While many investors and fund managers are particularly fond of discussing (and investing in) American stocks, the Japanese stock market is almost completely ignored. Otherwise, for that matter, most stock markets exclude the US. Could it be that we are all fixated with Technology, and argue all Technology is all about Nasdaq?
On the one hand, this is understandable – there is barely any information in English-speaking countries about the Japanese stock market. On the other hand, it is a shame to ignore the third-largest economy in the world, which means that global equity portfolios are not optimally diversified. At least in our view.
Japan is the third largest economy after the USA (and China). Germany is in fourth place, with the UK in fifth place. Japan has accumulated knowledge in the areas of automation, robot construction, electronics, automotive, semiconductor equipment, heavy (mechanical) engineering and precision (mechanical) engineering. We would argue plenty of Technology when thinking about Japan.
Yes, Japan is far away. Language and culture are quite different from the Western world. In everyday life, we hardly encounter Japan. As a result, many stock market investors lack access. However, that is no excuse!
Japan has been in a phase of economic stagnation for three decades. The country is in a kind of “twilight sleep”. However, this impression is deceptive.
There are some positive developments:
- With a shrinking population, even economic stagnation leads to an increase in Gross Domestic Product (GDP) per capita.
- In addition, the shortage of labour means that productivity increases are particularly important. This is one of the reasons why some of the leading companies in the field of automation & robotics are based in Japan.
- The Japanese government has renewed its efforts to encourage the country’s semiconductor industry towards a more globally competitive business model and in 2021 approved U$7.7bn in funding as part of a strategy to support semiconductor manufacturing in Japan,
- Due to their global positioning, many Japanese companies participate in the growth opportunities in international markets.
Overall, stable prices for the best part of thirty years imply that the cost of living in Japan remains comparatively affordable. The iPhone 14 Index as per the graphic below illustrates that in Japan one needs less than 3% of annual salary to purchase an iPhone 14. Tokyo is the only major city in the world where an average Starbucks employee can pay for an apartment within 45 minutes of downtown.
Japanese culture is more focused on the common good, long-term thinking, security, and stability than the American (or Western) culture. The Japanese way of living and socio-economic system is not better or worse, it is different.
An investment destination for global investors
We believe two events have unfolded in recent times making global equity investors take another look at Japan as an investment destination:
- Alignment between Japanese corporate governance and global best practices; and
- Berkshire Hathaway (Warren Buffett) acquiring equity stakes in Japanese trading houses or so-called Sogo Shosha companies.
A change in corporate governance
The role being played by the Tokyo Stock Exchange (TSE) in driving changes to corporate governance is significant in our view.
There are three main changes made by the Tokyo Stock Exchange:
- A redefining of the meaning of ‘tradable shares”,
- A reorganization of the structure of the market (for listed companies),
- Focus on companies that trade below book value.
As part of the aim of providing foreign investors with easy access to English materials published by listed companies in Japan, the Tokyo Stock Exchange provides “Company Announcements Services” – see Company Announcements service (tdnet.info)
It is not only the Tokyo Stock Exchange driving changes in corporate governance – the board of directors of Japanese companies are becoming more “shareholder friendly” and recent surveys indicate that Japanese companies are increasingly introducing performance-linked stock compensation for their CEOs.
TradeUnder the new definition, tradable shares do not include shares owned by Japanese commercial banks, insurance companies, or business corporations, even if their ownership is less than 10%.
Shares owned by special interested parties, other than directors and officers, are also not considered tradable shares.
This is significant because a long-standing deficiency in Japan’s corporate governance has been the tradition of cross-shareholdings, which has meant fewer shares are available for public trading, therefore lowering liquidity.
More significantly in terms of corporate value, it has resulted in “lazy” balance sheets and has been a drag on Return on Equity (‘RoE’).
We present a selection of our Japan watchlist in the table below, inclusive of the three companies in the Global portfolio (highlighted in light green), and three Sogo Shosha companies in which Berkshire Hathaway is invested (highlighted in dark green). Our target for RoE is 15% (in-house) and although Sony is below such a threshold, we are looking at Sony as a turnaround / corporate restructuring story.
Structure of the market
The Tokyo Stock Exchange has reorganised the structure of the market, moving from five segments to three in April 2022:
Each segment has strict listing criteria, including minimum market capitalization of tradable shares and a minimum tradable share ratio. At the end of 2022, about 10%-20% of companies in each market segment failed to meet the new standard, and sufficient time is allowed (about three years) to achieve listing criteria.
Stocks trading below book value and price/book value below 1x.
It is surprising when looking at the chart below that one-half of Tokyo Stock Exchange Prime companies trade at a price-to-book ratio below 1.0x – such a ratio is only 3% for the S&P500 companies in the US.
The opportunity to improve capital efficiencies for Japanese companies is significant – the percentage of stocks on the Topix trading below book value is on a par with the percentage twenty years ago (the Topix or Tokyo Stock Price Index is alongside the Nikkei 225, an important index tracking the performance of the Tokyo Stock Exchange).
It goes without saying to create shareholder value, a company needs to consistently achieve a return on equity (RoE) higher than its cost of equity. The benchmark estimate for the cost of capital is 8%. About half of Tokyo Stock Exchange Prime members have a RoE lower than its (8%) cost of equity, compared with 13% of S&P 500 members.
The higher the RoE, the more likely it is an indication of competitive advantages over the competition. If possible, all companies should generate a RoE of at least 10%. In some instances, the average RoE (typically over twenty years), could be misleading – it is our work to identify the investment opportunities.
Japan has one of the lowest levels of executive compensation in the developed world. Having said that, the median figure of Japan’s CEO compensation rose 34% to ¥270m (U$1.8m) in fiscal 2022 from a year earlier.
Such an increase is largely attributable to the rise in the ratio of long-term incentives. The survey we refer to by Willis Towers Watson also highlighted those long-term incentives as a percentage of total compensation being the lowest in Japan, compared to the US, UK, Germany, and France.
We believe integral to performance-driven compensation for CEOs, is the communication to shareholders about how the companies intend to share the operating cash flow it generates:
- Inventory-preserving and expanding investments (capex)
- Acquisitions (M&A)
- Share buybacks
- Debt reduction / building a net financial position.
Depending on the growth opportunities and business model, a different capital allocation makes sense. It is important that the planned capital allocation is communicated clearly and appears achievable.
If this is not the case, there is a risk of a reduction in the RoE over the years and thus also in the valuation of the respective stock.
The Sogo Shosha (trading houses) and Berkshire Hathaway
What is better than an endorsement from the world’s smartest and wealthiest investor? During a visit to Japan in April 2023, Warren Buffett, chairman and CEO of Berkshire Hathaway (BRK) revealed the company has increased its stakes in each of the five major Japanese trading companies the company is invested in.
What is the Sogo Shosha?
The Japanese trading houses are known as the Sogo Shosha, the conglomerates that stood tall as corporate powerhouses that were the epitome of Japan’s rise as an economic superpower, given their vast networks and immense resources. These trading companies came to control a large portion of Japan’s exports, imports, and investment flows. The Sogo Shosha dates to before World War II (WWII) and led the nation of Japan through its postwar reconstruction period, and the subsequent period of economic growth.
However, as the Japanese economy started to mature and globalization intensified, the landscape of the business world began to shift. Companies that focused on specific segments, such as electronics, automotive, and finance, rose to prominence, pushing the Sogo Shosha to the sidelines. The once mighty conglomerates were considered outdated, and their business models were no longer relevant in a rapidly changing world.
Twenty years later, our list of the top 25 companies based on revenue reveals that only Mitsubishi remains on the leaderboard (revenue expressed in U$m).
The focus of the Sogo Shosha has shifted in recent times, away from revenue growth (at all costs) to a focus on cash flow – longer-term investments provide more predictable and consistent returns and the improvement in RoE is one aspect we believe caught the eye of Warren Buffet.
Berkshire Hathaway and investment in five Japanese trading houses.
It all started in August 2020, when Berkshire Hathway acquired 5% equity stakes in each of Mitsubishi Corp, Mitsui & Co, Itochu Corp, Sumitomo Corp, and Marubeni Corp, for U$6.3bn, bought through subsidiary National Indemnity.
In an interview with the Nikkei newspaper in April 2023, Warren Buffett indicated his desire to potentially increase his equity holdings to 9.9% each in the five trading houses. During the 2nd Quarter of 2023, the equity stakes were increased to about 8.5% each.
If we calculate the total invested capital of Berkshire Hathaway in Japan, we arrive at a value of around U$22bn, which roughly equates to 2.5% of Berkshire Hathway’s gross asset value.
We remain excited by Japan as an investment destination in the Global Equities Portfolio.
Attractive stock market ratings – This observation does not apply to all companies listed in Japan. In general, however, the valuation level is significantly more favourable than the US stock market. Some of the market rating discounts are justified. If the Japanese company is growing slower, a lower valuation is a logical consequence. At the same time, however, the market rating discounts also mean that even if Japanese companies are growing more slowly than their US and European competitors, the return for shareholders can still be adequate.
Increase diversification across Global portfolios – Japanese stocks have a life of their own. In some cases, prices fluctuated sideways for years before there was a strong upward thrust within a noticeably brief time. Due to the large share of the domestic economy, economic development is decoupled from the US. Therefore, the situation can arise that Japanese equities remain comparatively stable when other stock markets are more volatile.
Unique companies – Japan is a leader, particularly in the high-technology areas of automation & robotics. Several companies have risen to become world market leaders. Those who avoid Japanese equities do not participate in these trends and themes, in our view.
Written by Johan Snyman
Portfolio Manager of Global Equities
Oracle Investment Management