Tuesday, March 9, 2010 0 comments ++[ CLICK TO COMMENT ]++

Thought about the Land of the Rising Sun

Reader craigatk, who apparently lives in Japan but hates investing there as much as any of us ;), was wondering about my thoughts on Japan. The excellent special-situation-oriented blog, Greenbackd, had a few posts on Japan that you may want to check out if you haven't already (post 1 & post 2.) I think classic value investors, who focus more on financial statement analysis, will probably have greater success in Japan than "modern" value investors who focus more on concepts like "moat."

I haven't looked at Japan very closely of late but even with all the crazy events of the last two years, I feel the same as I did when I wrote about Japan a couple of years ago (if you are interested, read the early posts tagged as "Japan.") Namely, it's one of the the most contrarian (major) markets in the world. Even Marc Faber has been bullish on Japan of late. As was the case a few years ago, many companies trade near book value, with many small companies trading below book value and sometimes below liquidation value. The change in government, to a more liberal one, is a positive in my eyes (although conservatives probably won't like it.)

The problem for Buffett-like investors, as always, is that the companies are not shareholder-friendly. ROE, return on equity, is terrible and there appears to be no way to raise it. Even foreign control investors appear to have serious problems because Japan is, I hate to say it, very xenophobic and possibly racist to some degree. Or maybe it's not an issue of ethnic discrimination but one of nationalism. But whatever it is, foreign investors have very little influence. Some, such as Martin Whitman, with Toyota Industries (JP: 6201), has had success in the past but I have seen very other cases of influence.

Without shareholder influence, you are pretty much stuck with a low ROE—in many cases, the ROE is due to high cash holdings or cross-holdings of unrelated businesses and shareholders can't unlock this—and take-over premium likely doesn't exist. As much as the 'barbarians at the gate' are hated in America in some quarters, stocks generally trade as if a barbarian will come and buy out the company if it's too cheap (for those not familiar, barbarians here refer to private equity, once known as LBOs or Leveraged Buyout funds. I am including hostile activist investors in this camp although I think 'green knights' is probably a better term for them :).)

Instead of reinvesting the wheel, let me quote an InvestmentU article written by Tony Daltorio (courtesy GuruFocus) that provides some examples backing my points above. To start off, Tony Daltorio references a Nomura research report (date not clear):


Japanese brokerage firm Nomura estimates a mere 4.7% return on equity for small caps this year, as compared to 6.6% for all Japanese companies and 13.4% for stocks in the developed world.

Fortunately, a projected earnings recovery over the next few years could push return on equity to 7%. That, in turn, could rally small-cap share prices up more than 50% just to keep up with other markets.




Yep. American investors may find it shocking but 4.7% ROE for small-caps in Japan is par for the course (to see how bad this is, realize that you will only earn 4.7% per year if you buy the company at book value—this is barely above a presumably "super-safe," long-term, US Treasury bond in America.) So, if you are investing in Japan, especially using a small-cap Japan ETF (the referenced article lists a few if you are interested,) you would be earning 4.7% ROE. If you buy below book value, you will earn a bit more but not much more. (If you are a newbie, do keep in mind that ROE is more of a theoretical return than a real return. It is sort of an indicator of the profitability of the business itself—if the business re-invested money at book value, this is what it would earn—whereas your actual return depends more on the price you purchase, P/E multiple expansion/contraction, etc.)

The author suggests the ROE will rise and small-cap shares will likely go up 50%. I hate to say it but I don't think it will happen in the long run. Japan is very cyclical so profits will go up significantly from their bottom an year ago. This may push up share prices but the amount is questionable (I don't follow the market closely enough to say if the market hasn't priced in future profit increases.) All I know is that, without structural changes (particularly without allowing shareholders access to the cash piles of these firms,) any rally is speculative and may not last.

Ever wondered what sort of bargains the small-cap space offers in Japan? The author of the article presents an example (this isn't a great example because it is an illiquid stock with questionable quality):


Just take Katsuragawa Electric, which makes wide-format printers. It has annual sales of about $200 million, $55 million net cash on its balance sheet and total net assets of about $190 million. And at its recent peak in 2007, it made a net profit of around $17.5 million.

Yet the company’s full valuation on Japan’s Jasdaq stock exchange amounts to less than $40 million. That means that every one dollar put into Katsuragawa shares yields $1.39 in net cash and $4.81 in net assets, while costing the investor only a little over twice the company’s peak earnings.


I took a quick look and it appears that company trades on the JASDAQ and has a ticker symbol 6416. Here is a chart of it:
 
 
Not a pretty chart and I'm not recommending this stock by any means—it could be well on its way to bankruptcy for all I know—but this is the sort of situation you have in Japan. Looking at the latest published data, it appears the stock is trading around 260 Yen, while the book value is 1130 Yen. This isn't a great example but there are better companies—slightly larger and listed on TSE—that may be safer.
 
The problem I have with a lot of these companies, in addition to the low ROE, is that these are generally cyclicals (most of the Japanese market is cyclical.) I am not generally a fan of buying cyclicals for the long run. Instead, my goal is to buy them counter-cyclically (buy when P/E very high or infinite and unload them when the situation is rosy.) I have never executed that strategy successfully but that's my goal. I would hate to spend a lot of time digging through Japanese stocks, only to hold them for a shorter period of time. I'm putting more of my effort these days into finding long-term opportunities and I prefer an easier understood market like America (or Canada or something like that.) Perhaps a blind contrarian macro bet on Japan (such as buying an ETF) is an easier strategy.
 
 
On Another Note...
 
One of the contrarian investments in Japan may be to look at companies that may have been sold off due to the problems Toyota is facing. This is an old story and well understood by everyone now, but the fact that Toyota hasn't put it behind them may mean the crisis is still impacting market perception. Toyota (NYSE: TM) itself did not drop that much but I wonder if some parts suppliers—most of Toyota's supply chain is in Japan and not listed on NYSE—may have been irrationally sold off. If some of these parts suppliers post big losses in the recent, or upcoming, quarter, it may be even more attractive (if short-term traders dump those companies and you believe the Toyota problems are not material to these companies in the long run.) Again, the problem of low ROE likely exists so the price needs to be low enough.

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