Real Numbers And Thoughts Behind A Weak Yen And Japan's Exporters

| About: iShares MSCI (EWJ)

History may not repeat exactly but it often rhymes, as Mark Twain observed, and as we market participants like to say. The love-hate sentiment for Japanese stocks, ultimately culminating in "false-start" rallies over the past two ("lost") decades and articles invoking a "rising sun" are all evidence of such. As someone with close ties to Japan, yes, I'm hopeful there's an improved macro environment on Japan's horizon. However, as a fundamental value investor, others' claims of rising suns, JGBs being the greatest short ever (with many prophets not even having skin in the game), Japan being a "bug looking for a windshield," and adult diapers outselling baby diapers, all mean very little in practice. In other words, it's mostly recycled noise.

Articles (and their authors) equating buying the iShares MSCI Japan Index EWJ to "playing" the Nikkei without mentioning the differences in the two should probably not be writing about Japan. Fundamentally, EWJ is a different and materially larger index than the Nikkei 225 (see here). If one wants to simplistically "play" Japan then by all means one's best bet is probably none other than EWJ given its trading liquidity and expense fee. Just don't be disappointed if the returns differ from and lag the real N225. Beside the obvious difference in composition, it goes without saying that foreign exchange rates will impact EWJ and its constituents, especially the exporters among them. See exhibit one below.

N225 - EWJ - 1 yr chart

As a former longtime Japan resident, investor in Japanese stocks, and writer about Japan's markets, I find the best value and most interesting investments to be in domestic demand-related stocks. The exporters at times can certainly represent compelling value opportunities, especially at presumable recent cyclical lows. However, these companies may not have the best margins of safety among value stocks, and timing is also difficult, not to mention so many closely-watched metrics and closely-watching analysts (though numbers of the latter have been declining in Japan) - Nidec (NYSE:NJ) somewhat fits that description today. Thus, these cases are less attractive than stable domestic-demand companies whose fortunes aren't contingent on the latest ECB meeting. A rare exception is Nintendo (OTCPK:NTDOY) (Osaka/Tokyo 7974). I know, I know, Nintendo is gimmicky: I've heard all the Nintendo's-best-days-are-behind-it arguments. But when a world-class company has no debt, cash/equivalents equate to 50-60% of market capitalization, and profitability is imminent, I can't resist.

My preferences notwithstanding, let's see then what a weaker yen means for the beloved at times, despised at times, Japanese exporters. (The CurrencyShares Japanese Yen Trust (NYSEARCA:FXY) declines in value as the yen weakens, it is trading at a 52wk low; lowest since April 2011.) A recent article in the Nikkei detailed what a one-yen change in the dollar/yen (and euro) rate would mean for a group of 30 automobile and electronics companies (aka the exporters). At a then ¥83/$1, the 30 companies would expect to see an aggregate ¥237 billion (~$2.7B) increase in operating income. As can be seen from the table below, and more broadly according the Nikkei, Japanese companies have previously forecasted a rate of around ¥79 on average. As the yen is now above ¥84 their forecasts are already 6% off, and that's a good thing (unless you are in the airline business, that is). Even more significant is the 10%+ difference in their euro forecast. The resulting one-yen changes in operating income speak for themselves! These are the unspoken numbers that have been/are being factored in implicitly in this fourth-quarter rally. As of intra-day Dec. 19, the broad Topix I index trades right at book value, 20.5x trailing earnings, and 16.4x forward earnings.

Forex forecasts and 1-yen impact on operating earnings
Company $ est. € est. OI Δ
Toyota (NYSE:TM) 78 100 350 50
Honda (NYSE:HMC)


105 160 10
Nissan (OTCPK:NSANY) 80 103 200 0
Sony (NYSE:SNE) 80 100 0 60
Panasonic (PC) 78 97 25 20
Hitachi (OTCPK:HTHIY) 78 103 42 8
Canon (NYSE:CAJ) 78 100 92 54
Komatsu (OTCPK:KMTUY) 79 97 58 4

Ordinary shares of Toyota (Tokyo 7203) have gained 45% year-to-date (ADRs +35%), with more than half of that coming the past month. The N225 is up 17% with nearly all the gains achieved since mid-November. There's obviously some serious operating leverage that will impact - in this case, boost - the exporters, and what's not mentioned are the values of dollar and euro-denominated cash that will need to be marked up. Whether the stock market gains continue to get tacked on depends largely on the new PM Abe's ability to deliver on his declarations to weaken the yen and bring inflation -- and most importantly how much time the market will afford him, his Cabinet, and the BoJ, to accomplish the heretofore elusive targets. So far the yen has been declining, which ought to help initial approval ratings. In addition to generating inflation, naturally all eyes will be on actual economic growth.

Meantime, the same worries persist, externally with the "fiscal cliff" here in the U.S., China's economic growth, Europe's various challenges, Iran, etc, and looking inward there will be a lot of talk about Japan's finances, it being the most indebted country in the world, although with many forgetting to mention its vast reserves and its at least until now ever-lower rock bottom refinancing rates. I am compelled to say that it's not exactly clear to me how one can either create the inflation desired nor sustain it using monetary policy unless one really were to air drop Fukuzawas ("Benjamins" in Japan). That's another article, but the failure of monetary policy in Japan is partially due to overcapacity, which is one reason why I'm less inclined to like the exporters in general.

As an alternative to debasement, in light of some $19 trillion in assets the Japanese citizens own, with negligible consumer debt (and it would be the rare case that one is going bankrupt over student loan debt or medical bills), and the overall sound balance sheets of companies, the government and companies should be trying to find ways to unlock and make more efficient all this pent up capital. Low-hanging fruit solutions include paying dividends quarterly as opposed to biannually - paying junior and mid-level employees more and/or making more of them full-time employees (I argue this is a no-brainer to supporting earlier and larger family formation); introduce a more market-making instead of the auction trading system that prevails on the TSE, and do away with minimum share purchase requirements.

It's not only the Japanese anymore that are yield hungry. Japanese companies have been increasing their dividends. A once regarded buy signal of dividends exceeding 10-year JGBs has become useless with dividend yields double the benchmark. Now companies need only to increase payout frequency. Boosting compensation is easier as higher-paid senior employees retire. Arguably the executives themselves ought to be compensated higher, too, as they receive a fraction (yes a fraction) of what their counterparts in the U.S. are paid. Finally, the market needs more liquidity outside the "exporters," "mega banks" and select net/wireless stocks.

Will this rally continue, gain momentum, be sustained, or fizzle out? Nobody knows. In some ways, as I have been tweeting recently, the favorable sentiment feels like it did during the strong 2005 Japanese market behind then PM Koizumi and his controversial but successful bid to privatized Japan Post. Japan was blessed with a strong global economy then, but that rally faced serious headwinds in 2006 beginning with the Livedoor scandal. We already had the mother of all Japanese corporate scandals in more recent history: Olympus. What could derail the good times this time?

There are a few serious yen and JGB bears that would relish in a blowup. Extreme moves could scare investors. My belief, however, is that the move in the yen will resemble its move surrounding the 2005 rally, which was a roughly 10% decline. Even if we see a 20% decline that would hardly be the end of the world (all things equal it would be mostly big smiles across corporate Japan); although the weaker yen did offset correspondingly the gains of dollar-based investors in '05. JGBs are a more concerning matter, but with Japan's printing press, if that's the ultimate solution, so be it. Maybe Kyle Bass adds to his fortune and legacy, maybe he doesn't. There are plenty of companies producing products and services that are in demand, and real people (not just robots) are working hard and care about their job/company/society. The hyperbole about demographics, deflation, and debt will surely, ultimately bring disappointment to doomsayers.

To conclude, beside Nintendo I am researching and buying high-quality domestic-focused Japanese companies that typically trade well below book value, have single-digit P/Es, rising dividends, and are investing in their businesses. I liken this to having opportunities that fit the ideal characteristics of both Benjamin Graham and Warren Buffett. For all the talk of lost decades it may come as a surprise that quality of life in Japan is better than it was during the bubble years. Some thanks is owed to none other than the stronger yen. Japanese people and companies have weathered some of the worst that mother nature and macro economics can possibly throw at them. The aforementioned 20x trailing P/E of the broader market is not so expensive in light of that. The 16x forward earnings level doesn't factor in already material moves in currencies. And it doesn't reflect in some cases very over-capitalized balance sheets.

I'm happy to see investors find opportunity in Japan, again, but for the sake of Japan needing to catch a break, and understanding the capriciousness of investors, I hope both the basis for the rising market will be realized and that financial advisors, investors, and portfolio managers won't feel shortchanged "playing the Nikkei" with EWJ. The same holds for many of the Japan-focused mutual funds and closed-end funds available to American investors.

Steven Towns is a co-founder of Nippon Value Capital, an activist hedge fund startup seeking to enhance Japanese equity valuations through a combination of improved asset efficiency, excess capital allocation, and corporate action. Steven is also the author of Investing in Japan: There is no stock market as undervalued and misunderstood. The only such book published in English in recent history, the author believes it will prove timely in light of historically-low equity valuations and timeless for its comprehensive explanation of the market's structure and various idiosyncrasies.

Disclosure: I am long OTCPK:NTDOY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long individual Japanese stocks and ADRs not mentioned in the article. No short positions in any securities mentioned in the article.

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