• Financial & Investment Management Group
  • Tuesday, January 06, 2009

Picking Through the Gloom: Japan Field Trip 2008

by Zach Liggett
Posted April 10, 2008
FIM Group
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Amari yoku nai (?not very good?) was the consensus response from a non-scientific poll of investors, analysts, local brokers, managers, and cab drivers I met on a recent two-week research trip to Japan. The question posed was simply, ?how is the mood in the Japanese market?? Given Japan?s high regard for reserved politeness, a true translation would probably amount to something like ?the market stinks!?

The doom and gloom in sushi-land should be somewhat anticipated given the ?30% return in Japan?s broad Topix stock market index over the past twelve months. Rising oil prices (+59% in yen terms year/year to March 18), a strengthening currency (+20% v. the greenback over the same period), and continued political malaise have not done much to help the sentiment either. Optimism for Japanese stocks was indeed in short supply during the trip, although my travels did turn up a few stalwart, longer-term oriented Japan specialists with a considerably contrarian view. These lone voices professed that the consensus is far too pessimistic and that the current Japanese stock market actually presents a once in a lifetime buying opportunity.

From a top-down view and looking strictly on a valuation basis, the Japanese stock market does in fact look cheaper than it has in a long time. The price-earnings ratio of the Topix index is now at a 33-year low and its price-book ratio is well-below its historical average levels (Figure 1). The ?yield gap? between the stock market?s dividend yield and the ten-year Japanese Government Bond (JGB) yield also suggests that Japanese stocks are inexpensive (at least relative to bonds, Figure 2).

Also on the positive front are subtle signs of hope that corporate Japan is finally starting to treat shareholders with more respect. The trend in share buybacks and dividend payouts, as noted by local research house CLSA Securities Pacific, made record new highs in 2007 (Figure 3).

Should cheap valuations and better corporate governance fail to entice investors back into Japanese stocks, perhaps the lack of compelling alternatives (at least for local investors) will finally do the trick.

For example, the aforementioned ten-year JGBs pay a pitiful .3% yield after stripping out inflation (yes there is a decimal in front of the six!). And the overseas investment products that have sucked capital out of Japan over the past few years are now turning sour as the yen surges against many foreign currencies including the US dollar (Figure 4).

As for my company visits (I met with approximately 30 companies on the trip), I did come across several pockets of optimism. Kyoto Kimono Yuzen for one, seemed upbeat about the stabilization of order trends for its traditional Japanese garments and opportunities to win a larger share from struggling smaller players. And management at Tose, a small videogame software developer, spoke of progress on its restructuring initiatives at a China subsidiary and strong global demand for its game development services. Both of these companies maintain solid balance sheets, show good long-term growth potential, and trade at less than 10x earnings. Kyoto Kimono Yuzen, also pays a 5% dividend yield, one of the higher yields in Japan.

At other companies like Kansai Paint, the outlook for external growth had management most upbeat. Japanese carmakers have long pursued overseas markets as part of their long-term growth strategies, and Kansai Paint has been happy to tag along for the ride. This is particularly the case in India where Kansai Paint commands 60% market share in automotive paints. Despite near-term margin pressure from higher raw material prices, Kansai Paint should do well over the longer-term as Japanese auto-maker customers like Toyota continue to gain traction in the massive Indian market. The stock trades at only 11x earnings, a level that we believe undervalues the quality of Kansai Paint?s assets and its global earnings growth potential.

While most of my company visits were typical green-tea-in-the-boardroom with senior management affairs, my trip to Sekisui Chemical?s prefab housing factory included a bit of a twist. Actually quite a twist as I was offered the chance to ?experience? first-hand the effects of two of Japan?s largest ever earthquakes at Sekisui Chemical?s earthquake simulator. I survived both quakes as did the Sekisui home module I stood in, which was reassuring given the company?s promotion of its homes as quake-resistant. Sekisui?s stock has been weak of late as the rising oil price hurts profitability at its high performance plastics unit and continued Japanese consumer sluggishness weighs on home sales. But with very strong product lines in prefab homes, high performance plastics, and urban infrastructure and trading at 10x earnings, we believe that the stock offers good long-term value.

All in all, the gloom in Japan seems overdone. With market valuations the cheapest they have been in quite some time, corporate Japan shareholder friendliness on the rise, and a wide variety of compelling company-specific investment stories, we continue to see good potential for solid long-term total returns in our Japanese holdings. While we might not yet be ready to join sides with those calling Japan the ?buying chance of a lifetime?, we do see plenty of opportunities for our portfolios and continue to pick through the gloom accordingly.

To learn more about the companies in Zach's article visit:
www.kyotokimonoyuzen.co.jp www.tose.co.jp www.kansai.co.jp www.sekisui.co.jp

 
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