I spent some time with Mark Pearson of Arcus Invest a couple of weeks ago. He has been investing in Japanese equities for 30 years and is known for having visited more companies there than anyone else working today. He told me that in all his investing career he had never seen such an investing opportunity for value investors. It is bigger in his view than either the dot.com bubble or the aftermath of the Global Financial Crisis. Of course it comes with a caveat - neither he nor we know how long it will take for the valuation anomaly to correct, ie. the elastic to ping back - and so investors need patience. But given the overall perception that ‘everything is expensive’, we think investors should be interested.
Some of his reasons are global: investors’ quest for quality income in the aftermath of the GFC has pushed valuations to record highs, while value stocks have languished. In Japan the gap between the former and the latter is as extreme as it has ever been, and additionally value stocks are close to their cheapest ever in absolute terms. Mark’s small cap portfolio stands on a PE ratio of around 5x.
An interesting point he makes is that that future earnings growth among the lowly rated stocks is not appreciably lower than those rated highly. To believe highly rated stocks will outperform, investors have to expect further valuation appreciation. Of course it’s not impossible but it seems an improbable scenario given where we start.
But some of Mark’s reasoning is more Japan-specific, particularly the transformation in Japanese corporate balance sheets, which is still largely unrecognised by investors. Here are some statistics to ponder.
In aggregate, Japanese corporates have created over Yen 560 trillion of cashflow over the past 25 years, despite very low levels of nominal economic growth. As a result a debt mountain has turned into a cash pile. It has been done by a tripling of recurring profit (equivalent to pre-tax profits) margins from 2% to around 6%. If we drill down, both operating and non-operating margins have improved, but the bulk of the change has come from the latter.
What have they done with this cash? Let’s start with what hasn’t happened. It hasn’t gone to employees. Despite the tight labour market, the % taken by labour has stayed at approximately 13%. It has only modestly gone to Capex, which remains at around 3% of sales. Some has gone to M&A - there have been some high profile acquisitions such as Takeda’s acquisition of Shire. Importantly, however, this has not led to an increase in intangible assets, which remain at around 15% of book value for TOPIX companies (cf. US S&P 500 at 70%).
Shareholders have been the big beneficiaries. Both dividends and share buy-backs have risen fast. Combined, they equated to around 5tr yen in 2004, around 20tr yen today. And the reason for this isn’t far to seek. A generation ago, around two thirds of shares were held for corporate reasons by connected entities, whose interest was in stability and corporate relationships. Now about two thirds are held by independent shareholders who want financial returns.
So we have the combination of ultra-low valuations and a vast improvement in both corporate quality and shareholder friendliness. If you can afford to be patient, our view at Linchpin is what’s not to like?
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This blog is intended for professional investors, and nothing within it is or should be construed as constituting advice as defined by the Financial Conduct Authority. If you are in any doubt about this, please consult your legal advisor. The information contained in this blog has been obtained from sources believed reliable, but we do not represent that it is accurate or complete, and it should not be relied upon as such. Linchpin IFM Limited has a consultancy agreement with Arcus Invest.