Investing in Japan

Reuters (article in Japanese) reports that Goldman Sachs issued a report earlier this week that argues M&A will be the major theme for Japanese equities in 2010. Having a ‘macro’ investment theme for the start of each new year is a ritual for brokerages in Japan, although it seems no one ever has the resolve to action or follow through; and the M&A theme itself is not a new one. So Goldman repeats known information that Japan (equities) was overly victimized in the financial crisis and remains largely defenseless to external shocks. With ROE so low, domestic demand remaining sluggish, and overseas competition ever-intensifying, the best bet for Japanese companies is to merge and restructure. M&A/restructuring should boost top-line growth, says Goldman, which also should help margins, and therefore drive stock prices higher.

However, the longstanding problem with inward M&A is that reorganization is easier said than done (as heads, and tails in the form of non-core subsidiaries, tend not to roll in Japan), the volume of M&A has often disappointed, and the size of deals has been on the small side.  Nevertheless, all of that means there is still great opportunity in Japan. The best opportunities appear to continue to be in smaller-sized deals, where there are plenty of gems, and in listed subsidiaries. Goldman is said to favor retail, machinery, services, land transport, non-bank financials, warehousing, and real estate — the underlying idea is that these industries are the most fragmented.

Bottoms-up then, as 2009 is winding down and 2010 is poised to be the year of M&A (at least thematically or in a macro sense).

No doubt David Einhorn (Greenlight Capital) is an astute investor. Recently he declared his bearish view on JGBs, which subsequently has generated heavy interest among financial and political circles. Hats off to Gwen Robinson of FT Alphaville for solid ongoing coverage of the latest JGB tale (see JGBs and the ‘end’ of the short-squeeze fest). My take is as follows:

Regardless of whether Einhorn still has his short trade on or not, the chips are stacked against him and any copycats. It’s a fat chance for opportunistic hedge funds, since JGBs, even with their paltry yields (and circumstantial concerns), have both sizable and perpetual domestic demand. As I said in my last post on this topic, in spite of subdued individual investor demand, there is always an obliged patron of JGBs (the domestic institutional investor), which in the collective can fend off any offensive.

On the surface, Japanese investors sure seem confounded, largely (and in the author’s opinion, mistakenly) shunning their own depressed equities, while settling for skeletal JGBs and feeling compelled to chase overseas trends.  I used to think they were unpatriotic, in a sense, for not being buyers of domestic stocks. However, it turns out they are exceedingly patriotic given that even if they’ve lost their appetite for JGBs (in the case of individual investors), they’ll be silent holders one way or another via proxy, thanks to institutional money managers.

The Einhorn-JGB story is a reminder to Japan bears that no matter how shaky the shoji rice paper sliding doors and tatami floors appear, the pillars are quite strong and have reinforcements. As I discovered last October (’08) when the Nikkei tumbled to 1982-levels, the seemingly disastrous cross-shareholding system in Japan actually turned out to be one solid floor for equities. With the addition of timely pension fund-buying, the two effectively stopped the hemorrhaging.

So it is, Japan remains an enigma to outsiders. JGB shorts with a prerequisite nine lives. And value investors stuck in, or already having pried themselves out of, the most elusive value trap.

The Mainichi Shimbun (original in Japanese) reported early Thursday that Japanese Government Bonds’ (JGBs) popularity is rapidly falling among individual investors. Beginning in 2003, the Ministry of Finance (MoF) has sold two types of JGBs (a fixed-rate 5-year and a variable-rate 10-year) four times a year to individual investors. However, as interest rates have been held at zero (remember ZIRP) to near-zero levels for years, Japanese individual investors may finally be voting with their purses. The October 5-year issue had a coupon of 0.6%, the lowest since the program began in ‘03, and less than half the peak coupon rate of 1.5% in July ‘07.

The MoF now only expects to raise Y1.3 trillion (US$14.3B) this year from individual investors, down from a prior estimate of Y2.4 trillion, and considerably lower than the record Y7.2 trillion raised in ‘05. Through the end of this September, individual investors held Y27.7 trillion or 4.6% of JGBs outstanding. The MoF argues that recent individual investor reluctance for JGBs is not an issue because their weighting is so low. However, it goes without saying, as the article accurately points out, that it is an issue, as the government is poised to take on even more debt in the face of declining tax revenues.

In fact, the MoF is reportedly planning to introduce a fixed three-year JGB for individual investors next July. At this time, it’s hard to imagine a warm welcome, let alone a return to previous years’ embracing of JGBs. The MoF may be right in not being very worried, since it can just pressure domestic institutional investors to pick up the slack. So whether individual investors like it or not, it’s probably the case that they will remain proxy buyers of JGBs.

Japan watchers and investors will readily recognize and perhaps even sympathize with the plight of domestic savers. The golden days of the yen carry trade seem so distant with US$1/Y90-level support so sticky. It’s a real shame that Japanese companies don’t pay quarterly dividends as is common practice in the U.S., for instance, since household, quality Japanese companies are in some cases paying dividends at multiples of what JGBs offer. The desperate search for yield could be called off. Instead of chasing the latest overseas investment fad or making risky leveraged forex trades, maybe something more productive could be achieved.

Disclosure: The author has no direct exposure to JGBs, and does not believe a crisis is looming for Japan despite David Einhorn’s position, and in spite of the serious problems the country faces but continues to bundle into a bumbling status-quo. 

More often than not, it is overseas factors that have the largest influence on trading in Japan. However, from time to time there is enough commotion domestically that also warrants the attention of investors. Unfortunately, the cacophony coming out of the government these days is more concerning than usual (e.g. Japan Post management/reform, debt moratorium, JAL, etc). But let’s not forget earnings season is here.

Following is a market summary of last week’s action courtesy of the Tokyo Stock Exchange:

Despite the decline in the American exchanges reflecting weak corporate financial statements, the market continued with slight gains from the previous week backed by the strong tone of the Asian stock market. Further into the week, rising prices of oil and other commodities in the commodities market led to buying centered around resource stocks as the market strenghtened. Heading into the weekend, while there were positives with the yen falling to the 91 yen-per-dollar level, easing concerns over deterioration in corporate export estimates, many uncertainties such as the reconstruction of JAL and the direction on the moratorium remained. In addition, a wait-and-see sentiment grew amongst investors as they chose to wait for the announcement of July-September period financial statements by domestic corporations. As a result, the market struggled to make any headway.

This brief post was inspired by a Bloomberg story on Asian currency strength — a good read, by the way. My thoughts: an even stronger Korean won would bring some relief to Japanese exporters. However, it’s not clear just how much (for instance, consider the volume of autos sold by JP vs SK) with such subdued demand (sans government gimmicks for autos). At this point, the currency story is driven by the depreciating dollar.

Global central bank rates (Brazil 8.75%, South Africa 7.0%, Mexico 4.5%, Australia 3.25%, New Zealand 2.5%, ECB 1.0%, UK 0.5%, USA 0.25%, Canada 0.25%, Switzerland 0.25%, Japan 0.11%) as of October 16, 2009. See chart image below. [Source: Bloomberg; Central Bank web sites]

Below is an extract of the latest data from the U.S. Treasury concerning foreign holders of U.S. Treasuries (year-to-date through the end of August). At least for now, the fear of foreigners dumping Treasuries can be allayed, although it is clear there is some month-month volatility from a key buyer (see the figures for Mainland China). Also, notice how the UK and Hong Kong have significantly stepped up purchases YTD. When I last published an extract of the data in January 2008, Japan was the largest holder at $586.9B, followed by Mainland China at $492.6B, and the UK at $160B.

Click table image to expand size.

For those in the area, below is a list of upcoming talks hosted by Japan Society New York. Click the respective link for additional information and for registration.

Oct. 20   Financial Reporting Reliability & Transparency: Activities of FASB & the ASBJ during the Financial Crisis

Oct. 27   Boeing & Japan: A Strategic Partnership for 21st-Century Aerospace Leadership

Oct. 28   How Foreign Companies are Remaking the American Dream

Nov. 3   Wanted: A New Engine for Global Economic Recovery

The latest and largest equity dilution — approx. $5.6B; 30% s/o — by Nomura (JP: 8604) [[NMR]] has sent its shares down 16% to ¥573 in Tokyo ($6.35 at ¥90.3/$1) following an earlier rout in NY.  I think the stock has further to fall, given that it was saved by its daily loss-limit (’limit-down’) in Tokyo with volume of only 8.9 million shares. Volume thus far in September has ranged from a low of 17M shares traded to start the month, to a high of 65M last Friday.

At this point, the $5.6B it plans to raise over the next month would have been more than enough to have just acquired Lehman USA last year! Now the company and its shareholders face the challenge and risk of having to use the capital to expand existing U.S. operations and somehow grow some new business. Doing these things (profitably) has never been easy for Nomura, though it’s always been a dream of sorts.

Meantime, the stock is massively diluted, and unattractive at current levels due to the uncertainty of how effectively it will deploy the capital — it’s about 40% above its March low. While I agree with Goldman’s take that the capital raising is offensive, rather than defensive, in nature, I think it’s a little much. The Japanese business press does too, apparently, dubbing Nomura and the broader market’s sell-off the “Nomura shock.”

- No position in any companies mentioned.

The DPJ’s rise (and the LDP’s fall) is no longer debate material, but a welcome reality. As expected, the yen exhibited strength, and looks poised to test ¥92. The Nikkei meanwhile was quite volatile, gapping up, hitting a new ytd high at 10,767, tumbling into the start of the afternoon session to a low of 10,423, to close down 0.4% at 10,492. The star of the day, if you will, was the Jasdaq, up 1% to 50.49, right around its ytd high. Of course, now that the DPJ is in power, the real challenge is to keep campaign promises and stick to them, even if there is near-term pain — rather than postponing the pain as has often been the case.

In terms of the markets and forex, the DPJ has almost certainly created a situation for further yen strength (and sustained relative yen strength after everyone piles into the trade and eventually moves on). Domestic-demand stocks, while not immune to certain negative externalities of a strong yen, are likely to be favored over exporters. The exporters, whether they like it or not, will have to get accustomed to a stronger yen. To summarize the first day of trading after Japan’s historic election, it is suffice to say that politics is front and center as it should be, but the market reaction was diluted by both a dose of reality and by the 6.7% selloff in Shanghai.