A Yen for Survival

After altogether eschewing Japanese investments throughout the 1990s, we decided to start filling this void in our portfolios about three years ago. At the end of 2000, Japanese stocks represented only about 9 percent of the assets of the Tocqueville International Value Fund, which has as its mission to invest principally in non-US stocks. A year later, Japanese stocks still accounted for less than 21percent of the fund’s total assets, but by the end of 2002 they had reached more than 34% of our non-US investments.

Needless to say, since this move was initiated after a 65 percent, decade long decline in the Nikkei 225 index, Japan’s economic problems were, by then, broadly recognized. Our decision thus was a textbook example of contrarian investing, and it came as no surprise that it should meet with considerable skepticism and concern on the part of individual clients, fund shareholders and well-meaning friends.

Yet, our interest in Japan at the time had very little to do with any enthusiasm about the macro-economic outlook for this mature and challenged economy. Rather, it was driven by a belief that corporate Japan was about to embark onto a management revolution, which had the potential to yield a quantum jump in the return on corporate assets – and thus in profits as well. (See: Will Japan Sink into the Pacific Ocean?)

Even with our partners, who had no problem recognizing the contrarian merit of this investment decision, we were hard pressed to argue that stocks selling at twenty times earnings or more represented value. Our theory about the coming corporate revolution also met with some skepticism, coming as it did from a team with relatively little Japanese experience, and with no echo among long-time Japan experts. The turning point came at a meeting with the research director of a leading Japanese investment bank, which was attended by several of our partners. As we pored over the list of growth companies that our guest was recommending (at prices far removed from any notion of value), our attention was drawn to one company that he was not recommending. Profitable, decent growth, no debt – and cash on the balance sheet equal to one-third of the company’s total market value. “How much was this cash earning?” we asked. “Less than one percent” we were told by the somewhat puzzled analyst. 

Suddenly, our value case had been made. Instead of the published price-earnings ratio of 22, the company ex-cash was really selling at an acceptable 13-14 times earnings (Japanese accounting tends to understate earnings). In addition, one could dream about what to do with the pile of inert cash, so as to raise its yield to a more acceptable return on investment rate of, say, 6% or 7%. Many companies in Japan had hidden (and unproductive) assets on their balance sheets – not only cash, but also corporate cross-holdings, very old real estate, etc.  And what we were finding was that there were enough of these to make a case for value investing in Japan – especially since things were beginning to stir in Japanese corporate management thinking as well.

The “return on asset” scenario has since played out, Japanese style: slowly, but steadily and unstoppably. It is far from having reached its full potential, but there is now broad recognition that it is unfolding.

Recent media articles and analyst reports have begun to chronicle the surge in Japanese corporate profits and management’s new focus on returns rather than growth. At the same time, the spectacular improvement in Japanese corporate balance sheets has also received notice, as debt has been aggressively repaid through non-strategic asset sales and surging cash flows. Total corporate liabilities, after repayments of 190 trillion yens ($ 1.8 trillion), have declined from a high of 125 percent of Gross Domestic Product (GDP) in 1996 to 90 percent last year. Merrill Lynch believes that corporate debt burdens are within a couple of years of reaching the 80 percent of GDP that prevailed in the 1970s – before Japan’s bubble years.

These improvements have not been lost on the Japanese stock market, which has risen about 50 percent in the past year – not including a further 10 percent gain from the yen’s appreciation against the dollar, even after the most recent correction. In spite of all this, investors remain concerned about the shaky banking system (though less so today than a couple of years ago) and about the lack of long-term growth potential of the domestic economy.

But now, something new and intriguing seems to be happening. Recent releases indicate that the Japanese economy has been accelerating for three consecutive quarters, and lately has been growing much faster than had seemed possible. GDP was up nearly 7 percent at an annual rate in the fourth calendar quarter of 2003. The third quarter itself was revised to show growth of 2.4 percent at an annualized rate, double the previous estimate. And previsions for the full year 2004 are beginning to move north of 3 percent growth.

As often is the case these days, the reason for this unexpected acceleration must be found in a re-organization of world trade patterns, with booming Chinese demand and the US dollar weakness at the center of this unfolding saga. Of these two factors, the more surprising (and likely the most enduring) is the emergence of China as the catalyst of Japan’s growth and renewal. Even we have been surprised by the speed of that change.

Only a couple of years ago, I sat at lunch besides Mr. Kunio Nakamura, President of Matsushita (better known in America under its Panasonic brand name, and one of our portfolio companies). Although published strategic plans in corporate Japan are, in the Asian tradition, longer on slogans than on details, the key words underlying Matsushita’s plan were blunt enough in their subtle reference to Adam Smith: “Deconstruct and Create”. Yet, there was little reference to China, of which Mr. Nakamura actually seemed to downplay the strategic importance at the time (probably for political reasons, both corporate and national).

But suddenly China seems to be taking center stage. According to an interview in the South China Morning Post, Matsushita expects its Mainland sales – including both imported goods and those made by its plants in China – to account for 20 percent of its total revenues by next year. This seems to indicate that Matsushita’s sales into China will have almost tripled in the three years since 2002. In addition, the announced goal will make Matsushita a major player in the Chinese market, with sales there in excess of US$ 13 billion!

Matsushita is in no way an isolated example. CLSA recently conducted a survey of Japanese companies’ involvement in China. Only about 200 companies, or 31percent of those contacted, responded -- and this only on condition of anonymity, which shows that the subject of corporate Japan’s bet on China’s growth remains highly sensitive.

For 76 percent of these firms, sales in China still account for less than 10 percent of global sales. But 14 percent of them expect the Mainland to contribute more than 20% of the growth in their global earnings over the next three years.

Another point of note is that only 23 percent of the firms export 70 percent or more of their mainland production. If my math is correct, it means that more than three-quarters of the Japanese companies manufacturing in China sell 30 percent or more of their production on the local market. This means that a large majority of the Japanese companies that are active in China already have already achieved meaningful sales penetration into the local market, which implies functioning distribution networks and logistics.

This brings us to the ongoing realignment of currencies. Much has been made of the weakness of the dollar against the Euro and the yen – a weakness that has been mirrored, of course, by the Chinese Renminbi, which is pegged to the dollar.

CLSA makes the point that the main motor of the Japanese recovery, so far, has been the capital equipment sector. This has been due to the capital spending boom among Chinese companies (not only for industrial capacity additions, but also for infrastructure building) and also to the demand from Japanese corporate affiliates setting up plants in the Mainland (capital equipment represents 56 percent of Japanese exports). Further, this has resulted in a capital spending boom in Japan as well, since Japanese equipment manufacturers have had to boost capacity to meet the surging demand.

What is interesting is that these Japanese exporters are suffering very little from the yen’s re-evaluation against the dollar, as U.S. manufacturers of machine tool and other equipment are not strong competitors on the Chinese market. Japan’s real competition, in this sector, comes from Europe, principally Germany. And the yen has depreciated against the Euro, thus giving Japan an added advantage.

Let’s go one speculative step further, by assuming that, as is likely, the Renminbi is eventually revalued against the dollar, the Euro and the yen. The decision to do so, on the part of the Chinese authorities, will be part of an announced plan to cool down an excessive build up of manufacturing capacity in the overheating East and South, and to replace this economic locomotive with a spreading out of consumption toward the less-rich provinces in the West and the North, as well as rural China in general.

In that context, a stronger Renminbi will make sense, by boosting the purchasing power of the Chinese consumer. Moreover, unless commodity prices compensate for the dollar’s renewed weakness, this will also lower the price of imported materials, which are a more important cost factor in China than labor.

If the above scenario unfolds, Japan will have made a huge amount of industrial investment in China while the yen was strong, while it stands to benefit from the ensuing consumer boom when the yen weakens against the Renminbi.

As for Japanese companies, they will already have established a strong foothold on the Chinese consumer market (modern production and established distribution) – not to mention that Japanese consumer brands already are some of the best recognized in China, often better than Chinese brands, which tend to be regional.

There is one caveat to the “best of all worlds” scenario for Japan: it assumes a smooth transition between the Japanese companies’ implantation onto the Chinese market and the imminent development of a consumer boom on the Mainland.

If the transition is not perfectly synchronized, problems could develop. The current upswing has been quite narrow, centered as it has been on exports of and investment in capital equipment. And, while various surveys indicate that 50 percent of Japanese corporations can cope well with  a yen stronger than 100 yens/dollar, these large corporations employ only 25% of the Japanese labor force, according to Merrill Lynch. Any loss of economic momentum could thus present Mr. Koizumi’s government with mounting political and electoral problems, and doom the economic and financial reforms that he has been laboring to implement domestically.

If, on the other hand, the Chinese transition is effected without major hiccups, Japan may be presented with a historic opportunity: to become a major beneficiary of the advent of a broad consumer society in China. In that case, the potential of the Japanese stock market will be well beyond what we expected when we invested in it as a corporate restructuring story.