Why Japanese equities are a Nirvana for stock pickers
Japanese equities is a great place to invest – if you are a stock picker.
This view may be surprising to some, and it is probably safe to say that most global equity investors seem permanently either confused or frustrated by Japanese equities (or possibly both at all times), but we will explain our position in more detail below.
NipponMarketBlog’s enthusiasm for Japanese equity stock picking may also come as a surprise to those who have followed the Japanese economy only on an aggregate basis over the past few decades, and most likely concluded that it is terminally ill and simply inherently incapable of performing to its full potential.
Both of these points are valid to some extent, and NipponMarketBlog has certainly been (and still remains) highly sceptical about the ability of the Japanese government and the BoJ to actively manage and direct the Japanese economy back onto a sustainable growth track, as we have written about here and here.
The whole thesis behind Abenomics is that government legislation, fiscal stimulus, monetary easing and structural reform can somehow transform the economy and give it a push that will allow it to gain enough momentum to start growing again, and hence increase tax revenues and save the government from some sort of default on its debt. We do not believe that it will be as simple as that, because many of the issues that need to be addressed are outside of what governments can realistically affect. We have expanded on these views in several pieces over the past few months, including in the piece ‘The Phoenix: Japan Inc. 2.0’, in which we argue for wide ranging creative destruction in corporate Japan as a means for Japan to resurrect itself economically.
However, all these apparently negative factors only provide the context or the setting for investing in Japan, and as long as one is aware of the nature of this investing environment, and as long as one has an eye on the state of the macro-economy and public finances, one can simply get on with the business of investing.
The case we are putting forward here is not one that takes its cue from Abenomics or any other policy initiative, past, present or future. Neither does it argue that Japanese equities are necessarily cheap (although they often appear relatively much cheaper than most other developed market equities). Our case is for picking individual stocks (and possibly hedging out the broader market if needed).
So why is NipponMarketBlog excited about stock picking in Japan? There are four main areas that make Japan one of the most interesting, and potentially most profitable markets for stock picking. We will go through them in turn.
1. An abundance of ‘pure play’ opportunities
The Japanese equity market is comprised of several thousand listed companies, spread across virtually all sectors.
Many of these are small- or mid-cap companies, and many of those offer almost ‘pure play’ exposure to major broad global product trends or even specific products, at least as far as what ends up being the swing-factor in earnings for the companies that have this exposure. In other words, it may be that the companies in question are not ‘pure play’ in the conventional sense of being dedicated to supplying a specific product or market, but in terms of what drives earnings it is often the case that just a few products end up determining the earnings trajectory of the company in the short term.
This is especially true in the manufacturing and basic materials sectors. This means that one can always find a company that is plugged into the prevailing global product trends such as iPad, Xbox, Playstation, solar panels, LCDs, hybrid cars, 3D-TVs etc.
If there is an electronic gadget that is in the process of either taking over a market or carving out an entirely new market for itself (such as the iPad several years ago), then chances are that it is possible to find several Japanese companies, either in the electronic components sector or the basic materials sector, that have direct exposure to this product. This offers opportunities to directly tap into that growing global demand in a way that is otherwise only possible by buying the shares of the (most likely over-valued) originator of the product, which in this example is Apple.
2.Strong innovation and engineering culture
Corporate Japan is essentially an engineering culture, at least as far as the manufacturing sectors are concerned. Corporate pride in Japan (as well as corporate goals) often revolve around R&D and general engineering prowess, and less around financial targets.
It is not unusual, when visiting Japanese small- and mid-cap manufacturing companies to discuss their most recent business trends and earnings outlook, to be faced with middle management all wearing coveralls. They most likely spend little to no time in an environment where that type of attire is necessary, but they wear it nonetheless. Anecdotal as this may be, it hints at the underlying truth that engineering prowess is highly revered within corporate Japan.
This is both good and bad. The negative side is that the engineers are often the most powerful people within corporations (especially in smaller companies), and this leads to a tendency to prioritize products over profits.
The positive side of this characteristic is that corporate Japan delivers a constant stream of innovative products and technologies – especially in manufacturing and basic materials industries – which are very much at the forefront of global technology and innovation. In addition, it is especially true in these two sectors (specifically electronic materials and industrial chemicals) that high R&D barriers to entry leave companies relatively free of competition.
There is an enormous amount of R&D going on in these two industries in particular, and these companies seem to like nothing better than to come up with a new and innovative design, or product or chemical compound, even if its actual use is not yet clear. Another way of illustrating this is by pointing out that if faced with financial difficulty, the average Japanese company will most likely look to one of their new products to save them, as opposed to looking to existing products and their profitability to determine if the business as a whole needed restructuring.
This tendency is the very essence of the engineering culture, and often leads to development of leading-edge products, if not necessarily profits.
There is however an additional, and perhaps surprising, positive consequence of the emphasis on engineering over profits, which we shall explain below.
3. Very high operational gearing
In general, Japanese companies are relatively poorly managed and inefficient when compared with many of their overseas competitors.
As indicated above, the emphasis tends to be on engineering prowess, and less on profitability. Most investors, especially Anglo-Saxon investors who approach equity market investing with an entirely different mindset, will point to this as a reason to avoid Japanese stocks altogether, as they generally deliver relatively low profit margins and returns during the course a normal cycle, when compared to global peers.
However, it is precisely because Japanese companies are often less than perfectly managed and have large but only marginally profitable manufacturing assets, that they can become highly attractive under certain conditions. The reason is that even a moderate increase in sales often result in an explosive increase in profits, i.e. their operational gearing is often huge.
For example, if a technologically leading edge Japanese mid-cap electronic component manufacturer signs a contract with Apple to supply its Taiwanese assembler with a certain set of components for the latest iPad model, then sales may only rise by say 15%, but profits could easily rise by 50%, because of the company’s high operational gearing. Depending on the length of the contract, this profit growth may last several years, and equity markets being as simplistic as they often are, will tend to extrapolate this growth into the future. In this scenario, it is not unusual for a Japanese mid-cap stock to double or more. The same could apply to the metals or chemicals companies that supplies the raw materials for the manufacturing of this new product.
This dynamic, which is particularly pronounced in Japan, offers up an almost constant abundance of investment opportunities in a variety of areas, that importantly are secular in nature. This latter point means that the positive impact on the relevant Japanese company’s earnings is often somewhat insulated from wider macro-economic conditions.
In short, relative to most other global equity markets, Japan often offers significantly more ‘bang for the buck’ where new global consumer products are concerned.
4. Inefficient equity pricing in the short term
In the long term, equity markets are driven by valuations. Ultimately, investors will pay $100 for a $100 bill, or $100 for $100’s worth of equity in a company. The latter of course resting on the assumption that markets can efficiently price companies, which in the long term is certainly true.
However, in the short term, equity markets are driven by simple supply and demand, global liquidity flows, country specific fund flows, as well as ultra short-term news. In the case of the Japanese equity market, foreigners are routinely more than 50% of volume across the exchanges, so their involvement often adds significantly to Japanese equity markets being a very inefficient pricing mechanism in the short term.
This fact, combined with the fact that liquidity (in the sense of trading volume) in Japanese equities is often relatively thin, means that the market as a whole tends to be very volatile, and individual stock moves often become highly exaggerated.
Volatility is often seen as a problem for investors, and certainly for macro-investors or medium-term momentum traders in Japan it can be problematic.
However, for a valuation and fundamental analysis centric stock picker with a longer time horizon, this volatility is a boon as it constantly provides an abundance of opportunities for exploiting mis-pricing in the market. Even in a relatively calm macro-economic investment environment, stocks routinely over-and undershoot reasonable fair value targets by 20-30%, and each one of these instances represents an opportunity to enter or exit positions.
The outcome of this is that mis-pricing of individual companies’ stocks are the order of the day, and so a dedicated stock picker will always have plenty of opportunities to both buy and sell stocks at attractive levels.
Reflections on the future of investing in Japan
All in all, Japan is probably a somewhat misunderstood market, in the sense that it is most often seen as a ‘play’ on global growth, or as a leveraged derivative of the USDJPY exchange rate. This is especially true as far as global equity managers and asset allocators are concerned.
Both of these approaches are entirely valid, and the evidence speaks for itself in terms of Japan’s role as a leveraged ‘play’ on global growth, but there is a much more interesting and potentially profitable way in which to invest in Japan, i.e. through stock picking. Of course, this approach requires significantly more dedication, as well as time and experience, but there will always be a market for active investing in Japan.
Importantly, in the event that Abenomics fails to deliver in lifting all the boats equally, it is going to become increasingly important to differentiate and apply a much more selective approach to Japanese equities going forward, and Japanese equity fund outperformance will increasingly come to rely on a proper understanding of the Japanese market’s opportunities and limitations as outlined above, as well as a structured investment approach with a solid valuation framework.
Tags: @NipponMarket, Abenomics, Apple, Asset allocation, Bank of Japan, Business, Dollar, economy, Economy of Japan, fair value, iPad, Japan, Japan government, JPY, List of companies of Japan, Operational gearing, PlayStation, Profit margins, share prices, stock picking, stock selection, Tokyo Stock Exchange, TSE, USD, volatility, XBox, Yen
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