Thursday, January 15, 2009 5 comments ++[ CLICK TO COMMENT ]++

Buffett's 1998 comments still apply to Japan... Plus thought on why ROE is very important

I have indicated in the past that one of the reasons I'm very wary of Japan, apart from the questionable demographics and extremely high debt to GDP, is the fact that Japanese companies have very low returns on equity (ROE.) The exceptions are some international companies, like Toyota, which are comparable to American firms. There are many successful investors who have been bullish on Japan in the last few years and paid the price. The list ranges from Jim Grant to Jean-Marie Eveillard to, more recently, GaveKal. Good stockpicking may have saved someone but I would guess that it hasn't been a good experience in general. Bloomberg has an article summarizing present-day Japan and pointing out how Buffett's 1998 comments still apply. Anyone considering Japan should keep the low ROE problem in mind.

Five specific issues are explored: a lack of business focus, murky corporate governance, little regard for returns on investment, the high cost of production, and clubby boardrooms.

...

Companies in Japan, Mihaljevic says, routinely spend as much as 10 percent of annual revenue on capital expenditures even though they are in businesses with pretax profit margins of less than that amount.

Japan also is a high-cost center. While companies have embraced global outsourcing, many prefer to produce goods at home. That increases costs and leaves companies vulnerable to the strengthening yen. Buffett has long said high costs thwart his desire to buy an entire company in Japan.

Finally, the lack of gender diversity in boardrooms speaks to a continued unwillingness to open up the corporate culture. If there is any developed economy that needs to adopt new ways of doing business, it’s Japan.

...

Japan’s longest postwar expansion did little to fatten the paychecks of average households. A decade after pledging to boost domestic demand, Japan’s remains largely a one-trick economy: exports. That recognition is now reflected in stock prices.


A lot of Japanese companies are extremely attractive from a balance sheet (asset) point of view. But their ROEs are terrible. You are talking about companies that earn below 5% ROE, with some at 2% or 3%, whereas US companies have ROE of around 12% in the long run. I see the argument that Japanese companies are overcapitalized and if you backed out the cash on their balance sheets, the ROE would be a bit more reasonable. I don't buy that argument for Japan. Given how very few companies are run for the shareholders, it is a mistake to back out the cash. It's virtually impossible to extract the cash and pass it to shareholders.

Some bulls are betting on structural changes in the environment that will make these companies more efficient. I have been following Japan for two years and read articles that analyze it over at least 5 years, and I see little change. There was some progress during the Koizumi era but that's about it.

If you are investing in Japanese stocks, you need to figure out a way to profit with low ROE businesses.


Side Note: Why Is ROE Important?

You should really read some of the articles by Warren Buffett for the full answer but here is my quick explanation of why ROE, or some related measure like ROIC, is extremely important.

Let's say you have a company that retains 50% of profits. If we simplify matters and assume nothing changes, the profits that are retained are re-invested by the company at the ROE rate. The ROE rate is what the company earns for each additional unit of equity that is contributed to the firm.

(Do keep in mind that ROE is not the same as the return you will get if you went and invested some capital in a company. What you get depends on the price you paid and hence is really the earnings yield (E/P). For instance, Coca Cola has an ROE of 28% but if you went and bought shares worth $100, you will not get a 28% return. But if the company reinvests $100 of profits, it will earn 28% on that. Only the company itself can invest at the ROE rate--the exception is if you are able to buy the company at, or below, book value, in which case you will earn the ROE or better.)

The most powerful effect of owning a company for the long term is the compounding of retained earnings without paying taxes. The ideal company will never pay dividends and reinvest earnings at a high ROE rate. If you ever wondered why Berkshire Hathaway never pays dividends, that's why. So you might ask why doesn't every company retain all the profits? Ignoring the case where shareholders demand dividends because they don't trust management and think management will waste money, the reason companies with high ROE don't always reinvest profits is because they are unable to find future business opportunities that yield such high returns.

So what happens if you go and invest in these Japanese companies? Well, every Yen of retained earnings will be reinvested at the super-low ROE rate. I personally don't look kindly upon a company investing profits at 3% ROE while I can go and get that same rate in Canadian government bonds with low risk. So, Japanese companies are not very attractive. This is one reason the market valuation of many companies that have totally dominated their fields, ranging from electronics, to super-high-tech robotics, to auto manufacturing, have not gone up much (part of the reason was because they were wildly overvalued in the past, but part is because they are bad investments for shareholders.) Again, there are exceptions like Toyota. So, the low ROE of most Japanese companies results in a perverse shareholder desire. We are actually better off if Japanese companies paid out as much of their profits as they can in dividends.

Having said all that, shareholder returns will be higher if you buy below book value. Since many Japanese companies are trading below book value, one can argue that the returns are actually better than the ROE implies. That is true; however, the returns are still very low and, in the super long-run, the low ROE will be a huge drag and underperform. (Related to this point, if the share price is way below a conservative estimate of book value, then buying back shares is better than reinvesting the money. Unfortunately, executives tend to be the dumbest investors around, other than me that is, and tend to buy back shares when they are way above book value or intrinsic value or estimate of any sort of value. For example, many oil & gas companies couldn't (supposedly) reinvest profits into further drilling & exploration so they bought back a huge amount of shares over the last 2 or 3 years at prices that were way above any notion of the value of the firm. These companies would have been better off issuing special dividends.)

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5 Response to Buffett's 1998 comments still apply to Japan... Plus thought on why ROE is very important

January 15, 2009 at 9:24 PM

A good article. One thing that I would point out though, is that different countries do have somewhat different accounting conventions and it's not always possible to directly compare ROE (or other measures) accurately without understanding the accounting involved in each jurisdiction.

The Japanese market was so grossly over-valued in the late 1980s that it was always going to take decades to recover once the inevitable crash came. Imagine a market where the average multiple was 80 times earnings or so (much of it related to property speculation) and you can immediately see the problem that was brewing in the late 1980s.

January 15, 2009 at 10:25 PM

Good point Stock Scribe... good nickname :) and you have a great blog... one of your posts is probably equivalent to 20 of mine ;)

Anyway, valuation played a huge role but that is not so true right now, with many trading below book value. These Japanese companies have low ROE right now, after their shares have collapsed by almost 50% to 70%! One can argue earnings are depressed but let's not forget that they saw the biggest continuous post-war boom in the last 3 or 4 years and have nothing to show for it.

Furthermore, Buffett pointed out in a speech in the 90's (might be the same one mentioned in the article) that Japanese companies were poor investments even during the glory days of the 80's. Growth investors would have done well; but for value investors, their businesses were unattractive with low returns on equity even during the boom stages. This is actually the most remarkable thing about Japan. They somehow built up a so-called capitalist system without ever rewarding shareholders or private owners. It's a unique, and bizarre, country for sure. They also somehow practice a so-called democracy with one party ruling for nearly all of 50 years (America was clearly pulling the strings behind the scenes in the early part but there is no excuse for having one party during the most recent 20 years.)

February 4, 2009 at 10:04 PM

Thanks for the kind comments.

Yes, I do agree with what you have said there. I would choose US stocks over Japanese stocks any day.

As you say, Japan is a difficult country to understand (from an investing point of view) and my preference has always been to stick to markets that I understand.

Anonymous
July 7, 2011 at 8:29 PM

The biggest problem I see in your argument against japan equities is the strength of the yen. Japan is going through deflation where each year that goes buy the purchasing power of the yen increases. America on the other dollars are worth less every year thus giving the ROE difference. and the willingness for japanese companies to hoard cash.

Sivaram Velauthapillai
July 8, 2011 at 8:34 PM

Anon,

Interesting point but the strengthening Yen isn't sufficient to make up for the low ROE in Japan. Even with the weakening US$, I'll bet you will make way more money in USA than Japan.

The currency typically moves 3% or 4% an year. That is nowhere near enough to make up for the large gap between US and Japanese ROEs (typically 12% in USA vs as low as 4% or 5% in Japan).

THe hoarding of cash by Japanese companies, along with weak topline growth (i.e. very low sales growth due to deflation and poor demographics) is too much of a detriment for owners of businesses. Just think about if you were hoarding cash in your account and earning near 0% interest on it. THat's how the over-capitalized Japanese companies look to me.

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