Japanese Stocks

There are cheap stocks in Japan.  This is not new and I am far from the first to mention it.  In the cycle of innovators, imitators, and idiots, this approach is one of imitation.  There now appears to be an ecosystem that could see the share prices of Japanese companies reflect their underlying value.  There is a range of evidence pointing to a multiyear trend of dividends, buybacks, exiting unprofitable business lines, consolidation, and buyouts combined with a diverse set of market participants spurring on this behavior.

As a possible investment opportunity, this backdrop resembles a cross between a Walter Schloss (“Noah’s Ark”) approach to investing and the “shareholder value” wave of The Eighties. Many companies are cheap on an earnings and tangible book value basis, with sustainable and resilient business models, sometimes a noncore business or two that is a distraction, and have excess assets (cash, securities, real estate) that can be monetized and distributed.

I will start with the events that creates the opportunity.  Then some process oriented guardrails.  Then a few examples.

As background, this is just my idea of fun.  I view this as personal investment journal, not a formal pitch. I don’t speak Japanese.  I am very dumb and find math hard.  I’m not a concentrated compounder bro.  This is all just thinking out loud and not investment advice.  If you know anything pertinent I don’t, a certainty, thank you in advance for sharing.

Japan Today

There is a philosophical exercise where one contemplates a grain of sand.  Another grain of sand is put on top of the first grain.  This continues with more grains being added.  The question that emerges is at which point do the grains of sand become a pile of sand.  As far as investment opportunities go, I believe the attractiveness of cheap stocks in Japan is now a pile of sand.  There is more than wishful thinking that one factor will prompt a complete change in behavior towards shareholders and there is evidence that the process is already well underway.  All of this is in contrast to the general disinterest expressed in valuations today.

1)      Abenomics – If a foreign investor historically met with a Japanese management team, the investor might think the only thing not lost in translation was “R-O-E.”  Japanese management teams say those three letters in English.  It meant it was literally a foreign concept to them, not that they had innate conviction in its validity as a goal, like the lack of a French word for “entrepreneur”.  Abenomics, which has been the agenda for almost 8 years now, is forcing the issue by prompting companies to exit loss making or super low margin non-core businesses and reduce cross holdings, which are inputs to the ROE calculation.  Focusing on the precursors to ROE as a policy is far more impactful than outsiders talking about ROE in the abstract.

Abenomics exists foremost in the context of national pride, which in part will be driven by how the business community responds to the threat of economic stagnation, increasing competition within the region, and demographic headwinds.  The famous Japanese samurai George Washington-san said that in a democracy “people must feel before they see,” and Japan is increasingly feeling themselves at the crossroads where they need to make economic decisions that run counter to the status quo.  It makes sense on their own terms for Japanese companies to focus on remaining economically competitive in today’s world and to more efficiently allocate increasingly scarce human capital, reducing the need for employment for life in economically irrational jobs.  To top it off, the easiest way to get someone to do what you want is to make them think it is their own idea, and the Abenomics branding conforms to this reasoning.

2)      Japanese Government Pension Investment Fund – This entity manages ~$1.5trn for Japanese public pensions.  The GPIF owns ~10% of the Japanese equity market.  About 5 years ago they finally appointed a CIO with investing experience, who has just been replaced by a former Goldman Sachs partner.  They have a “Policy to Fulfill Stewardship Responsibilities” on their website, in English to boot, that was first released in 2014 (along with the government stewardship code) and have been updated several times, most recently in November 2019.  An excerpt:

“As GPIF invests in equities and exercises voting rights through its external asset managers (asset managers), it promotes constructive dialogues (engagement) between asset managers and investee companies. GPIF will thus fulfill stewardship responsibilities by promoting engagement between asset managers and investee companies, and building a win-win relationship in the investment chain. In this chain, a medium-to long-term improvement in corporate value will lead to growth of the overall economy, which will eventually enhance investment returns.”

I am famous for saying that it is dangerous to be right when the government is wrong, but players like the GPIF show that such danger doesn’t exist for investors in the realm of Japanese corporate governance today.  In a similar vein, a senior director for a $120bn Japanese pension fund has traveled to the US and London to encourage activists.  It is hard to dismiss these people are meddling foreigners.  The GPIF isn’t perfect, but is headed in the right direction.

3)      Activism – Activism has reached exit velocity in Japan where it appears to be a permanent aspect of the market, with overall data showing the number of activist funds going from 7 in 2014 to 23 in 2018, 2 or more independent directors on most boards, and the number of shareholder proposals rapidly increasing.  Especially noteworthy is that it is not a homogenous approach in aggregate and shows evidence of evolution in the right direction to “unlock shareholder value” within the context of Japanese corporate culture.

a.       Domestic Activists – The main point will continue to be that Japanese people are telling Japanese companies what to do, which I find the most compelling evidence the shift is real.  They can’t be dismissed as gaijins.  They aren’t out of line with government initiatives either.  It also shows that people much closer to the situation see an opportunity in activism.  This is very distinct from Japanese activism in the 1990s or 2000s.  There are individuals active in microcaps, like Beji Sasaki (1, 2) as well as larger company activism, like Yoshiaki Murakami (1, 2, 3).  The activists are even breeding now, as the man behind Effissimo used to work with Murakami and the man behind Lone Alpha used to work at Oasis.  There are activists involved in small companies as well, such as Simplex, which appears to work behind the scenes.  Strategic Capital has a confrontational approach.  Hikari Tsushin is a tech reseller to SME’s with a colorful CEO that now shows up on the register of a lot of cheap Japanese companies and recently swooped and forced a higher premium on a MBO and owns a large basket of cheap Japanese companies.  Asuka has been working behind the scenes in small caps since 2005.

b.       Foreign Activists – Everyone is getting in on the act now.  There is a good diversity of players and approaches.  Third Point, Elliott, Oasis (1, 2, 3, 4), ValueAct, Fir Tree, Taiyo, Dalton, Silchester, King Street, and even Doc Burry.  Taiyo has been engaging with Japanese companies since the 2000s and their press releases are complimentary to the company and sometimes include a welcoming quote from management when they get over a 5% stake.  Third Point has had some success and some failure, but they are taking a decidedly un-Mr. Pink approach in recognition of Japanese social norms.  Several have been around a while and more players are entering the ring.  Even Fidelity is on the record pursuing “friendly engagement,” with Japanese companies.  This is a diverse lot with diverse approaches, which means the activist ecosystem should continue to evolve in a productive direction as the best approaches are identified.

4)      Crossholding clean up – Many Japanese companies have large securities portfolios consisting of shares in other Japanese companies they do business with.  There are also many companies with listed subsidiaries.  Abenomics encourages them to sell these off or buy in these businesses, and some are.  There seems to be some protection against a take under with companies being pushed to pay higher prices such as with Elliott and Oasis and Alps or Hitachi’s slimming down  or Toshiba acquiring companies in which they have large stakes.  The government is also finalizing some guidelines that suggests further safeguards for minority investors, recommending fairness opinions and go shop measures.  This can provide companies with opportunities to repurchase big chunks of their business or cash out to a large shareholder at a still attractive price.

5)      Private Equity – The involvement of private equity in Japan is quickly ramping up, which could serve as another catalyst.  KKR made some good money buying Hitachi Kokusai and selling it less than two years later.  Bain has been in Japan long enough that Apollo is now getting in on the act by hiring a Bain guy to manage a new fund.  KKR has done well so far and continues to be excited.  CVC is entering the ring.  Because there are companies with ample enough cash piles to basically fund their own LBO’s, there is the risk of a take under.  There have been domestic activists, in the case of Murakami and Kosaido with Bain’s approach or foreign activists, in the case of Elliott and Hitachi Kokusai with KKR’s approach or Elliot and Unzio with Blackstone’s approach, which demonstrate its more likely than not that PE can’t succeed with small premiums.  While I wouldn’t pursue a strategy of investing on the basis of a PE takeover, the risk/reward is favorable given the margin of safety in valuation combined with an insurance of sorts that lowball takeovers could attract activists and additional bidders.

6)      Hostile takeovers – There isn’t an abundance evidence this is the new normal, but hostile takeovers are starting to emerge.  There was recently a hostile takeover of a JREIT, a first for the sector.  These are examples of Japanese companies being hostile to one another, which seems like the crossing of the Rubicon for something once thought impossible and contrary to Japanese social norms.  These initial cracks hint at what is possible.  Once a few more of these occur, it would possibly be enough to unlock a slew of measures to preempt becoming a target.  Admittedly this includes poison pills, but perhaps it is still quite uncomfortable if there is an offer at a 100% premium for the company, which is feasible given how cash rich and unlevered many balance sheets are in Japan, both bidders and targets.

7)      Changing of the guard – succession issues are becoming prominent across SME’s in Japan, as the average owner is 69.  There is a company in Japan, Nihon M&A, that focuses on advising Japanese SME’s on M&A, and their business is booming.  This offers the opportunity for industries to consolidate and companies to get sold off.  Old men who have lived their lives under the traditional paradigm are not naturally keen on the idea, but it is gaining traction.  A broader acceptance of M&A increases the routes to underlying value being recognized without being directly dependent on management.

8)      Listing requirements – the Japanese Exchange Group is creating a potentially large catalyst for companies to consolidate or adopt good corporate governance by changing the listing requirements, outlined here.  There will be a size, liquidity, and governance requirements to be on the first section, which Japanese corporate society considers a prestigious sign, and supposedly helps with recruitment and access to credit.

9)      Proxy advisors – Proxy firms are getting a more prominent role in Japan, with Nomura as an example of their influence.  ISS is looking for a focus on ROE, etc. etc.  The importance of this is it acts as a clearinghouse for activism.  My understanding of successful activists in the US is that their presence alone isn’t the deciding factor.  They must influence other shareholders to have enough votes.  The proxy advisors are an important mechanism for doing so, especially as many institutional shareholders just follow the proxy advisor recommendation.  As more asset managers and the GPIF push the governance code, activists now have an opportunity to point out where companies fall short, communicate with proxy advisors who then disseminate a view to other shareholders.  A secondary benefit is that it allows shareholders to support the demands of an activist campaign without being involved in the messy elements.  This is particularly valuable when trying to address issues in a country where outright conflict is not an effective means of resolving them.