In 2012, we penned a note entitled The Sun Also Rises, in which we made a contrarian case for investment in Japanese stocks.  We argued that the market had experienced a multi-year process of de-rating, as stock prices languished while corporate cash flows and book values had multiplied, and had become inexpensive in absolute and relative terms.  While the argument we made was largely top down in nature, the real point was that when markets suffer negative sentiment and de-rate, it provides fertile ground for stock pickers seeking exceptional values.  The timing of the piece was serendipitous:  Prime Minister Abe’s election in late November was accompanied by bold policy pronouncements aimed at stimulating growth and reflation.  The Japanese stock market took off and by May 2013 had increased by over 80%. 
 

Naturally, after the rise in the market, questions set in regarding the effectiveness of “Abenomics”, the impact of the increased sales tax implemented this May, relations with China, the direction of the Yen, etc.  As a result, since the market peaked last May, it has moved sideways in a choppy fashion, as traders took profits and long term investors lacked conviction.  I have been asked repeatedly whether the Japan story was a flash in the pan, another in a series of false dawns.   As usual, the dialogue centered on the macro questions.
 

Parenthetically, my short answer on the macro debate is that the government is determined to stimulate growth and inflation and is likely to have some success.  More importantly, there is a growing consensus around the need for structural reforms, which would have a more lasting salutary effect on the Japanese economy.  As an example, it appears increasingly likely that Abe will succeed in cutting the corporate income tax rate, which should stimulate investment.  Immigration policy is under examination.  There is a movement to get more women into the workforce.  “Abenomics” represents the most concerted and comprehensive push for growth that I have seen in Japan.  I think the direction is positive.  To be balanced, I would add that success in achieving growth and inflation carries with it the risk that a rise in domestic interest rates destabilizes a highly levered government balance sheet.
 

But all of this macro debate, while important, is somewhat beside the point for us.  The real investment opportunity in Japan derives from a generational change in corporate leadership that is causing a revolutionary improvement in how companies are managed.  For decades, Japan Inc. has been managed for the benefit of multiple stakeholders, with social goals often taking precedence over financial goals.  As a result, corporate profitability and returns on capital have been sub-par, often 50-75% lower than the margins and returns at similar companies in other parts of the world.   Legal and regulatory impediments to hostile takeovers have prevented corporate activism from serving as a safeguard to discipline in capital allocation.  At the same time, a generally defensive posture towards risk has led companies to accumulate large amounts of excess cash on their balance sheets, which earn no return in Japan’s zero interest rate environment.
 

During the last decade or so, a new generation of corporate managers has begun to ascend to positions of executive power.  Some have experience working in non-Japanese companies, many have experience doing business overseas, and most bring a new attitude concerning the balance of objectives among stakeholders.  As a result, more and more companies are managing their operating and financial assets with an eye to shareholders’ returns.
 

This is, in a real sense, a private sector analogue to the change that is being sought in the Abe administration.  Further, it stands to reason that the administration would like to see corporations become more profitable to help produce additional tax revenues.
 

To illustrate the potential for value creation at a systemic level, we offer the following, admittedly oversimplified, example.  In the aggregate, the profitable companies in the Nikkei 225 Index are trading today at a P/E multiple of around 17x 2014 earnings, roughly in line with the profitable companies that comprise the S&P 500 Index.  The net profit margin of the companies in the Nikkei is around 4.2% compared with 9.4% for the companies in the S&P.  If we assume for the sake of argument that the companies in the Nikkei were as profitable as the companies in the S&P, then the P/E multiple for the Nikkei would drop from 17x to 8x.  Let’s further assume that the Nikkei companies in the aggregate have a net cash balance equal to 30% of market capitalization and decide to return all the net cash to shareholders as a special dividend, the implied P/E multiple for the Nikkei would drop from 8x to 5x.  This same reasoning can be applied to any number of individual stocks.
 

The Japanese market is littered with companies that have large net cash positions and sub-par margins and returns.  In some case, fundamental business problems explain the valuation, and in some cases business fundamentals are attractive, but there are no near or medium term prospects for positive change in management practices.    The key to successful investment in Japan today is, in our view, the ability to find attractive assets where there is the prospect for positive change.  Over the last decade, we have found, not surprisingly, that a change in senior management is a good reason to focus research time on a stock.
 

We began using this approach with some success at the beginning of the last decade when we observed stirrings of change in management thinking.  On a trip to Tokyo in 2003, we visited with a company called Amano, a maker of electronic time management and parking systems, and met then new CEO Kaoru Haruta.  Prima facie, this was a classic Tocqueville contrarian value stock.  It was down in price for no reason other than concerns about the Japanese economy.  It was covered by only 3 sell-side analysts.  The stock was cheap, trading at an Enterprise Value/EBITDA multiple of 4x, with a net cash position equal to more than half of its market capitalization.  It was a clear market leader in niche businesses, with a 50% domestic share in both time management and parking systems, good boring businesses with strong cash flow generation.  There was an opportunity to grow the time management business in China as new factories proliferated there, and in the parking business in Japan due to new regulations.  So the assets and business fundamentals were attractive enough.  What made us excited about the stock, though, was CEO Haruta.  He was 52, young for a CEO in Japan.  He was enthusiastic about his business.  He owned stock in the company.  He spoke in the language of margins and returns.  He had a clear plan to unlock shareholder value that involved cost reductions, dividend increases and share buybacks, in addition to growth in the business.  Not unlike Prime Minister Abe today, Haruta evidenced a fierce determination to achieve his objectives.
 

Last year, the Nikkei created a new index named the JPX Nikkei 400.  The constituent companies of this index are selected based on the return on equity the companies have earned.  The creation of this index would seem to suggest a degree of institutional buy-in to the notion that companies should be managed for returns on capital and judged accordingly.  Interestingly, it is considered prestigious to be included in this index.  Apparently, the opposite is also true.  Amada, a machinery company, considered that it should be part of the JPX 400.  When it was not admitted to the index in May, management responded by increasing the dividend payout ratio to 50% and announcing a large share repurchase to boost return on equity.  The stock increased by around 20% in value over night, and has continued to rise since then.
 

Today, there are 14 Japanese stocks in our International Equity strategy.  Of these, in eight cases, a change in senior management and management practices is an essential part of our investment thesis.
 

To be clear, we are not taking a view on the direction of the Japanese market, nor are we advocating a wholesale purchase of Japanese stocks.  We also recognize that there exist structural impediments to value realization in Japan, the absence of a mergers and acquisitions culture chief among them.  What we are saying is that Japan continues to offer a number of interesting value opportunities in individual stocks, and that our strategy is designed to identify those where value will be realized.
 

James E. Hunt
 

This article reflects the views of the author as of the date or dates cited and may change at any time. The information should not be construed as investment advice. No representation is made concerning the accuracy of cited data, nor is there any guarantee that any projection, forecast or opinion will be realized.
 

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