Japanese Stocks: Cheap for Good Reason?

Includes: EWJ, SHCAY, SNE
by: The Manual of Ideas

We’ve been doing some work on Japanese equities here at The Manual of Ideas and wanted to share a few quick observations. As you know, Japanese stocks have been in the doldrums for many years. They generally trade at low multiples of tangible book value, and many companies have significant real estate holdings that are not accurately reflected on their balance sheets.

We approached our study of Japanese stocks with the hypothesis that we should be able to find some compelling investments given the cheap valuations of a large subset of Japanese public companies. So far, however, we have remained unimpressed. A few points:

  • Lack of focus. Most mid-cap and large-cap Japanese companies still look more like conglomerates than focused Western-style enterprises. It’s almost as if major Japanese firms exist in an era pre-dating the age of specialization. For example, did you know that Sony (NYSE:SNE) has a life insurance arm and even owns a bank?
  • Murky corporate governance. Many Japanese companies’ org charts look like org charts of government entities in the U.S., with checks and balances and committees galore. The bureaucracy of Japan Inc. seems stifling. For example, Sharp (OTCPK:SHCAY) argues that it is a corporate governance leader, yet its org chart could be mistaken for that of a Chinese commune.
  • Little regard for returns on investment. Japanese companies routinely spend as much as 10% of annual revenue on capex, despite being in businesses with single-digit EBIT margins. While the companies include ROE calculations prominently in their annual reports, the firms exhibit little focus on improving ROE. Most companies keep making incremental investments despite ROEs in the mid single digits.
  • High-cost production base; currency mismatch. Many Japanese exporters have still not fully embraced outsourcing of manufacturing to low-cost locations, preferring instead to produce goods within Japan. This not only increases costs but also exposes the companies to yen appreciation (which has recently obliterated profits at many Japanese exporters).
  • Clubbish board rooms. So far, we’ve had difficulty finding female board members at major Japanese companies. Not that we're in favor of quotas or similar concepts, but it does seem that the lack of diversity in Japanese board rooms is emblematic of a lack of willingness to open up the culture and embrace new ways of doing business.

To be sure, Japanese stocks do not appear to have much downside. They generally enjoy significant asset protection, and their businesses appear sustainable. However, investors are likely to achieve impressive returns from investing in Japanese stocks only during short time periods of revaluation of price-to-book or enterprise value-to-revenue multiples. Assuming constant multiples, investors are likely to be disappointed, as they'll be earning returns similar to the companies’ returns on equity. The latter generally range in the low to mid single digits and appear unlikely to rise any time soon.

So as not to disparage Japan Inc. unduly, we also point out that Japanese companies have many good things going for them, including access to a highly skilled, hardworking labor force; superior technology and manufacturing processes; and a forward-thinking attitude on environmental matters.

A final note: We are beginning to understand what Warren Buffett meant when he told University of Florida students some years back that he had not found any investable companies in Japan. Buffett said something to the effect that Berkshire Hathaway could borrow money in Japan at only 1%. He then reasoned that all he needed to do was to find a company that would give him more than 1% per year over the long term. He concluded: So far, I haven't found anything.

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