Wednesday, February 6, 2008 0 comments ++[ CLICK TO COMMENT ]++

The Dilemma With Japan

This is a point I have been hammering away for a while but it is important for investors looking at Japan...

Japanese stocks have very low ROE (return on equity)! In fact, it has been like this for a long time. The dilemma for Japanese equity investors is that you have a lot of stocks trading at low price-to-book-value but their ROE is very low. How do you make money in this situation?

For example, Eliot Pen refers to a Barron's article talking about how Asatsu-DK (TSE: 9747), a Japanese advertising agency, is trading at very low value (P/B is around 1). Barron's points out that Asatsu-DK has a lot of cash and cross-holdings that are not being valued fully. Its forward P/E of 25 (trailing P/E 29) drops to around 12 if you adjust for the cash and investment holdings.

However, its ROE is around 4%--a terrible number. Needless to say, what is causing the low ROE is its cash and investment cross-holdings. If you were a CEO and asked investors to borrow $100 in order to generate $4, you would be run out of the company. In every country... except Japan it seems.

From a long term point of view, it's hard for me to see how you can make money off this company, unless you forcefully make the company unlock its idle value. This is the situation in many Japanese equities.

My opinion is that only a shareholder activist can unlock the value in these situations. You have to get the company to give back cash to the shareholders, get out of its cross-holdings, or take on more debt to boost ROE. Given the rigid structure of Japanese companies and the reluctance to embrace shareholder-oriented strategies, it remains to be seen what happens to these Japanese companies (Barron's does point out that this company is more shareholder-friendly than most).

In other words, if you simply passively bought these undervalued stocks, I think there are no guarantees that you will make money. You can buy a stock that is 30% below book but if the company doesn't do anything then that discount can persist. In contrast, if a company had a high ROE, it will be internally generating a sizeable return without external catalysts (even if management wastes some of it, it'll generate a higher return than the low ROE company that is cheaper).

To sum up, the low ROE makes Japanese stocks very dangerous in my opinion. I think you can compensate for a low ROE by buying something that has low P/E but this isn't one of those cases (but as Barron's points out, if you can optimize the cash and investment holdings, then the P/E is actually kind of low). I personally would be comfortable in companies with low ROE if the P/E was low; otherwise I pass. My investment in Takefuji (TSE: 8564) follows that line of thinking, with Takefuji's forward ROE and P/E around 7% and 7, respectively (Takefuji is also trading around 20% below book value right now).

(For what it's worth, Barron's points out that Asatsu-DK says it is shareholder-friendly, and value firms such as Third Avenue Funds have a sizeable stake. So smarter minds are liking the stock but I still feel that the value needs to be unlocked somehow.)

Post-Depression USA & Present-day Japan

One of my future tasks is to look and see if US equities had low ROEs between the Great Depression to the 1950's. Whenever I look at Japanese stocks, it resembles the US post-Depression equities. As Benjamin Graham remarked, a lot of US stocks were trading below book value (many even below net current asset value) at that time. There were several reasons for that but the big one is the fear of deflation and eroding profits.

I believe the same fear of deflationary profitability overhangs Japanese equities. In fact, if you follow some Japanese companies you can see it in person ;), with seemingly declining sales for solid companies. It's actually quite amazing to look at 5 or 10 year history and see declining sales and profits for (what I perceive as) solid, established, companies.

If US equities did have low ROEs during the post-Depression era, then Japan can potentially bounce back as the US did. Investors may well be rewarded hansomely for venturing to the Land of the Rising Sun... however, if US equities had reasonable ROEs then Japan may never follow the US path to recovery. As I allude to above, I don't know how investors can make money in the long run with low ROEs... the sun may never rise in Japan for a long time indeed.

(On an off-topic note, Seeking Alpha invited me to contribute but I decided not to (haven't responded yet). Some people don't join Seeking Alpha because they don't profit from it (especially if they already have the visibility) but I don't care about that. I personally would love to join Seeking Alpha and get some visibility but I don't feel I'm competent enough yet. With the disastrous Ambac investment, along with poor writing skills ;), I don't think I have much to contribute yet--although some might find all this entertaining :) ).

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