Is the 13-year bear market in Japan finally over? Our panel of experts thinks so. Here’s what to buy
For our monthly Roundtable, we invited five experts to join us for dinner and give us their views. Here, they reveal what they think about the Japanese market.
Merryn Somerset Webb: The Japanese market had a great run in 2003, but the rally seems to have stalled in recent months. Is it over?
Robin Geffen: We do our research on a global-sector basis with no bias towards countries. We carve up the world into separate industrial sectors, and then decide which ones we like and which we don’t. Then we pick the best stocks in those sectors around the world. Last year, a lot of those stocks were in Japan: in February 2003, there were a number of sectors – industrials, electronics, even one or two of the banking stocks – that looked really good value. However, three months ago, we halved our exposure to Japan and then a month ago we halved it again.
The fact is that we cannot find – with a few exceptions in the steel sector and one Japanese financial company – any stocks that stand out within their sectors. It is true that lots of the smaller companies are doing very well but, as soon as you start travelling up the ranks in terms of size, you just can’t find value anymore. In March last year, the Japanese market looked great, particularly given that it was such a play on China. But now, with China slowing, the fundamentals just haven’t come through. I think there’s a massive losing streak to come.
Ian McCallum: We do a global fund and came to the same conclusion as Robin last year – we just filled our boots with Japan. We looked at firms like Komatsu – in the same business as Caterpillar – and found that not only did it have massive market share in China and lots of free cash, but it looked a lot better in terms of valuations too. That was the kind of thing that pushed us into Japan last year. But, unlike Robin, we’re still there. We aren’t finding the value in exporters any more. Anything that exports to China is suffering in the slowdown – sales at Komatsu are down 60% in August/ September – but we can still find value in terms of growth and price among more domestically geared companies.
Rupert Foster: How much worse can it get for exporters to China? You’d think sales 60% down was near the bottom.
IM: It can get worse. China’s in a bubble. There is massive overinvestment and hence overcapacity. Inventories are back at 1996 levels. If you speak to the guys who actually go in and build the widgets there, you’ll find they’re not making any money – genuinely not making any money. That is why being in the exporters in Japan doesn’t work anymore and why our exposure to Japan is all to companies exposed to domestic restructuring.
RG: But mainly in the smaller companies?
IM: A cross-section. There is some good restructuring going on, from Kirin Beverages, which is huge, right down to the very small companies. We’re stock-pickers so we’ll buy anything that looks good, but we also look at the macro-economic environment. Nothing operates independent of this, but that side of things looks pretty encouraging to us. Corporate debt as a percentage of GDP is now 75% and that’s down from way over 100% – that makes it clear that the corporates have restructured significantly. It took 14 years, but now Japan is a very simple, economic restructuring story.
RF: It’s really an amazing achievement that Japan Inc doesn’t get enough credit for having turned cash-positive at a time when the underlying environment was so awful. After a decade of deflation and recession, levels of return on equity and assets are back up to 1989 levels. If you look for restructuring in terms of big slash-and-burn plant closures, you don’t see that much. However, if you just look at the incremental improvements in the figures, in terms of costs and the like, then it’s impressive.
RG: I wouldn’t say that debt at 75% of GDP is impressive. It’s a panic number.
IM: It’s more like 110% in the US.
RG: Yes, I hate the US too. Of our whole global equity fund, only 5% is in the US.
IM: The point about Japan is that it is chucking up cash like there’s no tomorrow. Profitability in terms of return-on-equity is back up to the highs of 1989 and that has been driven by all the cost-cutting that has been done. I’ve been staggered by how genuinely endemic restructuring is across the board. Even in an era of falling prices, companies have managed to increase their profit margins. So, imagine what they could do if prices started to rise. The gearing effect of the end of deflation on profits would be just ginormous.
RG: And that’s possible, even with oil at $50?
Jonathan Allum: That isn’t that big a deal. Japan has done a pretty good job of dealing with high oil prices over the years.
RG: Yes, but not in this game. Oil prices have virtually doubled in a year and no one’s accepting it. You’ve got companies from international airlines through to manufacturers from the Philippines budgeting for $25 a barrel. But what happens when oil is still at $40-50 in a couple of quarters? Then there’ll have to be some kind of mental adjustment all round – that’s not going to be pretty.
RF: Surely, the issue is not about the oil price itself but more about the extent to which the companies can pass it on to the consumer. If they can do that, straight down the line, it won’t be such a problem. At the moment, a lot of Japanese industries can, given that demand for their products is high, but there are capacity constraints all round. It seems to me that the overall capacity utilisation data supports the case for Japan. Clearly, there is still overcapacity in areas such as construction and retail – there’s way too many shops in Japan, so no one makes any money. But in other areas – say, steel – there is now limited capacity and the Japanese are reaping the rewards.
JA: Generally, this is the case through much of the old economy, including, obviously, steel and chemicals. There hasn’t been any capacity added for as long as anyone can remember. It hasn’t been needed. But the Japanese – be itby luck, judgement or simple idleness – also never cut their capacity in, say, shipbuilding, as we did in the UK and in the US. And, suddenly, by some quirk of fate, the entire world wants steel ships and there aren’t many places that you can get them – just Japan and Korea. No wonder the order books are backed up three to five years and profits are soaring. The Chinese may be about to start having a go at it, but building shipyards is a long, long road to go down – it is much easier to put up microwave-oven factories again.
RG: OK, but that’s not the case with the likes of petrochemicals. There’s massive capacity globally.
JA: But there are huge Asian markets for those products.
RG: I’ll accept that with steel. China still needs piles of it, particularly given the massive construction going on for the Olympics. They are not going to embarrass themselves with a whole load of stadiums that fall down, so you’re going to have steel beams and the like coming from Japan. Steel looks fine as an investment, but I don’t see the case for big exports of chemical products out of Japan to the rest of Asia because there is excess capacity there as well. There’s no pricing power.
RF: But you have got to remember that Japanese chemical companies produce a lot of their chemicals in Singapore, or wherever. They are not really domestic industries. In fact, this is another one of the long-term reasons to look atJapan. It is as much an Asian-financing operation as anything else. Still, I have to agree with Robin that the market is on the way down, but I think it is a purely short-term, cyclical thing. The long-term structural case is good, but right now year-on-year growth is slowing down globally and it’s hard for Japan to fight that cyclical slowdown. Too many of its companies are exposed to it and self-sustaining recovery is not quite strong enough. I would expect the market to trend down on a short-term, cyclical downswing.
JA: I agree. One important thing though is that I don’t think Japan will hit a new low on this downswing. If the US consumer packs up completely, or China implodes, all bets are off. But otherwise, I think that, thanks to the restructuring we’ve been talking about, last year’s low was the bottom. The longer-term is bullish. We are just in a short-term bear market now.
MSW: So, when will it be over?
RF: Hard to say, but I think it will run at least until November.
RG: I’d feel a lot more comfortable about the market if I saw some foreign buying. The market only went up last year because American money arrived.
JA: Is that a historically valid reason for being suspicious? It was the Americans who bought in first when Japan kicked off in the 1980s. Then domestic buyers followed.
RG: Yes, but it worries me that if all the American money decides to leave Japan, the market will hit a new low. American money all moves at once. You only need one top strategist to say that it’s time to get out and they will all rush for the door.
JA: I think there is something else going on in Japan. There have been three big jumps in the market over the last decade or so and none of them lasted, so most don’t expect this to last either. With the market up 40%, they’re taking profits – everyone’s so keen to be ahead of the curve that they’re just jumping out, regardless. But this isn’t like the other times: this time, fundamental data isn’t going down – just share prices.
RG: I’d argue that, even if you’re right and you see a Japanese domestic recovery of monumental proportions, there is every chance that US consumer spending will collapse and China will have a hard landing. Then, do you honestly see the Japanese market going up?
JA: If the world catches a big cold, Japan will too, of course, but the vulnerability of Japan to the US has diminished at least.
RF: The only other bearish thing I can think of at the moment is the continual problem in Japan of announcement risk: the government announcing something like a rise in taxation or a tightening of monetary policy, for example. That kind of thing is always a risk in Japan.
JA: Japan’s prime minister, Junichiro Koizumi, has said taxes won’t go up on his watch – which gives you three years – but after that, who knows? In terms of monetary policy, I think the Bank of Japan has made it as clear as possible that it is not going to tighten for quite a long time. One final point I want to make is that, if you compare Japan with the US or the UK at the moment, the striking thing about the current recovery is that it isn’t driven by the public sector. Public works spending has been going down for ages; that makes the recovery entirely a private-sector phenomenon, instead of the great Keynesian mish-mash that the last few cyclical recoveries have been.
James Ferguson: Worth mentioning is the importance of intellectual capital to the new Japanese economy. You’ve got firms like Asian Sasaike (which makes car transmissions) taking on the Americans at an intellectual level. They’ve got the money to do the research and development. It takes $3m-$4m to develop a new transmission – Ford and GM just don’t have the money to do it, so Asia will slowly take market share. I’d go so far as to argue that Japan could be the next UK or next US; the next big de-industrialising nation. It is moving into the tertiary sector and making its money from intellectual property. And that is where the upswing is – think pop music, computer games, cartoons and fashion.
RF: Japanese pop music?
JA: I listen to it.
JF: Do you know what the most dangerous thing in the world is? People like us talking about pop music.
MSW: Let’s talk about a few specific companies.
IM: One of my current favourite stocks is Warabeya Nichiyo (code number 2918). This provides prepared lunch-boxes for Seven Eleven stores, making it a good geared play on the chain’s current expansion. It is seeing strong free cash flow and growth. It’s as cheap as chips!
JA: I’d go for Kanematsu (code number 8020). Like other general trading companies, Kanematsu used to be involved in too many businesses, without too much success, and it was largely reliant on borrowed money. With the help of debt forgiveness, it has slimmed down, cut its debt and workers, and become more efficient in general. And its stake in a major LNG project in Indonesia is a genuine and undervalued jewel in its crown.
RF: I’d go for Anritsu (code number 6754), a telecoms equipment company that is heavily geared towards the global rollout of 3G technology. If I was to choose something to short, it would be Olympus. Its global domination of the endoscope market is ebbing away and it isn’t making any money in the digital camera market.
RG: I can’t bring myself to tip a Japanese company, so I’m going to suggest some non-Japanese firms. The first of these companies is a French exploration and production company, Maurel et Prom, and the second is the Russian oil company Sibneft. The oil price is going to stay high (the fact that Japan doesn’t have any oil will be the final nail in its coffin) and these are both undervalued.
JF: Japan Radio’s (code 6751) earnings have been forecast to grow more than 30% next year, putting it on a price- earnings ratio of only 11 times. That’s way too cheap for that kind of growth. I’d also look at Sumitomo Metal Industries (code 5405), which is forecast to make more than ¥13 a share this year; 50% more than it made in 1997, its peak earnings year of the last decade. Back then, it traded at around ¥300 on a 30 times multiple. Yet, today, it trades at ¥135 on a mere 10 times earnings.