Japanese stocks ‘fairly’ undervalued


The author’s intent is not to be misleading, but rather to be as frank as possible, regarding the longstanding debate of whether or not Japanese stocks are truly undervalued. In short, the answer is  no. I no longer believe Japanese stocks are undervalued, not to the extent that I once did, and not to the lengths that some pundits and money managers try to make a case for. In fact, I would argue that Japanese stocks may best be described as being closer to fair value instead of being deeply undervalued. I mean Japanese stocks, for the foreseeable future, may be destined to be “undervalued” by traditional metrics, but fairly valued by the market and in relation to the economy.

The Nikkei 225 Stock Average [[^N225]] (potential although not exact proxy [[EWJ]] last traded (1/22) at 0.92x book according to the Nikkei. That’s incredible for 225 of Japan’s leading companies to be selling at such a valuation, but when you look at P/Es, at approximately 9.1x trailing and 16.1x expected, you see a different picture. The broader Topix (1st Section) (sub-representative ETF trading in the U.S. [[ITF]] trades at about the same book value and slightly higher at 10.3x ttm and 17.0x (forward) earnings. The segment that can effectively be called the “big tease” can be found in Topix 2nd Section, which last traded at 0.56x book, but 16.5x trailing and 14.8x forward earnings. In recent years of low to no domestic growth and now a prolonged domestic and global contraction expected, be careful judging Japanese stocks only by their book value.

One area where it is safe to say that Japanese stocks look cheap is in terms of dividend yields. At 2.7% for the N225 and between 2.5% and 2.8% for Topix-1 depending on index weighting, the yields are mouthwatering when compared to the 10-year JGB at a paltry 1.24% (per Bloomberg as of 1/23 A.M.). Despite the preservation of a 0.1% overnight rate by the BoJ, stock dividend yields are still not worth the risk for most Japanese investors. Until now they’ve been right, since stock returns have been horrible since 2007 (e.g. the N225 is down by well more than half). Nevertheless, I have one idea I’ll share that could serve to attract Japanese and even overseas funds: issue dividends on a quarterly basis, like is done the U.S., as opposed to only an interim and/or year-end basis. This is but one of many ideas I have to facilitate capital in-flows and stable shareholding.

The problem with Japan is that when foreigners are bullish, the Japanese sell, and when Japanese are bearish, foreigners buy, and the two never seem to have plans to stick around long enough enjoy a return to even half the level of the ’89 bubble peak (see chart below). In recent years, foreign investors have dominated trading and held as much as a third of Japanese shares, but stocks were largely shunned by Japanese individuals, especially after high-profile scandals involving the maverick “Horiemon” of livedoor and M&A maestro Murakami. Meanwhile, pension funds were cautiously sticking to the bond market, while the government was liquidating its positions in equities from the bailout years. The stock plays that made a lot of sense then were the big name exporters and bank stocks, most of them components of the N225. That’s primarily the way U.S.-based Japan mutual fund managers played Japan. Largely unoriginal and rather predictable — effective in an up-market, but disastrous in a down-market.

N225 chart

At the same time there were some AIMs who saw the enticing value, not only of value stocks, but even among overlooked growth stocks that had fallen to value stock-like levels. However, while hedge funds and private equity shops were eyeballing the same universe, they mostly failed to realize that the universe is too big to accommodate isolated cherry-picking. With the Japanese unconvinced of buying domestic stocks via AIMs, most shops had disappointing results and/or were disappointed with the challenges, including difficulties with regulatory issues, shorting, and communicating with corporate executives.

The overall liquidity of Japanese markets, which for a long while seemed like it would always be a positive factor, especially given some of the regional froth (e.g. Chinese stocks), turned out to be anything but, as similar to the case of U.S. blue chips and favorites, it meant that these stocks were easier to dump in times of heavy selling, such as the painful bouts of deleveraging in Q3 and Q4 ’08 that encompassed the liquidation of positions to meet margin calls, redemptions, and a renewed approach to portfolio allocations.

Equally as disappointing for investors in Japanese stocks, the Japanese themselves never came around to embrace M&A in the way that it captivated investors in the West. This definitely knocked down expectations, as the take-out premium that was often applied broadly in the U.S., was hardly noticeable in Japan. While a disappointment, in hindsight, at least generally and comparatively speaking, Japan companies don’t have to face this economic contraction with such bloated balance sheets. Also recognize that the aforementioned high-profile scandals, and especially the case of Murakami, did not help at all in generating wide acceptance for domestic M&A.

Another source of hope that was very controversial but never developed into much of anything at all, was the triangle merger. Unfortunately, fear of hostile takeovers by barbarians induced a rush to enact takeover measures such as poison pill provisions and resurrected desire for cross-shareholdings.  The former eroded any sort of takeover premium that had existed, while the latter turned out to be the equivalent of shrapnel from exploding grenades given the precipitous fall in equities that was exacerbated by the unnecessary exposure to equities unrelated to core operations.

It may be possible to convince some Japanese about the virtue of increasing (or extracting) shareholder value. However, the reality is that the Japanese markets and economy operate with different priorities, placing stakeholders above investor-only shareholders. In times precisely like now, the Japanese model is quite compelling, since even though we hear of layoffs and unemployment concerns in Japan, it is nowhere near the extreme levels witnessed for instance in the U.S.  There is a sense of humanity in Japan, and regardless of whether chopping heads could yield better margins, the looting and axing that took place at the hands of some private equity players and corporate executives in America, is just not conceivable in Japan. The weight from the responsibility executives have for the well being of their employees is at least ostensibly more important than the weight of one’s own monetary wealth. Do note that I have some issues with compensation practices in Japan, but again, in times like these, I would rather continue to be compensated than be out of work.

Back to the matter of cross-shareholdings, around October of last year, in spite of the painful volatility and selling pressure,  I began arguing strongly that the one positive thing to come out of cross-shareholdings was that there was a solid floor for equities since selling by such shareholders is highly unlikely. Although I don’t believe in the efficacy of cross-shareholding, I still believe the existence of it in Japan does in fact provide a solid floor for equities. Over time I would advocate a lessening of such holdings, especially at firms where holdings are not even remotely related to core operations. In some cases where there are actual meaningful business relationships and/or real capital investments, I would encourage M&A; otherwise, some companies are simply over-exposed, such as in the auto industry. See The Economist on “Criss-crossed capitalism.”

On that note, I think it is appropriate that the N225 is again trading at 2003 levels, which are effectively quarter-century lows. Post bubble-Japan benefited more from global demand than from any sustainable domestic catalyst(s). While I am a fan of former PM Koizumi and former Economic/Financial Services Minister Takenaka, the momentum and support they once had is long lost and not likely to return soon. Incompetency is infectious and worst when it emanates from leadership — post-Koizumi failures, combined with today’s depressed domestic and global economy are a worst-case scenario come true.

Before closing, it’s worth mentioning that Japanese consumer confidence and investor sentiment (per Nomura’s January individual investor survey) are unsurprisingly at record lows and likely heading even lower. Contrarians may argue in favor of buying against these odds. No doubt, the contrarian voice in me has long tempted me to see the light from the rising sun and believe that Japan is for real.  There was a time in mid/late 2005 and the early days of 2006 that near euphoria surrounded Japanese stocks. The problem was that it was too early and difficult to realize the importance of external drivers, and the unrealistic likelihood that the export driver was sustainable, while hope was held out for the upside from domestic economic and political reforms and a reinvigorated citizenry to spur domestic demand for both goods and investments.

The truth is, as mentioned earlier, the Japanese model is different and is unlikely to change any time soon. While hedge funds and private equity ran wild in the U.S., Japanese stocks lagged badly and were widely disregarded. It turns out the U.S. funny money machine/regime and overly accommodative monetary policy (I won’t go into Japan’s ZIRP and the yen carry trade, but these played a role, too) were in full force and AIMs were able to seek supposed alpha by leveraging up to absurd levels. As reality set in in the West from March ’08, Japanese stocks for reasons explained (and deliberately omitting reference to the yen for now) above suffered more than their fair share. But if you really think about it, today’s equity/index trading levels being similar to those of 2003, really do reflect a painful reality and a proximity to fair value, rather than one of deep value. In effect, Japan remains the ultimate value trap. There is so much potential in Japan, but the apparent irrationality of valuations just may persist longer than most investors can remain patient. For those with patient capital, I remain open to serious correspondence of how to navigate the Japanese sea of equities (email japan [at] steventowns.com).

In closing, regarding the yen [[FXY]], while it is displaying impressive relative strength, the currency is not intended to be strong, at least as long as Japan is so dependent on exports and lacking in domestic demand. The governmet could intervene, but I don’t believe it will; not yet, since it would be premature given the severe weakness in global demand for exports. In trying to help explain sustained yen strength, some suggest it may be the case that Japan could come out of the global downturn first, but at this point I am very skeptical. Rather, with the unwinding of the yen carry trade and the yen being a sort no-brainer currency to want to be long and thus a piling in of starving risk capital, I wouldn’t be surprised by continued relative yen strength. It is similar to the strength of the US$, although with the yen being the stronger of the two weaklings and the strongest of a basket of mere paper (currencies). Of course, other matters such as repatriation of corporate profits and tax-related motivations, also play an impact, but nevertheless, I wouldn’t bank on the yen boosting gains in Japanese equities (e.g. through investments in ADRs and ETFs); instead, if anything, it may help buffer equity losses if it were to strengthen further.