Japan has been on our radar screen for quite some time. The aftermath of this year’s Great East Japan Earthquake has given us the impetus to look at this market in more detail, and to try to identify some bargains among Japanese mid and large cap stocks. These companies are quite accessible to non-Japan based investors, as they trade on one or more stock exchanges in addition to the Tokyo Stock Exchange.
When an already cheap market becomes even cheaper due to an exogenous shock, value investors are bound to take notice. While the human toll of the Great East Japan Earthquake has been devastating, we have confidence in the ability of the Japanese people to rebound from disaster. Japan has gone through many trying periods in history, repeatedly emerging with a newfound zeal to grow and prosper.
click on images to enlarge
Japan Remains an Economic Powerhouse
Most of the issues that have kept investors away from Japan over the years remain today. Japanese companies, to this day, have not embraced a goal of achieving strong returns on equity. Corporate boards remain entrenched, and value-unlocking strategic actions remain an exception. On the positive side, many Japanese companies are highly competitive on a global scale and have built truly global brands such as: Canon (CAJ), Sony (SNE) and Toyota Motor (TM). Executive compensation at Japanese companies remains reasonable, which contrasts sharply with the experience of major U.S. corporations.
Japanese companies’ balance sheets tend to be among the strongest in the world, with many large companies owning substantial excess assets. The latter can be seen as a positive or a negative, but the fact is that much improvement is possible with Japanese companies. Excess assets could be rationalized over time, while returns on equity have ample room for improvement. Contrast this with corporate America, where profit margins have almost nowhere to go but down.
Unemployment Has Increased but Remains Quite Low
Here are a few lessons from our research into Japanese companies:
- There is no such thing as a “Japanese” company. However, there is Canon which derives approximately 80% of revenue from outside Japan. There is Advantest (ATE) which is set to become the largest global producer of semiconductor test equipment following the acquisition of Verigy (VRGY). And there is Toyota, which created the world’s first mass-produced hybrid car. These firms are leaders in their industries and defy being labeled “Japanese.”
- Company-specific factors remain paramount for valuation. Companies like Kubota (KUB) and Mitsui (OTCPK:MITSY) are benefiting from the same trends that Caterpillar (CAT), and Glencore International Plc are taking advantage of. They also face similar risks, which likely outweigh the risk associated with a Japan-based headquarters.
- Governance is not all bad. In our research, we’ve mostly come across committed and experienced managers who are not overpaid or incentivized to bet the house every day they walk through the doors. Another, often overlooked, fact about Japan’s corporate governance is that it is a shareholder meeting system, not a board-level governance regime. Shareholders have strong legal rights, and can call a shareholder meeting at will. If shareholders want to dismiss the board or double the dividend, with enough votes, it can be done even against the board’s wishes.
- The Mitsubishi UFJ (MTU) factor. The Japanese mega bank, with customer deposits representing two-thirds of total assets, has avoided the fate of some of its Western peers during the 2008/09 financial crisis. Indeed, it has taken advantage of weaker rivals to buy up assets, including community banks in the U.S. as well as a stake in Morgan Stanley. Supported by strong balance sheets, many Japan-domiciled companies are similarly expanding their businesses. On the other hand, quite a few Western firms have taken on debt to buy back shares at the top of the market, ruining investors in the process. So much for “efficient” capital structures.
- The key issue is long-term competitiveness, not how “Western” the management culture is. It is under-appreciated how well-invested Japan-based companies are, and how much they spend on R&D to advance their competitive moat. However, this is one of the key determinants of long-term shareholder value. On this account, it is interesting to observe how former household consumer electronics companies such as Fujifilm (OTCPK:FUJIY) and TDK (OTCPK:TTDKY) have stumbled and are attempting to reinvent themselves. Similarly, Sony investors would probably prefer if Howard Stringer could win some product battles against the likes of Apple, than if he were to split the role of CEO and chairman, or sell the financial services business.
Japanese Stock Market Remains Significantly Below 1989 High
Mark O'Friel, former head of the Tokyo office of hedge fund Steel Partners and current managing partner of MOF Capital, told us recently:
What is overlooked in the reports and pictures of the disaster is in fact how well prepared Japan was and how the damage was minimized. The earthquake itself, despite its unprecedented size, caused relatively little damage. Even near the epicenter, collapsed buildings and deaths were few. This is after the main earthquake of 9.0 and over 800 aftershocks greater than 4.5.
The before and after satellite pictures now available on the web are testimony to the power of nature. The pictures now and the pictures one, five and ten years from now will be testimony to the speed and efficiency of how Japan can rebuild physical infrastructure. Japan has a long history of rebuilding, from the aftermath of World War II to the Kobe earthquake. Despite high levels of government debt, the government actually has quite a bit of leeway. Ten-year JGBs have remained quite strong.
We agree with O'Friel that Japan will overcome its recent troubles and go on to make major contributions to the world economy. While it may be hard to believe that the Japanese stock market will ever embark on a sustained bull run again, our analysis shows that Japanese stocks are cheap while having large exposure to global growth. We believe the time is now for long term-oriented investors to start evaluating Japanese investment opportunities.