The Phoenix: Japan Inc. 2.0
If, in modern global equity market history, there has ever been a potential Phoenix to rise from the ashes, it is Japan. At the moment however, there is no pile of ash from which the Phoenix can take flight, so what do we mean?
Japan is standing at the edge of an abyss in terms of government finances. We have previously made the case here that for all intents and purposes, Japan is already bankrupt and in the short term – judging by the price action in the JGB market – it is a whisker away from insolvency in the medium term. This event is almost certainly coming at some point in the medium-term future, and the consequences for the Japanese economy will be very serious. We have already laid out the case in our piece ‘Japan is insolvent – but “please don’t worry”‘.
First however, let us look at the context of the case for ‘Japan Inc 2.0’ as NipponMarketBlog sees it.
As we have alluded to in earlier pieces, by virtue of its many inefficient companies, the investment potential in Japan is enormous. This is perhaps a counter-intuitive reason to invest for most market participants, and certainly not the conventional view among market pundits and analysts at the moment, but we believe that this is where the vast majority of investment potential resides – certainly in the long term.
To put it very bluntly and very simplistically, things are good because they are bad. As investors we should not normally be concerned with whether the current state of affairs is ‘good’ or ‘bad’. What we should be concerned with is the extent to which things are changing. In other words, if in terms of management and profitability a company is evolving from being a terrible company to just being a bad company, then that could easily translate into a 30% rise in the share price. If a company is transforming itself from being a bad company to just being a mediocre company, then that could easily translate into further 30% rise in the share price, especially if profitability at the outset is low which means that operational gearing is very high. So because corporate Japan is relatively unprofitable, the potential for improvement is already enormous.
However, realization of that enormous investment potential vis-a-vis increases in share prices, comes down to a range of factors such as actual restructuring and improvement in profitability, sentiment, valuations, greed vs fear, fund flows, and government intervention in the equity market. These are often referred to in market jargon as ‘catalysts’. We at NipponMarketBlog do not particularly believe in catalysts per se. So-called ‘catalysts’ are mostly something we identify after the event, often as an attempt at explaining what has just happened. In other words, a catalyst is something you imagine happening ahead of you, but you will only ever see it clearly in the rear view mirror. We have discussed this issue in the context of causality and human nature in our piece ‘Investing, Cusality and Human Nature’:
The Phoenix argument
Returning to the main thrust of this piece, the core of NipponMarketBlog’s Phoenix argument is this:
There is a distinct possibility that the coming unravelling of the debt spiral that Japan currently finds itself in, and that will almost certainly eventually result in some form or government default or debt restructuring, will actually end up serving as a catharsis for corporate Japan and for the wider Japanese economy. We realize that this is a bold statement, but let us examine the possible future course of events. If the government defaults on its debt, what might be called ‘Japan Inc. 2.0’, could eventually emerge as a much stronger force than it has been for decades – business cycles or no business cycles.
In this scenario the economy will however first take an extremely severe hit and require very significant readjustments. Combined with the collapse of the Yen, the demand side of the economy will likely contract very significantly very quickly. Consumers will stop spending, the corporate sector will cease all investment activity, savers will hoard their wealth (cash, gold, US dollars or whichever asset class they flee into) and as a result of this turmoil, economic activity will virtually grind to a halt, and a large number of companies will go to the wall. Because the lender of last resort (the BoJ) can no longer print its way out of the problem due to the fact that confidence in that very ability has vanished, and because the government is bankrupt and so can not bail out anyone (whether they be financial institutions or auto manufacturers), many companies will simply go bankrupt.
What we are talking about here is creative destruction on a truly massive scale, in the context of a collapsing economy where only the strongest and most resilient companies will survive. Unless all the zombie companies aggressively restructure their inefficient businesses and/or merge with other companies, they will not survive. This event could subsequently set off the largest and most sustained Japanese equity bull market in decades.A bull market that would make the recent ‘Abenomics-rally’ of 2012 and 2013 look like a badly written prologue to an excellent novel.
Notice that our Phoenix argument has nothing to do with Abenomics, or any other potential future political initiative to pull Japan out of the economic quagmire it finds itself in. It is instead centered around a dramatic, fundamental and wide-ranging reorganization of the entire Japanese economy, brought about by the collapse of public finances and the purge from the corporate sector of zombie companies that would be unable to survive in a truly competitive market, both with regards to end product markets and capital ownership, the latter of which is notoriously rigid in Japan.
The Phoenix argument and corporate ownership
On the topic of capital ownership, it is worth noting that the potential for an M&A boom in Japan has been there for years, but many of the zombie companies have muddled through on their own and have never truly been forced to act and change their ways.
In this context it is worth mentioning the so-called ‘poison pills’, which for years have discouraged foreign investors – especially activist investors – from buying Japanese equities. The poison pill is a tool that Japanese companies have used in the past when their shares were being bought by foreign investors who were intending to acquire a significant stake (perhaps even a majority stake) in a company, in order to restructure it. This aggressive take-over process is inherently very un-Japanese, and the poison pill allows management to issue new shares ad infinitum and thus dilute the shares already owned by the activist investors, effectively removing the threat of take-over and restructuring.
However, in a situation where the economy is collapsing on the back of a sovereign debt default, there is still technically nothing to stop a company from issuing poison pills, but what would be the point if it was going to go out of business anyway. All else being equal, the imperative to do something – to do anything in order to survive – would likely override the impulse to dilute new investors, even if they were activist investors.
If and when push eventually comes to shove and the government has defaulted, thus throwing the economy into chaos for a period of time, we believe that corporate Japan will ultimately prove itself to be sufficiently pragmatic to – if not actually embrace, then certainly accept – the restructuring and M&A imperative that will become apparent at that time. There simply will not be an alternative. There will be nowhere to hide, and the only remedy will be to take drastic action. Given the multi-decade absence of a real M&A culture, it stands to reason that the current potential for M&A is vast, and the resultant positive effect on the efficiency and productivity of the Japanese economy as a whole will be similarly significant.
The timing of the debt crisis
The big question of course remains; When will the government end up defaulting, and to what extent?
Given the example from Greece is seems that a modern sovereign defaults are not as straight-forward as simply announcing non-payment of any outstanding debt. Some level of ‘Debt restructuring’ might end up being the term that is eventually applied, meaning partial default with the cost carried by those unfortunates still holding JGB’s. This somehow also seems more in tune with the Japanese psyche.
However, until this happens, there is still plenty of restructuring potential for investors to sink their teeth into. The argument is simple: Instead of looking to a well managed relatively efficient company to grow its top line in a highly challenging global economic environment, look instead to the company that can restructure, lower its costs and grow its profits, even when end-demand for its products is moving sideways at best.
As we mentioned in the beginning of this post, because many (especially smaller) Japanese companies are often operating very close to break-even, i.e. with very anemic profit levels, the operational gearing from any increase in sales is often very significant. If that is combined with a restructuring effort that can significantly cut costs then the impact on profits, valuations and share prices can be dramatic.
So in closing, what the Japanese equity market needs in order for the bulls to really be let loose in what could turn out to be a multi-decade secular bull market, is a pile of ash. Precisely when and how that pile of ash materializes depends on a myriad of factors, and we would be naive to think that we could predict the time when this will happen. But if and when it does materialize, and once the dust has settled, you should probably be very long Japanese equities for a very long time.
NipponMarketBlog would like to stress that we take no pleasure in painting this dire picture of Japan’s medium-term future. The coming debt crisis in Japan, whether it happens in 2 years or in 5 years, will bring with it serious disruption to the Japanese economy and to Japanese society as a whole. Large parts of the population will suffer financially, and it will invariably lead to a generational political conflict between the retiring Baby-Boomers and those young Japanese who will not only find themselves financially disadvantaged relative to their parents’ generation, but also simply outnumbered as voters because of the demographic skew of the Japanese population.
But it is important to keep in mind that this will not be the end of Japan. We are not talking about Armageddon. What we are talking about is a very serious negative impact on the economy, which will then finally provide Japan with the impetus to restructure organically, as opposed to in a centrally planned manner. And the aftermath at least, has the potential to leave the country much stronger economically than is currently is.