Time To Open Japan Back Up

Includes: JEQ, JOF
by: Asa Harrington

When Japan’s bubble burst, generations of good, hard-working people saw their savings disappear. And since the peak in the stock market, the two lost decades from 1991-2010 burnt everyone invested in Japanese equities. The only aspect of Japan that has improved the outlook for the Japanese in these two lost decades is the strength of the Yen. (The exchange rate strengthened from 134Yen/US Dollar in 1991 to 76Yen/US Dollar today.) I believe, however, that the status quo nightmare is primed for change in the near future. I will discuss two inter-related topics: the ballooning Japanese national debt and the future of Japanese equities.

Here are the two graphs best displaying what I believe to be the most important aspects of the current Japanese national debt situation []:

Graphic Source

You can see how Japan has earned the nickname, “land of the rising debt.” Right now, Japan has the world’s highest Debt to GDP ratio at 220%, and Japan also is the world’s third largest economy! That means each Japanese citizen (retiree, worker, and child) owes about $86,200 US (source: the Economist).

Japan’s cost of debt is only .98% on 10 yr bonds and 0.12% on 1 yr bonds. So the Japanese government is managing to float the looming bubble in the top right corner of the graph by paying very low interest rates and manageable interest payments. Now imagine what these interest payments would look like if the interest rate was 2% on 10 yr bonds like the US or even higher. The interest payments would become massive, and the Japanese government would have a lot of difficulty rolling over the debt, much less adding to it like they plan to in 2012.

In April of 2012, the Japanese government expects to market another $566 Billion US or (44.2 Trillion Yen) to simply pay for the budgetary spending in 2012 that they can’t fund with tax revenue. This bond outlay will raise Japan’s budgetary dependence on debt to nearly 50%; in comparison the US in 2010 only had a 37% dependence. I believe Japan’s dependence sends a very strong signal to the bond markets that this debt might not be as AA3 rated (according to Moody’s) as some might believe.

What allows the Japanese to maintain these very low interest rates and payments on their debt?

The answer is twofold:

1. Most of this debt is owned by Japanese citizens themselves.

2. The European debt crisis has made Japanese debt look safer (relatively) than it really is.

Now consider this graph showing the Maturity date for the Japanese national debt:

Graphic Source

During the next five years more than 60% of the current debt will need to be rolled over. This is a scary realization given what could happen if interest rates rise. If at any point world bond market investors no longer believe Japanese debt is as safe as it once was, a vicious cycle of ever-increasing interest payments will begin. This would be game over for Japanese debt and thus Japan.

This leaves two scenarios:

1. Japan defaults on JGBs (Japanese Government Bonds)

2. Japan inflates and pays its debts back.

What happens if Japan defaults on its JGBs?

Well, I believe this to be unlikely given who owns the majority of JGBs: the Japanese people. The older Japanese citizens have been paying to keep the Japanese economy alive in the decades after the bubble by buying these JGBs at unrealistically low interest rates. While this might seem naive to us, they believe they will get paid back and with good reason.

Consider for a moment the Japanese culture, which is considerably more homogeneous than the American culture. Japanese citizens are very patriotic and move in a very “tight” herd; this means they all succeed or die together. I won’t go into much detail, but look at Kamikaze bombers and the mentality necessary to be one, a sacrifice of all for country. Look at what was necessary before the Japanese surrendered in WWII. Also, think about how once Japan had unconditionally surrendered, no Japanese citizens continued to fight. In all the minds of the Japanese citizens, the war was completely over at that instant. For the Japanese it was no surrender and then total, unconditional surrender. No gray area.

Recent news shows this impressive culture remains intact: when the disaster at the Fukushima nuclear plant struck after the earthquake, some remarkable patriotic events occurred. Two hundred and seventy retirees and older workers in suicide squads volunteered and went to Fukushima to help with the containment. One stated, “I will be dead before the cancer gets me.” (Reuters, 6/6)

Does it seem likely that the Japanese government will be paying back their older citizens, when you put the Japanese culture in perspective? Yes, absolutely. Just as the citizens have a duty to their government, the government has a duty to their citizens. It’s a lot harder to bilk your elderly than the faceless foreign banks.

This is why I believe Japan will inflate and pay back their JGBs at some point.

What does all this mean for equities in Japan?

As of right now the Nikkei Index is at the 8,500 mark, near its 1983 pre-bubble level.

Nikkei 225 Historical Chart

When looking at this chart, I see that prices are now at the level they were 30 years ago. I also see that in 20 years the Japanese stock market has declined about 80%. In addition the 7,500 level has been tested twice in 10 years and appears to be a good level of support. This makes me believe that the Japanese stock market has stopped going down and will soon reach a turning point.

The P/B ratio Nikkei 225 Historical Chart 1980-2012

From this chart, you can see the average price of the Japanese stock is selling at a discount of nearly 20%. This means the assets on the books of these Japanese companies are selling at about 80 cents on the dollar. This is the lowest Price/Book ratio in over 40 years. With a P/B ratio of 0.8, Japan equities look good compared to the US stock market, which right now has a P/B ratio of 2.05. Benjamin Graham would have found the Japanese stock market enticing, especially given he recommended enterprising investors never invest in a stock with a P/B ratio above 1.2.

Below is the historical 10 yr Inflation adjusted Price/Earnings Chart 1980-2012. (This ratio avoids the problems of volatile earnings in the P/E ratio by averaging the inflation adjusted earnings of the last 10 years.)

To provide a counter point to the P/B argument, you can see that the average P/E in Japan is about 32, whereas in the US, it is about 21, which might indicate that the Japanese market is still over-valued. However, I would argue that in comparison to Japanese history, the Japanese P/E ratios are near their lowest in 25 years! You cannot say the same for the US, and when Warren Buffett visits Japan for the first time in his life, it’s hard to ignore that there might possibly be an “opportunity” in Japanese equities.

One more indication of value to be found in Japanese equities is the historical Market Cap/GDP ratio for Japan. This ratio has had long term predictive value in US equities.

Now, what makes this time different, and what has changed since the bubble?

Outrageously high valuations are certainly not a problem. Another issue during the bubble and directly afterward was the extent to which all Japanese companies were leveraged. This is not a problem anymore. Japanese companies have been deleveraging for two decades and have been very successful; you now can find numerous companies that have more current assets on their books than they have in total liabilities! For example: [6459:TYO] with CA/L ratio of 4.74, [1983:TYO] with CA/L ratio of 1.8, [8084:TYO] with CA/L ratio of 1.68.

So what have Japanese companies been doing with all this free cash? Some have been raising their dividends slowly, but not nearly as much as they could. Remember, those who survived the massive crash and deflationary decades had to be uber-conservative the entire time, so there is massive selection bias in which companies still exist: the cash heavy, careful ones.

On an even more positive note most companies are expanding outside of Japan as well as preparing for worse times if they come, rather than paying the cash out in dividends. In current news, Mitsubishi UFJ bought a large portion in an Australian financial company. This surely is a good sign.

As for dividend yields in Japan, despite all the free cash-flow issues and low increases in dividend yields, the separation between the dividend yield and the 10-yr government bond has grown. This is a positive sign. Just imagine if all that cash was paid out as dividends!

What does this all mean for the future of Japan?

With over 220% Debt to GDP ratio and extremely low interest rates, the Japanese Government’s current borrowing rate and upcoming interest payments appear unsustainable, which I believe will lead to inflation, weakening of the Yen and the improving success of exporters in Japan such as auto and tech industries. Now, consider Japan’s expanding monetary base (in billions of Yen):

Source: Bank of Japan

I find it curious and amazing that Japanese equities haven’t inflated with the Japanese money supply to even their pre-bubble levels.

Given that I believe Japanese equities are undervalued, how would I take advantage of that?

I was first attracted to the Japanese markets when I noticed that US Japanese closed-end funds are selling at a discount of about 12-14%, see JEQ and JOF.

This means that the assets held by these funds are believed to be only worth ~87 cents on the dollar. Data analysis of these securities seems like a good place to start.

In summary, for two decades Japan has not been the country to look at. But I believe the tide will turn soon for Japan and that investors should start looking now. The headlines haven’t been screaming Japan yet, but as soon as the herd has caught onto the new direction, it will be harder to find the best bargains. Forget Chinese, it’s time to relearn Japanese – just like in the early 80s.

Disclosure: I am long JOF, JEQ.