Japan has become a gold mine for value investors

Takisawa Machine Tool Co

10/11/2023 02:04

(The author is a Reuters Breakingviews columnist.  The opinions
expressed are his own.)
    By Edward Chancellor
       LONDON, Nov 10 (Reuters Breakingviews) - Conventional
wisdom holds that stocks deliver around 6.5% a year after
inflation. That’s the historic return from U.S. equities
publicised by Wharton professor Jeremy Siegel in his
best-selling book, “Stocks for the Long Run”. Yet there have
been certain periods when listed shares do especially well,
and others when they disappoint for years seemingly without end.
Investors in Japan know this only too well. Having experienced
a multi-decade decline after 1990, Japanese stocks have escaped
the doldrums. Their recent run could last for years. 
    It's not uncommon for equities to deliver negative real
returns over 10-year periods. The U.S. stock market has
experienced four such occasions since 1900. Yet American
investors have never suffered the tribulations of their Japanese
counterparts. Between 1990 and 2023, equities in the Land of the
Rising Sun compounded at an annual rate of -0.3%, according to
the Credit Suisse Global Investment Returns Yearbook. The
Nikkei 225 Index  .N225  remains well below its 1989 peak. 
    The obvious explanation for these miserable returns is that
in 1990 Japanese stocks were wildly overpriced, trading on
nearly 80 times cyclically adjusted earnings and three standard
deviations above their long-term trend. However,
stocks continued to disappoint even when the bubble economy had
become a distant memory. 
    One problem was that Japanese companies were far less
profitable than counterparts in the U.S. and Europe. Strategist
Alex Kinmont claims Japan Inc’s depressed returns on equity were
mostly due to deflation and corporate deleveraging that occurred
after 1990. This situation was exacerbated by the expensive yen
 JPY= .
    Those headwinds have passed. Today, Japanese companies in
aggregate have no debt but are sitting on nearly 2.5
trillion yen ($16.5 billion) of cash. Deflation has given way to
mild inflation. And the Japanese currency is extremely
competitive at around 150 yen to the U.S.
dollar. Local manufacturers enjoy some of the lowest labour
costs in the world. 
    Falling interest payments have boosted corporate earnings.
James Montier, my former colleague at the investment firm
GMO, points out that profit margins in Japan have risen to
nearly 5.5% over the past decade, from a historic average of
less than 3%. This improvement is reflected in the recent strong
performance of Japanese equities which have delivered annual
real returns of 7.4% since 2010, according to Credit Suisse.
    Another shadow that has long lingered over corporate
Japan is management teams which tended to neglect shareholders
and prioritise the interests of other stakeholders. Foreign
activist investors found they were unable to unlock the value
they saw trapped on corporate balance sheets. Slowly this is
changing.
    The impetus for reform comes from on high. The Ministry of
Economy, Trade and Industry (METI) believes excessive domestic
competition has made it difficult for Japanese companies to
thrive on the world stage. METI wants to consolidate fragmented
industries: for instance, the country is home to nine carmakers
and around a dozen printer manufacturers. To this end, the
ministry is working to create an active market for corporate
control.
    METI is also redefining the aim of Japanese companies, says
Stephen Codrington, founder of the independent research
firm Codrington Japan. METI has deleted references to other
stakeholders contained in former guidelines. Instead, companies
are enjoined to maximise future cash flows.
    Policymakers want firms to focus on high-return, high-growth
operations and offload underperforming businesses. Electronics
companies Hitachi  6501.T  and Fujitsu  6702.T  are divesting
non-core operations. Retailer Seven & i  3382.T  sold its
department stores to the U.S. private equity firm Fortress
Investment. Carmaker Toyota Motor  7203.T  is reducing its stake
in telecom operator KDDI  9433.T  and has pledged to halve its
cross-shareholdings in other companies.
    Other official institutions are likewise pushing domestic
companies to raise their game. The $1.3 trillion Government
Pension Investment Fund, now heavily invested in domestic
equities, requires higher returns to pay retirees. The Tokyo
Stock Exchange is seeking to improve corporate governance.
The bourse has also demanded that public companies whose shares
trade below book value come up with a plan to improve returns on
capital.
    Corporate activism is no longer seen as counter-cultural in
Japan, according to Toby Rodes of Kaname Capital. Rodes, whose
firm invests in small-cap Japanese stocks, has been approved to
serve as an independent director of a listed company. This
wouldn’t have happened five years ago, he says. Unsolicited bids
are no longer automatically rebuffed. Electric-motor
manufacturer Nidec  6594.T  recently completed a 17 billion
yen hostile takeover of Takisawa Machine Tool Company  6121.T .
    Incumbent managements are coming under pressure from
activist investors. A recent proposal by ValueAct to change
management at Seven & i attracted up to a third of the votes.
Grants of restricted stock to senior executives have climbed to
1.4 trillion yen from close to zero five years ago, according to
Codrington.
    It's too early to talk of a shareholder-value revolution in
Japan. More than half of listed companies still trade below book
value. For example, $25 billion machine maker Toyota Industries
 6201.T  is worth less than its cash and long-term investments.
Still, change is well under way.
    A recent paper by Edward McQuarrie, professor emeritus at
Santa Clara University, refutes Siegel’s claim that stocks
invariably deliver 6.6% real returns. Instead, McQuarrie
suggests that historic asset returns have been “specific to the
regime that prevailed at the time”. Since the 1970s, the
prevailing regime in the United States has been friendly to
shareholders. Now, U.S. public companies are considering the
interests of other stakeholders. Japan, whose regime was
formerly unfriendly to equity investors, is moving in the
opposite direction, says Drew Edwards, head of GMO Usonian
Japan. Throw in expected currency appreciation, and GMO expects
Japanese small caps to deliver 12.6% a year for U.S.-based
investors in the coming years.
    Yet there’s still a widespread assumption that the poor
returns delivered by Japanese equities since 1990 are the norm.
Foreign investors remain underweight even though valuations are
compelling, the currency is cheap and a market for corporate
control is taking off. Japan, as Codrington says, has become a
gold mine for value investors. That explains why Warren Buffett
is buying. 

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Japan's Nikkei 225 Index remains well below its 1989 peak    https://tmsnrt.rs/3QTIm1M
Average profit margins have risen to 5.5% in the past decade   
https://tmsnrt.rs/3MCsXA2
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 (Editing by Peter Thal Larsen and Thomas Shum)
 ((For previous columns by the author, Reuters customers can
click on  CHANCELLO/ 
edward.chancellor.bv@gmail.com))