Today, investors no longer pay much attention to Japan and most underweight their portfolios to Japanese equities or avoid the asset class altogether. Jesper Koll, one of the few long-standing Japanese market specialists still around explains the situation this way: “The Japanese market has disappointed clients so often that most do not have tolerance anymore. If you are long and wrong on most markets in the world, you get a second chance. But if you are long and wrong on Japan, you get fired.” The list of reasons to shun Japanese equities is long and familiar: aging population, heavily indebted government finances, years of deflation, questionable corporate governance, the rise of Korea, Taiwan and China and their increasingly competitive manufacturing sectors, etc. Add to this list 20 years of anemic economic growth and abysmal stock market returns and it’s easy to see why Japan has become the market most investors love to ignore.
Burgundy’s position on Japan has always been a bit different. Despite it being unpopular, we have long had big allocations to Japan in our Asian portfolios. Let me explain why we have been standing apart from the crowd. Our long-standing contrarian views on Japan are due to three factors.
First, the market is inefficient and that creates opportunities to find unloved, undiscovered, unappreciated businesses. Japanese equities are no longer a commercially viable product for most money management firms and by extension investment banks. With little demand or interest in Japanese company research, most firms have significantly cut back investments in this area and it shows; 2,800 companies in Japan, or approximately 74% of the Japanese market, have zero or one analyst covering them. We have met many small Japanese companies over the years that have told us they haven’t seen an investor for years. Consider that, according to Bloomberg, there are three times as many analysts covering Tata Motor – a US$15 billion Indian company that is a relative newcomer to the industry – than there are covering Toyota Motor – one of the largest and most successful car companies in the world that is more than 13 times the size of its Indian peer, with a market cap of US$200 billion.
Christopher Flowers, who made his name with a US$1 billion profit on a private equity investment in one of Japan’s failed banks back in the 1990s, summed it up best when he said, “We could lie down on the highway in Japan and not worry about getting run over, it is that quiet. Compare that with Beijing where I only have to walk down the street and I bump into some investor I know.” Inefficient markets lead to mispricing and that’s what we are finding in Japan.
The second reason we have found Japan interesting is because we have identified a number of very high-quality companies that are growing, very dominant in their business domains, very profitable, cash generative and that have fortress-like balance sheets.
Japan is full of world-leading sophisticated manufacturers of advanced components, materials and precision equipment. Many of these firms are small and less familiar than the mass-producing consumer electronics firms such as Sony, Panasonic, Sharp, Toshiba or Mitsubishi. But these firms have been much more profitable and competitive than their larger and better-known peers and have been generating attractive economic returns for years. And, just to reinforce my earlier point, these companies and their attractive returns are largely going unnoticed because no one is paying attention to Japan anymore.
There is a saying: adversity is not only valuable for what it teaches but also for what it reveals. Many of our Japanese holdings have been generating attractive returns for 15 years, despite an Asian financial crisis, a domestic banking crisis, a technology bubble, the global financial crisis, the European sovereign debt crisis and a devastating earthquake, Tsunami and nuclear disaster only two years ago. These businesses have generated nearly a 30% after-tax return on invested capital (ROIC*) – in a country where the corporate tax rates are 40% – despite operating in an economy which has stagnated for decades, which has been in deflation for 17 years, and which has seen its domestic currency almost double in value over the last 15 years versus the U.S. dollar.
Many value investors have found the Japanese market attractive because of its statistical cheapness. You couldn’t be a value investor if you didn’t find a 25-year bear market interesting! But we have found Japan more interesting because of the quality companies we are finding there. Put another way, we have ended up investing in Japan not because we like Japan, per say, but rather because we have found Burgundy-type companies that just happen to be headquartered there.
The third reason we have been attracted to the Japanese markets is a steady improvement in shareholder distributions. We like to invest in companies that can reinvest their profits in high returning projects. This ensures continued growth and profitability. When no such opportunities exist, we prefer management to return profits to shareholders in the form of dividends and, when it makes sense, share buybacks. Because the Japanese domestic market is mature and many companies have strong balance sheets and more cash than they know what to do with, we have been encouraged to see some companies take advantage of depressed stock market conditions to shrink their shares outstanding.
But while we have found opportunities in Japan, there are risks to consider when investing your capital there. While many of the risks are similar to those we face when investing elsewhere in the world, some are unique to Japan, such as the risks we face when investing in a country whose corporate culture often puts the interests of stakeholders (e.g., employees, customers, suppliers, creditors, society as a whole) ahead of shareholders – more to come on this topic in future posts.
*ROIC is a standard measurement to calculate how well a company is using its money to generate returns.