Japan: Not Buying The Debt And Depression Story

| About: iShares MSCI (EWJ)

Economist and author Gary Shilling has written about Japan in "Japan's Debt Sustains a Deflationary Depression," his second submission of a five-part series about Japan at Bloomberg.com. While much fairer than typical depictions of Japan (e.g. referring to net govt. debt), it still reads to me like a lot of the same old commentary. In light of the debt and deflation/depression stories, I want to share a few not so mainstream ideas, which will hopefully help readers better understand Japan and why I'm investing there.

Japan's ostensible woes can be difficult for non-Japanese to truly grasp because not dissimilar to how it failed to become a global leader for instance in smartphones and other devices, Japan has been unsuccessful in properly marketing itself. Japan had things like mobile apps and netbooks before such concepts existed in the mainstream in the U.S. Manufacturers clearly dropped the ball in creating demand (or at least fulfilling it when it arose) and spreading product overseas. In a similar but different situation, the notion that Japan is on the brink of bankruptcy and ruin is so far from reality but one almost has no choice but to believe it because there is no official or high-profile voice suggesting otherwise. Chalk it up to politicking and also perhaps to nobody being willing to risk their reputation. Of course bad news sells well, too.

It would be unwise to make claims that Japan doesn't have problems, yet I think it's equally unwise that Japan doesn't promote facts that could possibly encourage both more domestic confidence and foreign investment. It could also lead to more constructive conversation. I would argue that quality of life has only improved, as opposed to deteriorated, over the past decade or longer. With all the doom and gloom one would think Japan had turned into an impoverished country full of old people hobbling around hoping to spot the rare sighting of a young person, unemployed, bee-lining from their parents' home to an internet cafe. Good luck. A visit to Japan will show it has all the modern comforts, at increasingly competitive prices, and with the same level of politeness. Imagine in the U.S having fast and punctual trains, affordable truly high-speed broadband, and real convenience stores.

Back to Shilling. One of his arguments is that borrowers are "scared" and lenders "reluctant." That argument is misplaced by almost ten years. The truth is lenders would love to lend more, but there's rather limited demand (over the past several years in particular) since corporate balance sheets are on the whole replenished and high-quality with large cash balances -- no shortage of net-cash among publicly-traded companies. Nevertheless, it's not like there's no lending going on; one need only look at the relative brisk pace of outbound M&A behind the strong yen. Accordingly, when investing in Japan one could take an approach of [1] buying very attractively priced individual Japanese companies, not the broader market itself (which trades at a 10%+ discount to book value), and/or [2] buying companies Japanese in name but global in end user. Thanks to a mix of investor bearishness and disregard, opportunities are plentiful.

Among my own investments and research I'm seeing instances of companies borrowing from banks at very favorable rates for short- to mid-term durations (and in some cases publicly acknowledging such advantageous terms) as they expand both domestic and overseas operations. Companies that aren't borrowing include ones that are cash-rich and debt-free, at the extreme of which (based on size and brand recognition) is Nintendo (OTCPK:NTDOY) (JP: 7974). It recently has traded for a nominal premium to its net cash and securities. And as for individual borrowers, consider that the Bank of Japan estimated last September citizens had assets of JPY1,471 trillion or nearly $19 trillion at the current exchange rate. Consumer credit amounted to a mere 2% of their assets, mortgages, 10.5%.

So what's wrong with Japan besides the possibly misguided favorites among the series of d's: debt, deflation, demographics, and low G'D'P, none of which I believe are as bad as perceived. Why with rates so low and banks wanting to lend more is there not more lending? One key issue is the aforementioned abundance of corporate cash, and another is due to domestic and overseas conditions of oversupply and/or saturation -- more so in consumer electronics and components in terms of both domestic and global oversupply, and intense competition in many industries domestically in terms of saturation. Most industries in mature economies face these kinds of conditions. Still, there have been winners in Japan over the last so-called lost decade.

Today, even despite the difficult operating conditions, including the horrible year that was 2011 (3/11 triple-disaster and severe flooding in Thailand), as well as record yen strength, Japanese companies have largely remained profitable. Moreover, a solid selection of domestic demand companies even reported record fiscal-year earnings (year ended March 2012) and/or are forecasting such for the current fiscal year - I'm cited mentioning this in Barron's recent coverage of Japan. And if we consider the excess cash on balance sheets, already low P/Es (broad market forward P/E of roughly 11), become that much cheaper. Finally, the old gripe that Japanese companies skimp on dividends (another 'd') doesn't hold water (broad market dividend yield of 2.2% - 2.4%).

I am unmoved by the usual arguments that invariably result in red flags about Japan. The country's situation is unenviable but nowhere near as dire as one would be led to believe. Government debt is high, but it's not imminent collapse time, to the dismay of those betting on such an outcome. By the way, when is the last time you've heard of a Japanese investor or trader betting on the collapse of the dollar or Treasuries? At the corporate level, where indebtedness is not an issue, it should be more about how to more efficiently and effectively use the cash piles, particularly to better compensate younger workers, the very ones who should be having (more) children, getting married, and making purchases that come with having a growing family. There's clearly potential for a virtuous cycle.

Instead of trying to raise the national consumption tax I would support establishing a baseline for taxing over-capitalized companies that intend to continue sitting on excess cash. The government could also get much better at actual tax collection before sticking a tax hike to consumers at the point of sale. Having experienced what Richard Koo calls a "balance sheet recession," the above are just some of the reasons behind the Japanese government's indebtedness and companies' and individuals' wealth at large, and the market's undervaluation. To conclude, know that companies will increasingly realize compensation cost savings with older employees retiring. Thus, it's not a big leap to better compensate younger workers, though companies would initially forgo some of the margin boost.

Amidst all the known bad news, I find plenty to like as a value investor in Japanese stocks. I know there are bound to be "but what about …" questions, and of course concern about the yen. Again, keep in mind the profitability achieved against such a horrendous 2011, and even domestic demand companies reporting such strong results and forecasts against unfavorable conditions. With the ability to take any number of investment approaches in Japan given such broad/deep undervaluation, I am not losing sleep over currency movements. In my next article I will discuss two of my favorite investments among ADRs and why I don't particularly like the iShares MSCI Japan Index ETF (NYSEARCA:EWJ), though it's the de facto Japan proxy in the U.S.

Steven is the author of "Investing in Japan" (2012). Written from a value investor's perspective, Steven provides a comprehensive overview of the market and investment funds on both sides of the Pacific, explains key idiosyncrasies, and much more. The only English-language book in recent history focused on Japanese equities, Investing in Japan offers a fresh look at Japan, which the author calls the world's most undervalued and misunderstood market.

Disclosure: I am long OTCPK:NTDOY.

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