Value investing in Sanrio vs the Hello Kitty premium


Sanrio (TYO: 8136) (OTC: SNROF) shares have taken a beating the past several months and really got hammered last week — “blame” Goldman Sachs for the latter, as it appears that its post-earnings report casting undue pessimism and uncertainty on Sanrio’s business model fueled the selloff and compelled Morgan Stanley-MUFG Securities to publish a copycat note. (Sanrio’s statement emphasizing profit-focus and no plans to abandon lucrative licensing business.) Attracted to Sanrio’s high ROE, a weakening yen, and “Cool Japan” marketing in overseas markets that only solidifies the popularity and brand recognition of flagship character, Hello Kitty, I had the fortunate timing of building a position in Sanrio’s ordinary shares in Q4’12 ahead of a sizable run up in 2013. Following are some lessons learned from that profitable investment and the intraday 23% drop Sanrio’s shares suffered last Thursday.

Not one’s typical “value” investment, especially not in Japan, since Sanrio (best known for its Hello Kitty character) often trades at above-market P/E ratios and large premiums to book. Following the bounce after its selloff last Thursday: Sanrio trades at just under 17x F/P/E (as of 5/26).

However, with Sanrio’s successful business strategy shift towards character licensing of a few years ago, its ROE was over 43% in FYE May 2012, nearly 30% in FYE 2013, and a still respectable 23% in FYE 2014.  Sanrio’s shares more than doubled in 2010 and doubled again 2011. When I bought in late-2012, Sanrio was down around 33% from its then recent peak, trading at about 18x earnings.

It’s difficult to find high-ROE stocks that don’t trade at a premium to something. But value investors would be misguided if they dismiss an opportunity because it doesn’t fit some strict definition. I believe it was Howard Marks that put it more eloquently, but in short, for all those investors that say they don’t do this or won’t do that, they are in effect creating opportunity for other investors.

Sanrio character suite incl Hello Kitty

Sanrio’s ROE has been decreasing partly as a result of its success: retained earnings piling up as cash on the balance sheet. Meanwhile, debt is approximately one-half of equity, so it’s not particularly leveraged. And, with a flagship character that is loved by young girls around the world and has its fair share of older fans, no corresponding value is to be found on Sanrio’s balance sheet. Would Disney acquire Sanrio for a couple billion dollars, roughly Sanrio’s current market cap (240 billion yen), and around 10x operating income? No question if only it could at such a price; I suspect the control premium would be substantial. In a sense, loosely or more qualitatively, there is some margin of safety by way of the brand value/baseline earning power of the beloved Hello Kitty.

Is 40% ROE sustainable or likely to be seen again? Probably not. But how about 20%? Certainly possible. In a few years, Sanrio could be debt-free if it wanted. Yet it’s currently opting to payout around half of its earnings as dividends. I do find it difficult to get comfortable with the fact that Sanrio’s revenues aren’t growing much, nowhere near as much as the excitement to be seen (and read about) among its fans and particular target demographic.

What spooked Goldman (Japan) and others last Wednesday, is Sanrio’s mention that it plans to invest in building out stores and new products. Costs are naturally expected to increase. Note, Sanrio didn’t say it was abandoning its successful licensing strategy (statement linked above). It’s forecasting another solid year and set a ROE target of 20%+. Overseas amusement parks are also planned. Sanrio hasn’t done so well at home with its two parks (i.e. break-even to slightly profitable), but arguably, the parks are serve as a brand marketing driver in the very least and will do increasingly well both with better management (Sanrio has heard criticism before about its underperforming parks) and sustained increases in tourism expected from neighboring China to the 2020 Olympics.

Sanrio fell to a low of JPY2,400 last Thursday, down 23% at one point. I had long sold my shares at a 2x+ gain when the P/E surpassed 40x in September 2013. A bit too much, too soon, but I happily took profits and have been periodically looking at Sanrio’s stock price, tracing its possible (though I had thought, unlikely) decent back to the JPY2,000/share level. Much to my surprise to see such a sharp selloff last week. A quick read at that time of the earnings and guidance materials on Sanrio’s IR website left me unconvinced more than a 2% or 3% selloff was warranted, let alone 20%!

Did I buy Sanrio again in light of the now even better P/E valuation than my original purchase? No. For two reasons. Firstly, buying a company with a ~30% ROE at less than 20x earnings, with what is expected to be sustainable profitability and material growth opportunities, is a very different story than a low- or baseline 20% ROE at the same valuation with some near-term uncertainty over capex. Though I expected a bounce in share price, I also thought it was possible selling would continue since European and U.S. investors might not have had a chance to sell due to the time difference, not to mention the downward momentum possibly attracting greater short interest (technical analysis is big in Japan). Sanrio closed at around JPY2,600 on Thursday, marginally higher Friday, and at JPY2,759 on Monday.

The second reason why I didn’t buy Sanrio is because I was effectively fully-invested in my yen-denominated portfolio. Though the Nikkei has lagged year-to-date, my concentrated holdings among small(er) caps have done well and they all have more potential upside, and importantly they have less overall uncertainty than Sanrio. I contemplated paring a position and reestablishing one in Sanrio, but I couldn’t justify it, again on the merits (valuation and growth prospects) of my existing holdings versus the changed and likely further changing situation with Sanrio. I can live with capex spend, but 20% ROE is not 30%(+) ROE.

I have missed a few hundred yen per share in the Sanrio bounce, but I haven’t lost any sleep over it. Perhaps I was lucky to have not had available cash to invest in Sanrio. While Goldman and MS-MUFG seem excessively negative (and though ML is much more upbeat), the fact that I recognized greater value in my existing holdings and sensed more extreme volatility on the horizon for Sanrio, I made the right decision to do nothing. If I had cash available, I may have been tempted by relative value and the panic selling to build a new position; that I had a quick 2x recently with Sanrio no doubt would have been a more poignant reminder.

I started one of my book chapters with the quote: “There’s always something to do” [title of book about the late value investing legend, Peter Cundill, originating from a quote by the indefatigable Irving Kahn, who is apparently still around at 108!?]. It’s a powerful quote/belief in the merits of fundamental analysis and trust in one’s ability. At the same time, sometimes the best action to take is none. Quick doubles are arguably as much luck (e.g. timing of Abenomics rally) as skillful security selection based on competitive and security analysis (high ROE investment opportunity following extended profit-taking). In ten years time I think most will agree that Sanrio shares could be substantially higher than they are today if it maintains its profitable licensing and executes reasonably successfully in store expansion and partnerships in developing theme parks. That said, it will almost assuredly be a bumpy ride for Sanrio, flying up to 40x earnings when everything seems great, and dropping sharply by half or more when that particular ride has reached its apex.

I want to end by saying ideally there is always extra portfolio cash available for new found gems and sudden sharp selloffs alike. Had Sanrio continued to sell off and approach JPY2,000 or fall through said level, it would have been more interesting. The optionality of cash, in my opinion, far outweighs the diminished portfolio returns from holding it. Cash will conveniently serve as a buffer in a down market, but most importantly the actionable opportunities it affords make value investing all the more rewarding financially and enjoyably so. Despite all-time highs in some markets, there’s plenty of value in Japan, among other places and in individual securities. I look forward to putting new cash selectively to work, and meantime, I’m most comfortable doing nothing to my core holdings or feeling pressured by a past winner whose shares aren’t quite as attractive as they once were.

Watch list: Sanrio (TYO: 8136) (OTC: SNROF).