toward Japanese equities. To keep things in perspective, Japanese stocks represent a little over 20% of our international fund, but a much lower percentage of individual clients’ portfolios. However, “Tom” has more experience than most of our clients with Japanese business, and he gives us an occasion to air our stance anew.

Dear Tom,

Thanks for your comments on Japan and the articulate, negative report you forwarded with them.

My short answer is that there is no equally articulate way to refute your concerns or, for that matter, those of the many experts who share your views. I have on my desk an overwhelming pile of reports describing in great detail both the intractability of Japan’s travails and the dire consequences that are certain to ensue for the country itself and, perhaps, for the world economy. As Japan’s recession and financial crisis have worsened in the last several years, these reports have become increasingly well documented, convincingly articulated and seemingly irrefutable.

A parallel with America’s decline in the 1980s, though its causes were entirely different, may illustrate how the debating tools of the conventionalists and those of the contrarians are always very unequal. The first group deals with well-established trends. Because they are rooted in the past, these trends can be supported by ample data and causal analyses: they are therefore tempting to extrapolate. The second group tries to discern signs of a different future amid present turmoil, and it thus only has a hodge-podge assemblage of “straws-in-the-wind” to work with.

In the mid-1980s, leading economists and management gurus on both sides of the Pacific were painting Japan’s economy as invincible, and its conquest of world markets as unstoppable. The Japanese model of corporate management was seen as an ideal that American managers could never emulate, let alone surpass.

Beyond its manufacturing supremacy, Japan was also becoming ever richer under the seemingly unstoppable virtuous circle of growing current account surpluses, strong capital inflows and, later, a strong Yen that allowed low inflation and interest rates. As a result, Japanese interests were gobbling up U.S. assets, including such real estate landmarks as the Rockefeller Center.

Incidentally, during all that time and in fact up until a little over a year ago, when a decade-long, 60% decline began to intrigue me, I had zero exposure to Japanese equities because valuations more than reflected the certainties investors thought they had about Japan.

During the same period, as you may remember, there was a great deal of gloom about the U.S. manufacturing industry. It could never regain its competitiveness and was becoming hollowed as a result of the inexorable move offshore of many of our country’s plants. Incapable of creating anything but low-skill, low-paying service sector jobs, America was condemned to become an “economy of hamburger stands”.

In true contrarian fashion, I had created in 1985 a whole research program involving in-house analysts as well as professors of management, accounting and manufacturing technology in several universities around the country. The purpose of that program was to chronicle what I believed to be a New Industrial Revolution shaping up in America, in contradiction to the slow death of manufacturing that was credibly projected by a wide majority of experts and commentators.

In 1987, I was invited to speak to the Annual Meeting of the American Manufacturing Association and, within weeks, also to the Japanese Chamber of Commerce in the United States.

As the only speaker from the financial community at the American Manufacturing Association meeting, I was also the only one to argue that U.S. industry was not dying, but being reborn. Every other speaker lamented the travails of manufacturing in the United States, and the association’s chief economist (later to become its president) offered one of the gloomiest keynote speeches I ever heard.

My speech to the Japanese Chamber of Commerce – essentially the same one, but in front of a smug audience -- was received rather icily. This may have had to do with my uncharacteristically tactless conclusion: “I am sorry to inform you that, in the future, it is more likely that your economy will become like ours than our economy will become like yours – and that is how competitiveness trends will be reversed.”

I do not mean these recollections to be self-serving, and I had not in any way imagined the computing, software and communications revolution that was about to unfold. But no one had. The important point is that even the highly knowledgeable experts and practitioners in these two audiences had been thoroughly indoctrinated in the then-prevailing consensuses about Japan and the United States.

Now, only fifteen years later, the Japanese stock market is 60% lower, the Yen behaves like a chronically sick currency and valuation ratios on Japanese shares (price to cash-flow, earnings, or sales) have collapsed – even on depressed operating statistics. While it is true that many corporations are in technical (or, increasingly, actual) bankruptcy, many others are selling for a total market value that is less than the net cash (after deducting all liabilities) on their balance sheets.

Regardless of this, since Japan’s situation is so widely believed to be hopeless, disinterest in Japanese shares by large international investors is rampant and their low exposure historically unmatched for a large market, as regularly documented in surveys by Merrill Lynch and other large brokers.

Meanwhile, even after the recent bear market, the United States is still viewed as an invulnerable economy, champion of technology and innovation, and continues to enjoy large inflows of international capital and a seemingly rock-solid currency.

This kind of situation falls squarely into the category that calls for the Headlines and Bottom Line approach. My requirements for such an approach are 1) a market consensus that is overwhelming and irrefutably documented by expert studies, commentators’ opinions and even business leaders’ statements; and 2) market prices that seem to reflect the full extent of the prevailing gloom.

A combination of these two factors is simply irresistible for two reasons.

§         First, seemingly desperate situations such as the current one in Japan trigger change that is not readily discernable at first because it happens one household or one corporation at a time. As a result, studies that extrapolate recent trends by arguing that \"all else being equal\" this or that outcome is ultimately unavoidable are always wrong.  \"All else\" never remains equal. One can debate whether there is enough of a sense of desperation in Japan yet, but that sense is nascent and will spread further, triggering an acceleration of change.

In the 1980s, none of my many U.S. manufacturers friends thought there could ever be a revival of American manufacturing, but they were all working, in different ways, to make their own companies competitive. Most of the Japanese I have had a chance to meet in the past year or so are deeply pessimistic and skeptical that things can change. They often claim that their peers lack any sense of urgency or that social and bureaucratic rigidities prevent the necessary changes. At the same time, these very individuals, too, are implementing in their own corporations changes that would have been unthinkable a few years ago. True, some of these changes seem tentative by American standards, but in Japan the very fact that they are happening, at an accelerating rate, is revolutionary. Paradoxically, the kind of environment where a growing number of decision makers complains that change is impossible is symptomatic that change is, indeed, occurring below the surface.

§         Secondly, if everyone is aware of Japan’s poor situation and avoids investing there, something close to the worst case scenario must be reflected in prices. We are dealing with markets, whose behavior incorporates both fundamentals and psychology. The worst does not need to happen for prices to bottom: it only has to be feared. This is why stock markets trough in the midst of recession. So, it can be assumed that, short of a truly cataclysmic event, the risk factor in financially viable Japanese shares has been considerably reduced by the current, quasi-universal pessimism.

I grant that the state of Japan’s financial system remains a big roadblock to recovery, and that the political system further hinders progress. But these kinds of problems, too, are solvable in ways that their complexity makes difficult to articulate in advance. For a country with the size and resources of Japan, the deflationary write off of bad debts can be offset by aggressive monetary expansion, as long as the banks become operational again, through temporarily and partial nationalization (to avoid the dreaded “liquidity trap” syndrome). This was done in the past in several other countries, including the United States.

Of course, the government debt that all this would create is a major worry in Japan because of that country’s fast-aging population. But, as has been demonstrated in the United States, debt and budget deficits can best be reduced on the backdrop of strong economic growth. Whereas there exists much skepticism about Japan’s ability to grow at more than an anemic rate, a recent McKinsey report argues that enough pent up demand exists in several areas of consumer demand to allow for a 4% growth rate – if bureaucratic rigidities can be reduced or eliminated.

At this juncture, all the problems of Japan are amply documented and largely reflected in share prices, whereas one has to work hard to discern the straws-in-the-wind that may indicate change for the better. My own feeling is that the only bet we are making by investing in Japan is that the country will not sink into the ocean. In this view, I am in scarce company, but not entirely alone. Long Leaf Partners, an investment group with a superior long-term investment record, was recently quoted to say that Japan is now their largest geographic exposure. Also, two groups have recently contacted us, which are raising money to invest in management buyouts and other \"activist\" types of investments in Japan.

François Sicart

^© Tocqueville Asset Management L.P.
February 24, 2002