Nihon - September 2018
The Japanese stock market recently hit a new 20 year high. This news, of course, neglects the fact that the stock market peaked in 1989 at a level almost 2x where it stands today. The asset crash that took place in the late 80’s and early 1990’s in Japan reshaped nearly everything about the economy for the foreseeable future. Foreign equity investors have had a mostly negative relationship with the market ever since. It’s a large enough market to not completely ignore, but one that except for short, spirited spurts, underweight was the preferred course. We believe the investment reality in Japan is relatively more positive than it has been in a long time. Policymakers remain fixated on the structural issues such as deflation. Corporate Governance is something that is taken more seriously with push from the recently strengthened Corporate Governance Code. And on a possibly related note, corporate earnings have soared. Irrespective of 20-year highs, we at Ballina Capital have found attractive value in Japan, and remain bullish on our Japanese holdings. Here follows a brief description of some of what we like:
Marubeni (8002 JP)– a Japanese Trading co. By definition, Marubeni are involved in a raft of industrial, commodity, finance/leasing and supply chain arrangements both within Japan and around the world. These companies (“Sogo Shosha”) have always looked cheap relative to book value and sales. They still do. The negatives have been: a) a willingness to invest pro cyclically with losses resulting in the following downturn, and b) stubbornly high debt levels. For Marubeni, they are more invested in agriculture and metals/resources than they are in oil and gas assets. Less than 3% of 2019 adjusted net profit is estimated to be from Energy, according to the company’s own estimates. Free cash flow went negative in the Year ended March 2015, when commodity prices had collapsed. This brought renewed discipline back to the group, and since then free cash flow has been positive. Equity has resumed climbing, and Net Debt has fallen steadily since 2016. The Net Debt/Equity ratio is expected to reach 0.9x in FYE 3/19. There was a time in the early 2000’s when this ratio was almost 10x. The ROE was 14% in the latest fiscal year, a high level for the group considering the balance sheet is much safer today. The shares are at a 10-year high, but the valuation is still attractive at 1x book value.
Sumitomo Mitsui Trust (8309 JP) – the Japanese banking sector is notorious for low profits. The Japanese Central Bank extraordinary monetary approach in recent years has been unhelpful given that lending spreads were already miniscule to begin with. Sumitomo Mitsui Trust (“SMT”) is not immune to these issues, but they have the advantage of being a Trust Bank, and therefore they have Assets Under Management that are more than 3x larger than the loan book. Therefore, the goal of driving the % of fee income higher is less of a challenge than for others. They still have an enormous amount of equity holdings for their own account (more than ¥1.5 trn at market), that they are very slowly selling. The Balance Sheet is healthy, and the dividend payout is as well. Trading for roughly 0.7 tangible book value (that keeps growing) seems too austere for a solid institution.
Mitsubishi Materials (5711 JP) – manufactures and sells cement, metals, ceramics and other industrial materials. The group has been mired in scandal for much of the last year, as they, like others in Japan, were found to have falsified data related to product quality. Governance is a very serious issue in corporate Japan that will take quite a while to improve. The President has resigned, and the culture is on the way to improving. The scandal has brought the share price down by 17% in the last year, but we believe the base of the company is not industrially weak. The group has a strong international base with roughly half the sales emanating from outside Japan. And the group has a strong presence in the materials needed for the next generation of automobiles, as well as for many other end markets. The balance sheet is significantly stronger than it has been during the group’s history. We like the strong free cash flow the group generates, as well as a valuation at a discount to it’s own history.
Japanese shares have been the beneficiary of ultra-loose monetary policy from the Bank of Japan (“BOJ”), with bond yields targeted for around 0%, and a central balance sheet of more than ¥500 trn. Corporate Japan is riding high on this wave, with capital spending in Japan set to hit a 38-year high. Japanese profit margins have doubled since 20131. BOJ policy has aided the extra sensitive cyclicality of corporate Japan, but the additional kicker has been corporate governance reform. As with profitability, Corporate Japan has given lip service to shareholder interests for far too long. The lowest trailing 5-year dividend CAGR of the companies mentioned herein is 5.3%. The Japanese market is not without risk: policymakers can change direction rapidly, and Japan remains a country significantly sensitive to a global economy that appears to be in the latter stages of the cycle. Trade war concerns for Japan are legitimate. We believe that in the case of the shares that we own, that expectations are low, and that valuations are attractive. Our bottom up approach has led us to allocate roughly 22% of our International All-Cap Value strategy to Japan. This is more than 400 bps ahead of our benchmark. The profit margins mentioned above still sit at about ½ the level of the U.S. The dividend payouts are still in the range of 30%. More work remains to be done.
International All-Cap Value returned 1.68% (gross basis) in September 2018 versus 0.21% for the benchmark. Year to date performance was -5.26% (gross) versus -3.21% for the benchmark.
Global Small Cap Value returned -2.03% (gross) in September 2018 versus -2.03% for the benchmark.2 Year to date performance was -1.76% versus 3.03% for the benchmark.
1 Source: Factset
2 Benchmark for Global Small Cap Value comprised of 50% weight iShares Russell 2000 Index (IWM) and 50% weight Vanguard FTSE All-World ex-US Small-Cap ETF (VSS)