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Japan’s markets are dirt cheap

Nicholas Smith, Japan Strategist at CLSA in Tokyo, made headlines with his CNBC appearance on Monday. Luckily, we already had our interview scheduled for right after, so Nick provided a deeper discussion of his perspectives on the Japanese markets, how foreigners have left just as profit growth was accelerating, why the Bank of Japan’s ETF buying spree has had little effect, and warns against underestimating Suga-san as Prime Minister. Here is the essence of our interview, edited for ease of reading. For the full interview, please click below for Spotify, or check the podcast platform of your choice.

We saw you on CNBC yesterday. So the headline for this podcast has been made already. Japan is still cheap — why is it so cheap?

NS: I think the trouble we’ve had with the Japanese market is that foreigners been selling it off since the first week of June 2015. So they sold off about USD 240bn, which is a very, very big number. They got excited at the beginning of Abenomics. They thought, “Yeah, we are going to see some quantitative easing, we have seen that movie before, we know how it ends.”

So the strangest thing is if you run foreign buying at the market against corporate profits, initially, they both go up together. But then foreigners start selling and profits keep on going up. So they clearly got bored with something. And the thing that amazed me was, if you run that against BOJ’s buying of bonds, the two charts just sit straight on top of each other. And I was stunned by this. A client had asked me, “Can you update numbers of BOJ buying?” and I yawned a bit and thought, “God, what a boring thing to be doing. Everyone knows that is a dead story.”

Then I looked at the chart and went, “Oh, my goodness, I know this chart from before, I know that they are going to sit on top of each other.” So now we do not have a story for Japan anymore. I would have thought that people should be interested in profit. Isn’t that what we are here for? But that has not been enough for them, that I think is the problem.

A couple of days ago, ADIA, the Abu Dhabi Investment Authority, was closing down its Japanese investment team. They said they want to look for places with bigger growth. This always confuses me. The strongest period of GDP growth in Japan was the 1960s, from 1963 to 1967, during which time the market went absolutely sideways, while the GDP growth was literally 10 to 12% a year. So GDP growth and market growth do not seem to go together. In fact, I saw one study by LSE that was showing they are actually slightly negatively correlated, looking back at 120 years of 20 countries’ data.

That is where we are at the moment, when people get very excited about GDP. They say we must invest in places with fast GDP growth. I don’t think that is what the markets are about at all, the market is about finding mispriced assets, which we very definitely got in Japan.

So the foreigners basically sold to Kuroda-san at the BoJ?

NS: That does not actually work as well as you think it does. So the BOJ buys ETFs. In order for them to do that, someone has to create the ETFs which is very often the trust banks, the trust banks buy stocks to put in the ETF to back the ETFs.

Then they need to do something to raise their return on those stocks. So they lend securities out to hedge funds. So the strangest thing is that you can hear people talking about this and they say, well, Kuroda has bought and buried all these stocks. No, actually, there is a reason they are counted as part of free float. They are actually out for lending to hedge funds, who use them to short sell the market. I went through the rather dull job of calculating exactly what the BOJ must own, and the stocks that it defacto owns the most of are now the most heavily traded stocks in the market. So it has not squeezed out liquidity on these names and driven up share prices, rather exactly the opposite which is completely counterintuitive.

The result is it does not actually do terribly much for the market. Then you run that alongside one other thing, which is saying actually over the period that Kuroda has been at the the Bank of Japan, since April of 2013, the valuations of Japanese stocks have gone down instead of up, so all those trillions of JPY worth of BOJ buying stocks have gone along with valuations going down, not up. So it clearly has not done what it said on the wrapper.

I went back to some of my notes from the fabulous CLSA Forum in May. There was a note in Mr. Seagrim’s presentation on how the BOJ ultimately could divest itself from the 5.5%, or maybe now 6% of the stock market it owns. The proposal was to issue an ETF on their holdings, offer it to the the Japanese public, and then make it tax free on inheritance tax, so that then creates an incentive for private investors in the Japanese stock market.

It is an interesting idea. I mean, another thing they could do is sell off their stocks to the Government Pension Investment Fund (GPIF), which is somewhat light on Equities generally. But Equities are different from Bonds. The bond has a sort of use by date, and at the end of a 10 year bond it is redeemed, whereas that is not the case with equities. So you do not actually have any time pressure on them at all.

You say, “What is the BOJ going to do? It is not getting a return on it.” Well, it did fund them with money that it had created out of nothing. A lot of voters find that difficult to understand. And they ask, “What are you doing with my money?” It is imaginary money, it does not really hurt you. It is the equivalent to clipping the outside of a gold coin, theoretically it reduces the worth of other notes. And yet, if that were the case, well, we would have had inflation caused by that. And we have not had any at all.

Every central bank has been printing money like crazy. And some people would argue that we had a decoupling of the stock market and the real economy. As you said, the price/earnings ratio in Japan has actually been trending down. So it is still a mystery why it didn’t take off in any meaningful way here.

Japan actually has a quantitative easing (QE) story going back to 1994/95. An old colleague of mine from Jardine Fleming, Richard Werner, he wrote a book on the “Princes of the yen”, and he was the guy who originally came up with the idea of quantitative easing, the words quantitative easing are words that he created, or rather translated into English. He was rather worried about the idea of just printing money.

I remember writing about that right in the fourth quarter of 2012, saying, “Well, my experience of working with Richard Werner is that this is not going to work, it is basically like trying to fill the bathtub with the plug out, it is not actually going to change anything,

I am getting a little bit technical, what you are doing is print all this money, but the velocity of the money keeps on going down. What quantitative easing really does is when it works, basically you are taking toxic assets off the banks and putting it on the balance sheet of the Bank of Japan. That allows the banks to get on with what they do, which is lending money.

This business about the Bank of Japan, buying all sorts of other assets, is a nice idea. But lowering interest rates has nowhere, in any market, managed to result in accelerating GDP growth. It is a lovely idea. But the idea that lower rates accelerate the economy is something that economists have treated as axiomatic without actually testing that it really works.

Which is a difference that I always find frustrating between economists and scientists. I am a particle physicist by training. If we get something wrong, if one particle goes in the wrong place in CERN, then 300 years of Physics go out the window. But with Economics, they just keep on saying it ought to work.

We just standardize the assumptions, and everything is a perfect market, everything is priced in, which could not be further removed from the real world.

NS: No, we are talking about people. People are very complicated things. They act for sort of non-scientific reasons. Very often we know that something is wrong, and we do it anyway. But you look at the equations that the economists provide and wonder, “That is an equation?” We were doing more complicated equations in science when we were at elementary school. And economists believe that those equations are going to describe the activities of human beings? Probably not

Half of the listed stocks trade below book value, some of them probably for a good reason. But I assume you have some quality that you are spotting there as well?

NS: The simple way of looking at it is just to say that half of companies trade below tangible book value. Tangible book value, that is sort of a hard number, the kind of things that you can stub a toe on like buildings, property and so on. In some cases, it is a useful number. If you are a real estate company, or a retailer, for example.

Don Quixote bought a number of retailers for their property. I remember going along to one department store in 2006/2007. The foreigners had this idea that you persuade the department store to sell off its real estate, and then lease it back. The person with a department store made me feel like a complete moron, he was going, “Sorry, really, we would sell off this real estate. And then what we would pay rent in the real market, which is so much more than we could ever get back through what we sell?”

Essentially, they are working as if the real estate costs next to nothing, because they bought it immediately after the war, really, they are worth more dead than alive, that puny department store business does not cover the costs of the real estate. That is why Don Quixote was buying companies. It is much easier to buy their real estate on the stock market than in the real estate market, because realtors understand the value of these things. And clearly equity people do not.

Also, a lot of companies that are trading below book, they are trading below book because they do not cover their cost of capital. It is a bit like a person who has died, all of their photograph albums and books and so on that are incredibly valuable to them, they are not of any value to anybody else. Hence companies are trading below book because they are not really worth anything. The value of their ability to produce buggy whips disappears once we move to autos from a horse market.

Then you can find companies on negative enterprise value, that is to say they hold cash that is worth more than their market capitalization. So it is like you are wandering into a supermarket and find that they have got cashback coupons that are worth more than the sticker price.

That is something you do not get really outside Japan and Korea, which is another place where you get a certain amount, but it shows that the market is not pricing in the possibility of these companies being bought out. And they were not getting bought out until the beginning of 2018. Now we have the beginnings of the market for corporate control. And then the whole underpricing stance changes.

Since 2018, we have seen some “hostile takeovers”…

NS: You can run the numbers back for a few decades. Until 2018, the value of these transactions was literally tens of millions of dollars for all of the hostile takeovers, that is pocket change. It is hundreds of billions (!) of dollars in the US, but not in Japan. And then all of a sudden, a few cases went through.

UNIZO was effectively a hostile takeover. And then when Toshiba was about to take out NuFlare, then Hoya turns up and says, “We put in a higher offer.” Hoya is — of course — the bluest of blue chips. So from that point on, you are going, “Wait, if they can do it, anyone can do it.”

We have always looked at hostile takeovers, looked at private equity as vulture funds in Japan. Then, over these last two years, we have had management buyouts, and from then on, if the managers are trying to buy out the company, how are they any different from the private equity that wants to buy out the company? So now we have a sort of level moral playing field. That is what really gets the whole market for corporate control moving.

Sometimes we have seen action as a result of activist behavior, but in the opposite direction. Think of Sony Financial, they had activists at their door steps, asking to spin Sony Financial off, and they bought it in instead. But given that Japan is the market with the largest cross-shareholdings or subsidiary listings, all of this is just good to clean up the market further.

NS: Obviously, Japan is not the only market with cross-shareholdings. Germany was another example of that, although tax changes wiped out a lot of that at the beginning of the 2000s. But we have a very odd situation of listed subsidiaries. One listed company owns a controlling share and its subsidiary in listed on the market. That is a ticking legal time bomb. Ultimately, someone is going to show that you are picking the pockets of minority shareholders.

Strangely enough in Japan, you are able to control a company like that, but we have had big problems with that recently. Obviously, Nissan was a good example. Renault thought that it had control with around 40 to 43% shareholding, and in the end, it did not.

There were also big problems with one of the oil companies, Idemitsu, where the management decided they wanted to buy out Showa Shell in Japan. The founding family had a blocking stake and would not let the buyout go ahead. And so they sort of diluted the founding family off the face of the earth. When it went to the courts, the court said that diluting the founding family was one of the reasons, but it was not legally proven that it was the main reason that the equity issuance was done, and therefore they were allowed to go ahead.

Most people looked at this as outrageous. Essentially, you are saying that anybody can dilute any shareholders that they do not like, and that makes the whole parent/child listings dangerous. It is not a sustainable model. As a result, a lot of the parents are starting to buy in the subsidiaries.

So if you pick the right child, and you play the game of waiting for the buyout, you have some probability of success as this can be a profitable strategy for the Japanese market.

NS: Theoretically, if you take all this information, and you create a big database. Then, over the last few years, broadly there has been a 30% premium for corporate control. And then we have this case recently where the parent said, actually, we are not going to buy it in after all, and the share price collapsed. So rather than sort of sitting there and assuming that it does not matter whether it is the parent or somebody else that buys it out, regardless there will be a 30% premium for corporate control, for all of those models, the wheels are falling off.

A similar story was expected from the regional banks, restructuring and possibly consolidation. That seemed to have been priced in quite a bit as well, and so far, has not really materialized. So is there a risk of that premium unwinding as well?

NS: The banking business has been a license to burn money for decades. If you look at the Topix bank index, it peaks against the Topix in 1987, towards the back end of 1987. I believe Tiger Management had been shorting the banking industry, and they called it the gift that keeps on giving.

Within that universe, you have the regional banks, they are the most ragged of the banks, and really challenged trying to cover costs, their lending spreads are so wafer-thin now, it is really tough. Basically, there are too many of them. Some people say that, with those comments from Suga, there is open season for activists.

There are a number of those regional banks that have some interesting crown jewel assets. I have been arguing all along that they will need those crown jewels to make themselves look attractive to a potential bank acquirer. The right thing for them to do is not to give a special dividend or a share buyback to make a one-off profit for some activist fund.

But the risk is that they just slowly die over time, and we have seen a lot of cases like that. So you could just merge them. That reminds me of the old saying that you can tie two bricks together, but it will not make them float.

The other thing you have probably been asked 100 times as well was when Warren Buffett invested USD 5bn into the trading companies, everybody was scratching their head and trying to decipher the meaning behind that. What was your take?

NS: Obviously, you look at these companies, and their return on equity, five-year return on equity is lower than their cost of equity, their return on invested capital is lower than the weighted average cost of capital, so not really a Buffett-kind of thing.

Then you look at the number of listed subsidiaries. We are talking about equity holdings of over 180 in one case. Think of Buffett’s comment about liking to buy simple companies. These should not be on your shopping list. They are paying a decent dividend, about four and three quarter percent dividend yield, and Buffett’s cost of debt to buy them was about two thirds of a percent. So he is making a spread. But this is not the kind of returns, the 20+% a year returns that made Buffett famous and a billionaire.

This is really about deal flow. Any mergers & acquisitions deal gets shown to the trading companies first, and they are an enormous source of information. The relationship with the trading companies allows Buffet to get a look at all the deals, and Buffett is struggling to find deals and probably that is what he is after. That is also the reason why he split his investment. We are talking about USD 5–6bn, which is not a big investment for him, and he split it between half a dozen companies instead of investing into a single one, which means he wants to look at all of that deal flow. If the valuation had been fantastic, or he really liked a specific company, he would have picked one.

Lots of excitement in Japan, of course, with the new administration, and we have experienced some changes that happened in a short time, with the pandemic as a catalyst. What are the sectors that you like going forward?

NS: It is a tough day to be asking that question. For the last couple of years, my model portfolio has done very nicely, thanks to staying away from value investments, and just buying quality. When money costs slightly less than nothing, then I can afford to pay up for quality. And that has definitely been the case, when we went into the pandemic, then people were looking for something that is just going to keep ticking away. They did not want to deal with the massive cyclical downturn, and then the recovery, they wanted something that was pretty much bullet proof, and they did not mind paying up for it.

Now we have just heard that a story about a possible vaccine, and although it is still very early days, but if we got a vaccine, then all sorts of things change. As you can see, the stock market is going absolutely nuts today (Tuesday, November 10, 2020). So a lot of low quality stuff is shooting up and a lot of stuff that has done very well is coming off. Mostly what we are seeing is short covering.

I am still doing very nicely today on human resources, like recruitment companies. I keep reminding people that one of the first reports I wrote at this company was called “Japan’s perfect demographics”. Alot of people complain about Japan its shrinking population. I do not believe there is much wrong with a shrinking population. China had a one child policy, and we have not been running around wishing we had more people on this planet. In a world of AI and robotics population growth is not a good thing.

Japan is different, because we are down on bended knees praying that we can come up with technologies that will take the jobs off people. And that makes Japan all the more interesting from an AI and robotics point of view. Companies like Fanuc, of course, are interesting in that regard. Japan has some of the world’s best robotics makers, and actually, the job market is tight.

Even now we have more job openings than there are applicants. That is kind of interesting. So once we come out of this downturn, then all of a sudden companies will be looking for “battle casualty” replacements, all those people that have retired over this period. The working age population is down about 420,000 over the last year. That is why we have such a tight job market.

Technology generally is looking good. Recruitment companies are looking good. I have some real estate, particularly related to an activist fund, Strategic Capital, who are tightening the screws on Hanshin, for example. So those are some of the areas that I have been looking at.

Final question — last time we spoke we talked about all these cryptocurrencies and you also mentioned that you have read through all the central bank white papers on digital currencies, central bank digital currencies. So what is your take?

NS: On the face of it, the central banks want to provide options when all the paper money is going to disappear, and will issue digital currencies instead. Our fear is that there is a lot more to it than that, they would like to squeeze out paper money, partly to get more information about what people are doing with their money. You would be particularly worried about that if you live in a centrally planned regime.

In any case, we do not want the government to know everything about where our money is going, not because we are doing something naughty, but because it is none of their damn business. The other thing I think, is that central banks want to use it to put interest rates — plus or minus — on cash. I am not sure that I am very happy with them doing that either.

There are some interesting parts to it. Obviously, when we had the pandemic hit first, then governments wanted to put money into people’s bank accounts. In Japan, that was a complete mess, because the government that taxes us does not know what we earn, because we do not have an identifying number. “My Number”, that about 20% of Japanese people have been issued, now they want to roll it out aggressively, and then they want to be able to put money into the hands of the needy. Whereas with this particular case, the UK, for example, was able to do that, they put it straight into people’s bank accounts. Japan did not know the numbers or the neediness of anybody. So we just gave a smaller amount of money to everybody, which was a mess.

Having a real time pulse on all the economic information, all the activity that is actually going on would be a good thing.

NS: Increasingly, people are coming around to the idea that while GDP used to be a useful number, it is harder and harder to use it now. And it has less meaning. People make far too much fuss about GDP for Japan in my business. Japan is a function of global growth rather than local growth. I tie stocks much more to global trade than to local GDP. So I just have to keep reminding people that you cannot buy a piece of GDP, you can only buy a piece of a company. That is what we do for a living. So GDP is really not that interesting.

Thank you very much, Nick, great insights into the Japanese market. Do you have targets already for the end of 2021?

NS: You can work off valuations to suggest 15% upside to the market easily from here.

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