Active 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).

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.

Pricey, and Japanese stocks, are typically not heard together in the same sentence. However, since last September’s market rout, earnings have deteriorated to the point that the Nikkei 225 is trading at over 175x forward earnings; 10.1x on a trailing basis. No doubt the ratio will swell some more, potentially going negative for a quarter, before it begins to ease. For some time now, I have believed that Japanese stocks are being priced fairly by the market. Still, it remains true that money managers the world over see deep value in Japan.

In order to prevent this article from getting long winded I will summarize my position as follows: (1) Recent trading has been ostensibly positive given the strong rally in percentage terms off the bottom, but the action has been quite thin; which leads me to point (2) in that the 9,000 level has proven pretty elusive due it being right about the middle point of last year’s finish and this year’s high (remember the N225 flirted with 6,000 a month ago); and (3) buying up headline exporters and bank stocks is the easy and obvious way to play, but lack of participation and depth in this rally will surely create a situation of more range bound trading between 7,000 and 9,000. Therefore, with all eyes on the U.S., and with the country’s financial magicians seemingly running out of rabbits, I would exercise caution at current levels. Aside from media cheerleading, last check the economic negatives far outweighed the positives.

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