Land of the Rising Stocks: A Conversation with Neil Hennessy

Includes: FJTSY, SNE
by: Benjamin Shepherd

It’s been a long time since Japanese companies received much love from investors. Even as Asia has become the investment destination for both retail and institutional investors looking to get a piece of the region’s growing economic prosperity, most funds make it a point to avoid Japan, a country that’s struggled with deflation and a weak economy for decades. But Neil Hennessy, portfolio manager and chief investment officer of Hennessy Funds, makes the case that that Japan is undergoing a structural transformation that will alter the face of the Japanese government and the way the nation does business.

Q. Why Japan and why now?

Neil Hennessy (NASDAQ:NH): The exact same question went through my mind: Why? You can’t find an uglier chart. The Japanese market has been down for 20 straight years, so you can’t blame people for not being energetic about its prospects. But you have to remember that you’re buying global companies headquartered in Japan.

If I look for value names in the US based on price-to-sales ratios, why not apply this valuation metric to Japan’s Topix Index? By this measure, you can buy a dollar of revenue today for 60 cents.

The last time I saw that was March 2008, when you could buy a dollar of revenue for 60 cents on the Dow Jones Industrials.

In the BRIC nations (Brazil, Russia, India, and China) and the emerging markets, it costs $1.80 to buy a dollar of revenue.

Japan’s market is highly regulated, and it’s the second-largest economy in the world why pay three times the price to sales to take on the added risk of emerging markets?

It’s true that over the last 10 years the BRIC markets are up 465 percent, while Japanese equities are down 41 percent. And quantitative measures don’t paint a pretty picture: the population is aging, the workforce is shrinking, fewer babies are being born and the country is saddled with debt. None of these stats inspire confidence.

Why would I want to invest in Japanese equities? Two major shifts are underway in the country.

The first factor is the change in government that occurred last year.

Although there have been a lot of false starts with new governments over the years, this is a really proactive government that wants to see Japanese companies to do well globally.

For instance, the government recently had representatives in the US trying to win contracts for Japanese companies to build bullet trains. It’s unheard of for the Japanese government to try to sell other countries on the virtues of its companies.

The new government also wants the economy to be a bit more consumer driven. It also wants tourism to multiply to four times its current level. Right now, about 6 million tourists go to Japan annually; they want to increase that number to 25 million people. Only 125 million people live in Japan; meeting this goal would involve 25 percent of the population coming in and out every year.

One of the interesting parts is that China is three hours away, and 1.3 billion people live there. We also know that the Japanese and the Chinese have had strained relations for centuries.

Up until recently, the Japanese government required a Chinese citizen seeking a visa for anything other than business or governmental purposes to travel with at least four people and a tour guide. But as of July 1, if a Chinese citizen makes approximately USD35,000 or more a year in China, Japan will grant that person a visa to travel wherever he or she wishes. Japan is marketing itself to the Chinese as a tourist destination.

The other major story is that Japanese corporations are changing.

Until the early 1990s, the government controlled the banks, and the banks controlled the public companies in which they invested because they were their clients. Other shareholders were just sort of dangling out there.

Then came the banking problems in the late ‘90s and early 2000s, when the major banks had to divest liquid assets to shore up their books.

What where those liquid assets? Shares of public companies, many of which were sold to foreigners who demanded much higher returns on their money.

That’s forced Japanese companies to become more transparent, more open and more shareholder friendly. This shift is driving a desire to generate higher profits and to pay dividends.

The Wall Street Journal recently ran a big story about the fired president of Fujitsu (Tokyo: 6702, OTC: FJTSY).

The company had a board of nine people who refused to talk to the reporter, but the displaced president stated that he wanted to close unprofitable businesses and remove layers of middle management.

That’s an enormous cultural shift for the Japanese; the board didn’t see things his way, leading to his dismissal. The deposed president has sued Fujitsu for wrongful termination—an unheard of step in Japan.

Sony Corp (NYSE: SNE) is another example of this cultural shift. The electronics giant has struggled to make its manufacturing plants profitable, so management sold two television plants to a Taiwanese company.

And consider Nippon Sheet Glass (Tokyo: 5202), one of four companies in the world that makes windshields and big sheets of glass. Management just hired an American who formerly worked for DuPont (NYSE: DD) to run the company in Tokyo.

The Japanese view of business is clearly changing, and these companies are shifting to become global enterprises. Disregard all the negatives associated with Japan and remember that you’re investing in global companies that just happen to be headquartered in Japan.

The game of employment for life is over, the bureaucratic government is gone, the old-boy network is gone and Japan is entering a new era.

Q. How competitive can Japanese companies really be in export markets? Can’t other countries in the region produce goods more cheaply?

NH: Over the past 20 years the Japanese market had a lot of false starts because many investors assumed the Chinese and Indians would purchase a lot of consumer goods. But households in these emerging markets bought the necessities—not lifestyle products.

Now consumers in China and India have moved beyond necessities; now they want things that enhance their quality of life.

This sounds simple, but it has bullish ramifications for companies like diaper-maker Unicharm Corp (Tokyo: 8113). A diaper isn’t a necessity in China, but 18 million babies are born every year.

Now Chinese families want diapers, bottles with nipples on them and feminine hygiene products—all simple products that enhance quality of life. Now that the Chinese are becoming wealthier, they’re buying more and more of these things.

If you think about Japan’s relationship with the US, the Japanese made the Americans happy by building cars, televisions and electronics for us.

Now our markets are saturated, but the huge number of new Asian consumers is a massive opportunity for Japanese companies.

And Chinese manufacturers can put out a lot of units, but the quality is lacking. That’s an issue as Chinese consumers become more discerning.

Q. Are there any key industries that investors should consider?

NH: In the 1960s Japan had a major problem with pollution, which it has since cleaned up. In the process, Japanese companies gained a lot of know-how about remediation processes.

Many of China’s industrial cities are in a similar situation today and are looking for ways to clean up the mess. Well, guess what? Japanese companies can do it, and they’re just three hours away.

Q. What’s the biggest reason for investors to look at Japan now?

NH: As the Japanese market turns the corner, its performance will resemble that of emerging markets. Why take on the added risk of investing in emerging markets that can be fraught with criminals and fraud?

Japan’s markets are highly regulated, and while scandals do occur, they’re far less frequent than in emerging markets.

Although Japan certainly isn’t as sexy as the BRICs or other emerging markets, there’s a ton of money to be made there.

Disclosure: No positions