Japan’s '80s 'Bubble' Has Completely Deflated - and Then Some

The credit crisis fingers of instability are engulfing essentially all financial markets—interbank lending, commercial paper, stocks, commodities and now currencies in the great de-leverage. Even the gold-backed South African rand is down 40% against the US dollar, while the US dollar itself is down 27% against the yen since November 2007, and the yen’s trade-weighted index is up 35.6% since June 2007. The yen has soared above JPY90/USD for only the second time in post-war history.

While the strong yen is a symptom of the credit crisis and plunging global equity and commodity markets, it feeds into the negative feedback loop that is currently pummeling Japanese equities. John Mauldin and others have been talking about a long-term secular bear market in terms of valuation for the US market for some time, while Japan’s stock market has actually been in a long-term secular bear market since a historical high of 38,957 on the Nikkei 225 hit in December 1989.

During the bubble, which is generally believed to have begun in 1983, Japanese P/E multiples surged to the 80s and 90s and the market traded at several times book value while dividend yields were miniscule. In other words, stock prices were discounting earnings growth for the next century.

On Monday, October 27, 2008, the Nikkei 225 index closed at 7,162.90, its lowest point since October 7, 1982, before the infamous 1980s bubble began. The trailing P/E multiple for the Nikkei 225 was 8.58X and the forward multiple 9.53X, while the Nikkei 225 PBR was 0.87X, while forward dividend yield was 3.07% versus a historical dividend yield of 2.97%. The Nikkei’s earnings yield (inverse of the P/E multiple) was 10.47% on historical earnings and 9.92% on forward earnings, while the market’s ROE was 10.1% on trailing earnings and 9.1% on forward earnings—versus a JGB (Japanese government bond yield) of 1.47%. In other words, market valuations are also back to pre-bubble valuations that existed some 30 years ago.

Then, foreign investors strongly believed that Japan would never be able to recover from the oil shocks because of its high dependence on imported oil and other key raw materials. I have lived in Japan since 1971, I remember when the city officials used to turn off all of the neon lights in Shinjuku (Tokyo’s tinsel town) after midnight to conserve energy. I also remember panicked Japanese housewives lining up to buy, of all things, toilet paper. But Japan and its major companies survived.

Then it was soaring oil prices. Now it is a global credit crisis exacerbated by an ultra-strong yen. As was dramatically demonstrated over the past week, Japan’s stock market moves in inverse to the yen once the yen breaches JPY100/USD because this level of yen strength (not only against the USD but also against virtually all of the currencies of Japan’s major trading partners) decimates the earnings of Japanese exporters, who normally also account for a significant amount of aggregate corporate profits.

However, major Japanese companies already have demonstrated they can survive a year of ultra-strong yen, when the yen traded to an historical high of JPY79.5 in 1995 and stayed above JPY100/USD for about a year. They also survived a serious deflationary $1 trillion liquidation of non-performing loans in Japan’s banking industry during the Heisei Malaise.

For the fiscal year to March 2003 (a year before the the end of the Heisei Malaise), operating profit margins were 4.9%, return on equity was 3.8%, equity ratio was 29.6%, and cash on hand was JPY39.3 trillion. As of the March 2008 fiscal year, operating margins were 6.1%, ROE was 9.3%, equity ratio was 36.5% and cash on hand was JPY46.7 trillion.

Despite this, some 800 stocks listed on the first section of the Tokyo Stock Exchange traded at PBRs of between 0.40X and 0.60X as of the October 27 close of 7,162.90, i.e., these companies were trading at 60% to 40% discounts from stated book value. Essentially, these stocks are trading as if they might go bankrupt, or at least show a couple of years of earnings deficits that would book value by an equivalent amount. On the other hand, there is little on the balance sheets of these companies (which do not include any banks) in terms of bad debt that needs to be discounted from book value. In other words, a lot of good Japanese companies have been thrown out with the bath water.

For example, Toyota (TM) (7203), arguably the world’s strongest automobile company and Japan’s best company, is now selling at a 16% discount to book value, sells at a P/E multiple of 8X and offers a dividend yield of 4.4%. While the company stands to lose JPY600 billion or over 30% of operating profit if the yen continues to trade in the JPY90/USD range, earnings will still be positive. Moreover, the company has interest-bearing debt of JPY12.21 trillion versus shareholders’ equity of JPY11.87 billion, annual cash flow of JPY3.0 trillion, and cash and deposits on hand of JPY2.36 trillion. In addition, return on invested capital is some 9.3%.

Currently, Toyota is trading as if it might go bankrupt. If this company is going bankrupt, the entire global automobile industry is bankrupt. If it is not going bankrupt, it and the other blue chip companies selling at noticeable discounts to book value will at some point in the future begin trading again as going concerns.

Disclosure: none

Comments

[Alex Filonov:]

Well, Toyota trades at 0.86 book value today. Triple buy? Not so fast. Company has huge, $143 billion dollar debt, of which as much as $62 billion is short term or current (data from Yahoo! Finance). Comes refinancing, and company most probably would have to pay through the nose, at least hundred basis points more than last year. Caterpillar last debt offering is telling: CAT paid about 180 basis points more this time than for their last offering.

2008 Oct 29 02:16 PM

[Darrel Whitten:]

Here's how Toyota's consolidated debt breaks down as of March 2008, or end of FY07.

-Total Debt (@JPY100/USD) : $122 billion

(S-T Debt)
S-T Debt: $35 billion
L-T Debt due in one year: $24 billion

- As of the end of March 2008, the company had an unused credit line of some $26 billion. Remember that Toyota can borrow in Japan at much lower rates.

- S-T debt includes commercial paper of $23 billion at an average interest rate of 3.76%

- Other short-term debt of $12 billion-plus at average interest rate of 3.36%.

- $54.5 billion of medium-term notes are due in stages between 2008~2027. 2008 portion included in "long-term debt due within 1 year".

(Bloomberg) **Yields on three-month corporate debt with the highest credit rating rose to a 12-month high of 0.83 percent on Sept. 25, the week after Lehman Brothers Holdings Inc. filed for the biggest bankruptcy in U.S. history.
Japanese banks are rushing to the blue-chip names, so the companies benefit from tighter spreads on loans.

Doesn't look like Japanese banks are running away from refincing by large, blue chip Japanese companies.

2008 Oct 30 02:14 AM

[Karim:]

Darrell, I have followed your writings which I find very valuable. As a counterpoint, Edward Hugh's article on Seeking Alpha (Japan's Grim and Bear It 2009 Outlook) seems to indicate that the public sector in Japan can do very little to help its economy and that, with foreign export markets reeling, Japan is set to enter into a severe decline. Assuming he has a (very little) point, how do you think that earnings underperformance in 2009 and maybe 2010 would affect the level of the Nikkei 225 or that of the main large Japanese companies' stock valuations & related P/Es? Thanks. Karim

Feb 10 11:51 AM