This month we have Jeetu Panjabi penning his thoughts on Japan, post a visit there. Jeetu is a director on the board of the River Valley Core Compounding Fund and is increasingly acting as a valuable input in our investment process. Jeetu recently left Capital International (one of the largest active money managers in the world) after a career of nearly twenty years with them in Singapore and Mumbai. He was a part of the global macro team and a valuable part of their India investment process; when he left, he was also the head of the India office for Capital.
Japan is a market which is potentially seeing a fascinating inflection point. Partly driven by fortuitous events like a large currency drop but also aided by internal events like a larger focus on corporate productivity, twenty years of market correction, etc. Meanwhile we at River Valley have been looking at Japan closely over the last few months and hope to increase our direct exposure there.
Homiyar D Vasania, CEO
I spent a couple of weeks in Japan between Tokyo and a few other towns in Japan. This is my third visit in seven years, with my first one being twenty years ago. I had ten meetings with companies and macro folk including Canon, Softbank, Hitachi, Asics, Shinsei Bank, Nomura and BoA. I came back feeling extremely constructive that Japan is finally changing significantly and has hit an inflection point for markets. The adjustment needed from a mispriced economy in the early 1990’s is largely done, albeit over twenty years at a classic Japanese pace. I would call these changes the normalization of Japan in the context of prices, corporate RoE’s and valuations which are all relevant to equity investors.
First, some anecdotal data points as I spent a fair amount of time walking around the streets and talking to locals. A few things about Japan that surprised me and friends that I talked to: e.g. a filling Japanese curry meal at a serviced fast food restaurant cost US$ 4-5 and a drink at a self serve bar in either Marunouchi, Roppongi or Shibuya cost just US$ 4-5. This is less than half of what it would cost in Raffles Place in Singapore or Central in Hong Kong. The train and bus fares were extremely reasonable and an umbrella at a 7-11 (remember Japan does not sell poor quality stuff) cost as little as US$ 2.50. I came back feeling that Japan is very cheap both in a regional context and also relative to its own history.
The two aspects we found relatively expensive were the cost of an interpreter which was over US$ 600 for a one hour meeting and a taxi ride which was around 4-6x Singapore levels. The bottomline is that the adjustment in prices that Japan needed to go through has happened over a twenty year period and partly through Yen weakness, and is now largely done. This is true in areas which are market driven and not where the supply curve is suddenly caught short.
Another factor worth a mention is that Japan seemed extremely humble and open relative to its own history as well as the region. I would attribute part of it to cultural factors and part of it to an environment where people worked hard and saw no growth, and this backdrop was a source of humility. The religious and cultural factors helped in providing a base by preventing the society from breaking down with higher crime rates. I would believe that behavioural scientists would find this a good laboratory to test this thesis.
Now, the Normalization of Japan and why I came back bullish:
- Abenomics is transmitting into corporate demand through multiple means
Japan is a country that saw twenty years of deflation from high mispriced levels to more normal levels. This was in the backdrop of flat wages for twenty years with real income growth primarily driven by the level of deflation for the economy. The entire Abenomics focus is working and we can see that in the trend growth rate moving up structurally to the 1.5% range and trend inflation in the positive range. This is further catalyzed by tourist arrivals which are up 100% yoy with the Chinese and Taiwanese tourists being the key drivers. Foreign tourists account for 2% of retail sales and my guesstimate is that the tourists alone take up overall retail sales by over 2-4% this year. I could see queues at good Chinese restaurants and Royce chocolate shops, while Yamazaki liquor was sold out in most places. It also came through in meetings that a fair number of companies were targeting pay hikes which has not happened in many years, which is partly a function of tighter labour markets and a greater ability to pay. The external dynamic of lower oil prices too is helping Japanese GDP growth by about 1%.
Also, a new learning for me was the high levels of equity holding in public markets in the 65+ year old age cohort. This is currently paving the way for a generational transfer of wealth to the next generation that has been through twenty years of a tough economic environment. This would clearly add to a feel good factor and help improve the household balance sheet of a generation that has struggled for years.
A key message here is that Japan is very early in its cycle after a long adjustment period and the macro risks at this point in the run up to the Olympics in 2020 are very low.
- Corporate Japan is changing with a focus on shareholder value creation
The biggest change from an investor standpoint is that Corporate Japan is continuing on the transformation that it embarked on in 2005-06, after a pause in 2009. Corporate Japan was dysfunctional for eighteen years during which investors lost 3.3% on average each year between 1991 and 2008. The RoE for the Nikkei averaged 4.4% over the 18 years in a period where the EPS growth averaged 2.7%, and equity valuations averaged 106x earnings. Essentially Japan lost close to two decades which is the period it took to go through those adjustments. This has now changed with RoE’s in the 9-10% range and valuations in the mid teens.
My meetings were filled with discussions around RoE targets moving north with a 10-15% target range, dividend payout targets of 25-35%, stock buybacks, the number of external directors moving up, divesture of businesses that were destroying value and change in compensation structures focused around meritocracy versus historically focused around seniority. Stock buyback announcements in 2014 doubled to 4.5 trillion Yen from 2.3 trillion Yen in 2013. I had heard a little about these trends four years ago, but this message now was loud and clear. The RoE improvement was being driven by improvement in margins through business restructuring rather than through higher leverage. All of this is similar to what happened in Germany and France in the early 1990’s during which these markets did very well. My sense is that many Japanese businesses have strong competitive advantage v/s global peers, and this is the time to be owning them in the run up to the 2020 Olympics.
- The valuation of the Japanese market is for the first time normalizing
The data on Japanese valuations used to stun me in the 1990’s and the early 2000’s when analysts would rationalize buying a stock at 40x earnings saying it was cheap relative to its own history. This was the eighteen year period when valuations averaged 106x earnings and the markets fell an average of 3.3% a year. Currently valuations for most companies I met were in the 10-22x PE range, and free cash flow yields were in the 4-7% range. Many of the companies had cash of at 15-30% of market cap, which was their way of managing risk if the world collapsed. I think this is a new story for Japan and one which we have seen only in the last three years and one which should sustain as we go up to the Olympics in 2020.
So how should we be investing through this coming cycle?
I would want to own businesses where Japan has a core competency and globally competitive business or brands. I clearly would want to lever into a global market and not just to the Japanese market which I think would still be growing at low single digit rates. I would also like to look at businesses like the railways where the capacity has been built out and has scope for a jump in capacity utilizations as economic activity and tourist arrivals rise. I also believe the banks will be reasonable investments as credit growth which is a lagging indicator turns up in a few years. I also believe some of the consumer companies would do very well. The few names that come to mind are JR Railways, Hitachi, Asics, Fast Retailing, Honda, etc. My return expectations from quality businesses in Japan would be in the 12-18% range driven by a rising profitability and shareholder payouts.
On a parallel note, real estate residential market yields were in the 5-6% range with the mortgage cost at 1%. Central Tokyo apartments were in the $1000-1500 PSF range which did not seem too expensive for a busy vibrant city. My sense is that it would be great to buy into a levered real estate fund with clean assets and no developer risk going into the cycle.
What are the risks as we navigate through the next few years?
The demographic risks are well articulated and known for many years and should not be an immediate headwind for the next few years. I would believe that tourist arrivals and the activity around the 2020 Olympics would neutralize part of this for the next few years. The second well-discussed risk is of high government debt to GDP, while having the largest net external assets globally. I tend to worry less about it as the debt is primarily denominated in its own currency with over 90% of it being held locally. On the contrary, I would be a little concerned about a mindset of risk aversion by the corporate sector which is driven by their experience of the last few decades, which in turn makes the companies a little overcautious for the opportunity ahead of them.
End
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