The Sun Also Rises?
A Contrarian Take on Japanese Equities
One of the questions we are asked most often by investors is why we would invest in Japan. Normally, there is a slight tone of derision in the question, as if to say: “Everyone knows that Japan has poor demographics, a huge public debt and weak growth prospects.” And of course, all of these things are true. The answer goes something like this: “Everyone thinks Japan is sinking into obscurity and this negative sentiment provides us with the opportunity to buy what we consider to be excellent global franchise businesses at attractive valuations.”
Recently, Japanese equities have been suffering from a quadruple whammy, a confluence of four negative factors, which has compounded the general disinterest in the market. They are: a slowdown in global GDP, which hurts demand for Japanese exports generally; a slowdown in China’s GDP, which hurts demand for Japanese capital goods that go into China’s factories and mines, inter alia; the remarkable strength of the Yen, which makes Japanese producers less cost competitive on a global stage and/or less profitable; and sabre rattling and protests in China in relation to disputed island territories and concern that this could result in Chinese boycotting Japanese products. As a result, Japanese stocks, which for a decade had traded in close correlation with U.S. stocks in US $ terms, broke ranks in 2011 and have lagged the S&P 500 by some 25% over the last two years.
Nikkei 225 vs. S&P 500
Total Return in US $
As bottom up stock pickers, a contrarian take on a geography or sector is often the starting point for new idea generation; the storm of negative factors effecting Japan combined with the poor market performance is just of the sort of situation that piques our interest.
Viewed in a broader context, the Japanese stock market has undergone a multi-year process of de-rating, which is to say that the multiples of earnings, cash flow and book value that investors are willing to pay for Japanese stocks, have been in decline. During the last 12 years – not a magic timeframe, but one which roughly corresponds with my stewardship of Tocqueville’s International strategy – the total return for the Nikkei 225 Index in US$ terms has been approximately zero. At the same time, the consolidated EBIT margin for the companies that comprise the index has gone from roughly 9.5% to 11.4% , aggregate earnings for profitable companies have gone from Yen 438 billion to Yen 608 billion and, importantly, the return on equity has increased from around 6% to around 10%. Correspondingly, the price to earnings ratio for profitable Nikkei 225 companies has gone from 24x to 15x, while the price/book value has compressed from 1.7x to 1.1x and the dividend yield has increased from 0.8% to 2.3%.
Nikkei 225 - Price to Earnings vs. EBIT Margin & Return on Equity
There will be a moment when the broad process of de-rating has run its course. With valuation multiples having compressed to quite reasonable absolute levels, we may be approaching that moment.
More immediately, the perfect storm that has been hobbling Japanese equities will clear, gradually or not so gradually. The noise about the islands will likely dissipate with time. The Chinese economy, which has been depressed this year as the nation undergoes a change in political leadership, is showing signs of recovering. Global GDP growth in the developed world is weak due in large part to the financial crisis in Europe, uncertainty deriving from the prospect of the fiscal cliff in the U.S., and their respective impacts on the behavior of consumers and corporate managements vis-a-vis spending. It would not surprise us, with several governments having enacted stimulus measures and interest rates in Europe having come down, to see global GDP stabilize and even pick up in the coming months. And then there is the question of the Yen. The conditions that should cause a weakening of the Yen have been in place for some time; that is, weak economic growth, a very high ratio of government debt/GDP, and an aging population that promises to put more strain on the nation’s fiscal balance. The Yen has defied economics for some time, in part because Japanese investors’ reflexive response in the face of risk is to bring money home and invest it in Yen-denominated assets, and because with domestic deflation, real interest rates in Japan are actually higher than their U.S. counterparts, which are being suppressed by government policy. It has been a fool’s game to guess when the Yen would finally weaken, but economic healing in the West and eventually inflation and rising interest rates here could certainly be a catalyst, as could money printing in Japan. Meanwhile, the strong Yen has forced exporters to become more cost efficient in Japan and to move production to lower cost sites in Asia, which will enhance their profitability in the long run.
According to Merrill Lynch’s Global Fund Manager Survey, global fund managers have the lowest net exposure to Japan in 10 years, 1.4 standard deviations below the average.
In our exploration of Japan as a contarian them, our bottom up stock selection had tended toward exporters that are global leaders in niche businesses. In broad terms, we have been buying companies in areas where Japan excels, including high technology content auto parts, precision equipment, tools used for precision measuring in industrial and other processes, and equipment and tools used in the manufacture of electronics, to name a few. Our discipline generally is to buy good business franchises at a discount to their intrinsic value, and we are not as focused as many investors on catalysts and timing for the realization of value. That being said, with expectations so low and the market having underperformed, we would not be surprised to see the sun also rise in Japan.
November 14, 2012
This article reflects the views of the author as of the date or dates cited and may change at any time. The information should not be construed as investment advice. No representation is made concerning the accuracy of cited data, nor is there any guarantee that any projection, forecast or opinion will be realized.