Are Japanese Businesses Worth More Dead Than Alive?
Benjamin Graham travels 79 years and 6,700 miles.
Part 1: Selling Businesses for 50 Cents on the Dollar
In 1932, in the midst of a more than an 80% decline in the U.S. stock market, Benjamin Graham wrote an article for Forbes magazine titled, “Is American Business Worth More Dead Than Alive?” In his 3-part series, Graham examined several important issues facing investors at the time, including market sentiment, dividend policies, and company liquidations.
The following article is a humble ode to Graham’s original work and includes several Japanese and U.S stock comparisons in the Grahamian tradition, which may be found in the appendix. A link to Graham’s original works and brief synopses of his 3-part series are also included in the appendix. JP:8066 MITANI CORP.
- Cash & equivalents $600,000,000
- Receivables & inventory 858,000,000
- Factories, real estate, etc 333,000,000
- $1,791,000,000
- Less owing for current accounts$1,081,000,000
- Less any debt $165,000,000
- Net worth $545,000,000
- Last Year’s EBIT $109,000,000
The purchaser looks over your statements and offers you a bid of $406 million for your business-- the cash, receivables, inventory, real estate, all the assets that have produced on average $82 million of profit over the past 10 years. For the offering price of $406 million, would you sell? Even after the company has bought back shares and returned $34 million in dividends to shareholders over the past 5 years?
This must surely be in jest: who in their right mind would trade $600 million of cash in a company they own for $406 million? And along with the rest of the company’s productive assets!? As crazy as it sounds, this very deal, and hundreds like it, are taking place on Japanese markets on a daily basis. Although we would agree that Microsoft (MSFT), Dell (DELL), and Cisco (CSCO) look cheap by many standards, they’re nowhere as cheap as a Mitani or hundreds of other Japanese stocks right now.Part 2: Why Mr. Market Doesn’t Like Japan and What He’s Likely Forgetting
Why Mr. Market is So Depressed About Japan
Japan has spent the past 20 years recovering from a hangover caused by one of the greatest and rarefied bubbles of all time. Japan experienced irrational exuberance in many sectors, but a large portion of the speculation was directed toward real estate (sound familiar?). At one point, the Tokyo Imperial Palace (2.86 square miles in all) was reckoned to be worth more than all of the real estate of California!
It’s really no wonder that the world was so in love with Japan in 1989-- think about what they had accomplished the previous 44 years. They went from a country with all of its infrastructure literally leveled by American bombers to the third largest economy in the world, all with limited natural resources no less. The growth rate of Japan was the highest in the world over that time period, as they became a first class manufacturing country and an economic dynamo.
The bubble for Japanese businesses peaked in December 1989 when the Nikkei reached an all time high of 38,915. During the bubble, 8 of the top 10 companies in the world by market cap were Japanese. That number is now down to zero. The Nikkei is currently priced around 8,700, down 74% from its peak. And we all thought 2008 was a rough ride for investors!
There’s no doubt that Japan’s current economic outlook is gloomy. Considering the aging population (soon Japan will have more retired people than working people), a ballooning government debt (~200% of GDP, most of which is of shorter maturity), and a tragic 8.9 magnitude earthquake and resulting tsunami and nuclear meltdown at Fukushima, there are plenty of headlines to scare away investors.
In fact, Merrill Lynch’s Survey of Advisors shows that 40% of advisors recommend under-weighting Japan. If you’re an investor that enjoys bad press and a sour sentiment, Japan is definitely for you.
Another concern for investors is the perceived lack of shareholder friendliness. Some believe that Japanese companies are run more for their employees rather than their shareholders. Huge cash positions on the balance sheets lead some to think they exist solely to ensure management and employee job security, rather than enriching their owners. We’re more of the view that the Japanese culture is generally conservative in nature and that’s reflected in the high cash balances and low debt in Japanese companies. Jean-Marie Eveillard of First Eagle Fund fame, in a recent Forbes article, is understanding of this Japanese conservatism and sees it as a potential strength:
Nothing is perfect and that’s a sin which I have been willing to forgive – excess conservatism, as opposed to excess aggressiveness. Today to have a very sound balance sheet is a tremendous advantage. It is one of the strengths that will allow some companies to gain at the expense of other companies burdened with debt.
Typically in the U.S., large cash balances would be a catalyst for acquisitions, special dividends and even liquidations for unprofitable businesses. Shareholder activism has increased over the years as younger managers and owners are on the rise in Japan, but it is a still a smaller fraction by U.S. standards. Minority shareholders may not be able to count on a catalyst like Larry the Liquidator as played by Danny DeVito in the film “Other People’s Money” to come to their rescue yet. As a result of these potentially captured assets, it may be prudent to demand an even higher margin of safety than normal. Fortunately, the current valuations of many stocks are so cheap they are more than accommodating on that front.
Many pundits will remind investors that cheap markets can continue to get cheaper. The long decline in the Nikkei since 1990 was fully justified as 1990 saw price-to-book ratios of approximately 5.0. A nation selling at 5x book value is clearly unsustainable and would require years to work through that kind of bubble (2x-3x is closer to normal). Contrary to popular belief though, the Japanese market has not always been as cheap as it is today. In fact, since the peak of its bubble in 1990, the market was only this cheap one other time. That came in 2003 amid a global slump. Soon after that low, the market realized the discrepancy and bid stock prices up nearly 100%. Fast forward eight years, and the market is back where it was in 2003. Can history repeat?
I have observed that not the man who hopes when others despair, but the man who despairs when others hope, is admired by a large class of persons as a sage.
-- John Stuart Mill (1806-1873)
One of Warren Buffett’s truest axioms is “You pay a high price for a rosy outlook.” As a value investor, you have to be willing to dig through the not-so-rosy dumpster to find potential gems thrown away with the garbage. Value investing as a principal is largely successful because things are never really as bad as they seem. It’s human nature to overreact to a given situation, both positively and negatively. As social animals, we humans take cues from those around us about potential danger and it often doesn’t take much to spook the herd. Although this adaptation made sense for our ancestors’ survival on the grassy savannah some 100,000 years ago, it’s not a good way to run a portfolio in the modern jungle.
As difficult as it can be due to the cacophony of financial noise out there, keeping your head is the key to sound investing. Those who can detach their emotions and avoid biases of thought stand to outperform their peers as they avoid emotionally-charged decision making. (We’re particularly fond of James Montier’s work on the topic of behavioural investing and encourage readers to explore his equal parts lucid and entertaining writings.)
Another key principle of value investing is reversion to the mean. Whether it’s a career .300 hitter currently batting below the Mendoza line (named after shortstop Mario Mendoza who struggled to bat over .200 over 9 seasons in the Majors) or a business or country that has hit a rough patch and is about to bounce back, reversion to the mean is a powerful force. A bleak outlook, plus a little bit of time to heal and regroup, often leads to a better-than-expected outcome. The world simply doesn’t project out on a linear trend line; just as trees don’t grow to the sky, the world is cyclical. In his new book "The Most Important Thing," Howard Marks' reference to a swinging pendulum of investor fear and greed is more than apt: “Whenever the pendulum is near either extreme, it is inevitable that it will move back toward the midpoint sooner or later. In fact, it is the movement toward an extreme itself that supplies the energy for the swing back.”
Reversion to the mean can always work against you as well - something that is too good to be true often leads to disappointment (see US housing, circa 2007). Disappointment seeks out stocks when too rich a price is paid. In fact, there are really no good or bad stocks without the context of price information. We would even say there’s not such thing as “toxic assets,” only “toxic prices.” Quoting Howard Marks again: “Investment success doesn’t come from ‘buying good things,’ but rather from ‘buying things well.’”
Part 3: Taking Advantage of Mr. Market
MBA Students Go Fishing in the Cheapest PondsFor the past three summers, the authors have taught a course on value investing at the University of California, Davis Graduate School of Management. The students wrap up the class by submitting their top investment picks to a year-long portfolio contest. Given the relative abundance of investment opportunities in the US in 2009 and even 2010 to a lesser extent, the students focused their search on domestic markets. Fortunately enough, the relatively fertile hunting grounds in 2009 and 2010 afforded 85% of the students’ portfolios to outperform the market averages over the course of the competition (handily, in fact). Given the lack of quality domestic investment ideas (largely due to 2011’s higher share prices), the students focused their search on a cheaper market: Japan.
A study made under the authors' direction (covering some 3,700 stocks traded on the Japanese exchanges), found 512 stocks selling for less than net current asset value (includes long-term investments) and 212 selling below ⅔ of net current asset value (Graham’s famous “66% net-net” threshold). Equally interesting, 763 of the businesses were selling for less than cash plus short and long term marketable securities. Suffice it to say, there are large parts of the Japanese market selling for extremely cheap.
The authors also performed a meta-analysis of 9 distinct “value” studies examining the results of buying a basket of specific stocks selling below net current asset value. These baskets of cheap stocks yielded an impressive annualized return of 23.3% vs. the S&P500’s 9.0% over similar time periods. Covering a range of 52 years, multiple countries and market sentiments (read: pendulum swings), these studies indicate that a basket of businesses bought extremely cheap handily outperform the general indices. The timing, location, and specifics didn’t matter; if you buy stocks cheap enough, the results were more than satisfactory. We believe that was Benjamin Graham’s final conclusion after studying the markets for decades. To wit, a few months before he died, Graham was interviewed and had this to say:
They called it the "Bible of Graham and Dodd." Yes, well now I have lost most of the interest I had in the details of security analysis which I devoted myself to so strenuously for many years. I feel that they are relatively unimportant, which, in a sense, has put me opposed to developments in the whole profession. I think we can do it successfully with a few techniques and simple principles. The main point is to have the right general principles and the character to stick to them...To try to buy groups of stocks that meet some criterion for being undervalued - regardless of the industry and with very little attention to the individual company.
Graham is supposing that buying a basket of statistically cheap stocks is all that is required to achieve satisfactory returns. The UC Davis MBA students sorted through a 3,700 odd stock universe of publicly traded Japanese stocks and narrowed the universe to 30 attractive opportunities, creating a basket exactly like Graham was speaking of.
Here is a description of the 30-stock portfolio metrics:
| Average Market Cap | $86m |
| Market Cap / Net Current Asset Value | 0.37 |
| Price to Book | 0.32 |
| Price to Earnings | 6.9 |
| Average Enterprise Value | -$6.8m** |
| Average EBIT (TTM) | $12.4m |
| Earnings Yield (EBIT/Enterprise Value) | Undefined, as Enterprise Value is negative |
| Average Dividend Yield | 3.3% |
** The market is in essence saying “Take these profitable businesses off my hands and I’ll pay you $7M, on average, per company.” Hence the question: are Japanese businesses worth more dead than alive?
Based on the studies previously referenced, we would anticipate this basket of cheap Japanese stocks to similarly outperform the market indices. If the 30 businesses were afforded a modest multiple (8-times earnings before interest and taxes) + net cash, similar to what businesses typically sell for in private-party transactions, the average valuation for the 30 businesses would be $191 million vs. a market-cap-inferred-price of $86 million. You’re theoretically getting $191 million worth of private-party businesses for the public market price of $86 million. This represents a tremendous upside potential when the market’s sentiments toward Japan become normal again-- offering a handsome potential reward for those brave enough to test their resolve in the face of threatening headlines.
Individual securities can be attained through most brokerage houses without too much fuss. Although the trading costs can be steep (we've paid $100 per trade through one of the bigger name houses), we feel the potential upside justifies the transaction costs, depending on the size of your portfolio. For smaller amounts of money and certainly increased liquidity, WisdomTree's Japan SmallCap Div Fd ETF (NYSE:DFJ) may be a good way to participate in Mr. Market's mispricing of Japan. Although the DFJ is not as cheap as a readily-attainable basket of individual stocks (Price-to-Book of ~.77 vs. much less), the liquidity and diversification is quite attractive.
When Will the Market Price Japan Back to Normal?
The truth of the matter is, no one can say for sure when the market will realize its overshoot and correct. The timing is always the most unpredictable aspect. Below is a 1955 exchange between Senator William Fulbright and Benjamin Graham regarding when financial markets will eventually recognize intrinsic value:
Chairman Fulbright: … One other question and I will desist. When you find a special situation and you decide, just for illustration, that you can buy for 10 and it is worth 30, and you take a position, and then you cannot realise it until a lot of other people decide it is worth 30, how is that process brought about – by advertising, or what happens? (Rephrasing) What causes a cheap stock to find its value?
Graham: That is one of the mysteries of our business, and it is a mystery to me as well as to everybody else. [But] we know from experience that eventually the market catches up with value.
Testimony to the Committee on Banking and Commerce
(11 March 1955)
We believe Jeremy Grantham of GMO was channeling a bit of Graham in his most recent newsletter (pdf) regarding Japan:
The market has this always disturbing habit of ignoring the obvious and ignoring it some more, until, in the blink of an eye, it doesn’t... We at GMO also believe that Japan is likely to “regress,” in the mathematical sense, toward levels of profitability that would be considered normal in other developed countries. We expect the progress to be very slow and uneven. If it does not happen at all, then Japanese stocks are priced like the average of all other developed equities, or a bit cheaper. If, however, by some chance margins improve quite fast, then Japanese stocks will likely be the best performing stocks around and could hit double-digit real returns for seven years. Japan’s remarkable resilience in the face of electricity shortages gives some inkling of what they are capable of. How quickly we have forgotten their obvious talents of 20 years ago. Can all of those talents really be lost forever? --Jeremy Grantham, August 2011
Appendix:
Part 1 - Inflated Treasuries and Deflated Stockholders
In the early 1930’s, many U.S. companies’ shares were selling below their net-quick asset value (current assets minus all liabilities), and in some cases well below net-quick asset value. In other words, these companies were worth more to the stockholders in liquidation than as going concerns in the stock market. Graham attributes three factors to the seemingly irrational share prices:
- Ignorance of the facts: Investors were no longer paying attention to the balance sheet. Over the past decade, investors had become too accustomed to looking only at the earnings statements. Asset values were a thing of the past.
- An over-subscription of shares during the late 1920s bull market resulted in increased working capital values but an over-dilution of shares outstanding. As the economy and stock market decline accelerated, investors impulsively sold out. Meanwhile, those that recognized the excellent values in the market had an inability to buy due to dire economic conditions.
- Expectation that future losses would squander away the company’s healthy working capital positions. As Graham points out, if a company is expected to lose money indefinitely, why stay in business? When the company can be purchased well below net quick asset value and then liquidated, why not wind up the business and collect the money?
The thesis of Graham’s second article can be summed up in one sentence. In his own words, “Let corporations return to their stockholders the surplus cash holdings not needed for the normal conduct of their business.”
The same words can be said of many of the publicly traded companies in the world today. The Japanese stock market, for instance, is flush with companies selling below unencumbered cash and net quick asset values. Many of these Japanese businesses are also profitable and non-capital intensive with little need for the excess cash balances they possess.
Part 3 - Should Rich But Losing Corporations Be Liquidated?
In his final article of the series, Graham specifically addresses the rationale for such low share prices being due to the anticipation of future losses which will diminish the current working capital or unencumbered cash balances. Graham’s claim was that stockholders should take action to influence directors and managers to wind up the business now before the realizable liquidation value further depletes. Lessons from these past events can be applied to Japan today. One glaring difference, however, makes present day Japan quite different from the U.S. in the 1930s. Today, many Japanese companies selling below net quick asset value are not losing money. In fact, many have a long running history of sustained profitability. So it begs the question, what justifies such low market prices?
One of Ben Graham’s favorite teaching exercises was to conduct an examination of two companies. Mr. Graham would usually select a stock and compare it to the adjacent stock alphabetically in the Moody’s manual. Adapting from Graham, here are 4 sets of similarly sized firms in similar industries; one Japanese, one American. These comparisons shed light on the relative price-to-value relationships (what you’re paying for vs. what you are getting) that exist between the two markets today. As the world shrinks due to technology and ever-improving logistics, are the prospects of an American and Japanese company selling to the same global customers really that different to warrant the valuation differences? We have our doubts.
Ohmoto Gumi Co Ltd. (JP:1793) vs. Sterling Construction Co Inc (STRL)
Industry: Civil engineering
[all numbers $ millions] | JP:1793 | STRL |
Market Cap | $157 | $216 |
Cash & Investments - Debt | $288 | $84 |
NCAV | $630 | $103 |
Market Cap / NCAV | 25% | 210% |
Price / Book Value | 0.25 | 0.86 |
Price / Sales | 0.15 | 0.46 |
Price / Earnings | 24 | 6 |
10-Year Avg EBIT | $12 | $17 |
Enterprise Value | -$131 | $132 |
8x EBIT + net cash | $381 | $219 |
Dividend Yield | 3.0% | 0.0% |
Kanematsu Electronics Ltd (JP:8096) vs. Actuate Corp (BIRT)
Industry: Software
[all numbers $ millions] | JP:8096 | BIRT |
Market Cap | $316 | $288 |
Cash & Investments - Debt | $334 | $43 |
NCAV | $390 | $58 |
Market Cap / NCAV | 81% | 493% |
Price / Book Value | 0.77 | 2.98 |
Price / Sales | 0.53 | 2.14 |
Price / Earnings | 6 | 15 |
10-Year Avg EBIT | $35 | $6 |
Enterprise Value | -$18 | $245 |
8x EBIT + net cash | $617 | $92 |
Dividend Yield | 4.7% | 0.0% |
Nakano Refrigerators Co Ltd (JP:6411) vs. Standex International Corp (SXI)
Industry: Food services equipment manufacturing
[all numbers $ millions] | JP:6411 | SXI |
Market Cap | $133 | $424 |
Cash & Investments - Debt | $199 | -$68 |
NCAV | $196 | $124 |
Market Cap / NCAV | 68% | 342% |
Price / Book Value | 0.69 | 1.90 |
Price / Sales | 0.37 | 0.69 |
Price / Earnings | 6 | 8 |
10-Year Avg EBIT | $20 | $27 |
Enterprise Value | -$66 | $492 |
8x EBIT + net cash | $356 | $144 |
Dividend Yield | 1.1% | 0.7% |
Taiyo Kisokogyo Co Ltd (JP:1758) vs. Willdan Group, Inc. (WLDN)
Industry: Engineering and construction services
[all numbers $ millions] | JP:1758 | WLDN |
Market Cap | $23 | $27 |
Cash & Investments - Debt | $26 | $7 |
NCAV | $39 | $15 |
Market Cap / NCAV | 60% | 181% |
Price / Book Value | 0.39 | 0.84 |
Price / Sales | 0.19 | 0.31 |
Price / Earnings | 4 | 13 |
10-Year Avg EBIT | $4 | $2 |
Enterprise Value | -$3 | $21 |
8x EBIT + net cash | $61 | $26 |
Dividend Yield | 2.9% | 0.0% |
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in DFJ over the next 72 hours. The authors are long numerous Japanese stocks.
