Japan: A Fresh Look at Challenges and Opportunities

David Nadel and Jim Harvey in Japan

Royce has been investing for a number of years in Japan, guided by an attitude of tepid optimism befitting a market that is not only currently "cheap," but has been so for nearly two decades.  We spent March 7-11 in Japan meeting with local companies, making our second week-long trip to Japan in a year.

Settling into our seats around 2:40 Friday afternoon on March 11 for our 3:05 return flight from Tokyo's Narita Airport, we wondered aloud six minutes later why the plane was abruptly shoved away from the gate without warning. It was soon apparent we were in the midst of an earthquake.  After a seven-hour wait on the tarmac, our plane departed for New York, leaving behind the enormous tragedy unfolding about 180 miles north of Tokyo, details of which we learned only after landing some 13 hours after take-off.

Without trying to appear dispassionate, we think that a natural disaster as horrific and sad as the Tohoku Earthquake often has a way of galvanizing people, bringing fractious political parties together and moving a country forward. In this piece, we explain why our once tepid optimism for Japan has turned a little warmer, and why we are deepening our investments there.

The Challenges

Japanese equities are among the cheapest in the world, counting both developed and developing countries. Having declined 75% from its December 1989 peak, the Nikkei trades at:

• a discount to book value (versus 2x book for the U.S. and China)¹
• less than 40% of sales (vs. 2.7x for the U.S. and 0.9x for Europe)²
• less than 14x earnings³

Source: Mike Churchill—Churchill Research

In addition, China traded at 1.76 book value, and India at 2.22, as of March 4th, according to Bloomberg.

Clearly a lot of negative projections are already baked into such dire numbers. Why is that? Much of the answer lies in Japan's very challenging macroeconomic climate, which helped to make some sense of those bargain-basement valuations even before the Tohoku Earthquake. These challenges can be summarized by the 'three Ds' of debt, deflation and demographics.

Debt

The flipside to corporate de-leveraging during Japan's two lost decades was, unfortunately, a ballooning of sovereign debt. Much as the U.S. has done since 2008 with the tripling of the Fed's balance sheet, Japan has effectively converted corporate debt into government debt. Consider:

• At the peak of Japan's bubble in 1989, corporate debt was 1.3x GDP and sovereign debt was 0.7x; fast-forward 20 years to 2009, and the numbers had switched places, with corporate debt at 1x and sovereign debt at 2x GDP, among the highest in the world. In fact, Standard & Poor's downgraded Japan's debt rating to AA- from AA in January 2011⁴
• Add to sovereign and corporate debt the increased household and financial debt, and the picture becomes truly alarming: 3.9x GDP in 1989 had grown to 5.3x in 2009⁵

As is the case in the U.S., Japan's interest burden is eating up an outsized portion of tax revenue, and this is in a low-interest rate regime that is arguably unsustainable. Today, more than 25% of Japan's tax revenues are eaten up by debt service, and an estimated 36% of total central-government interest expense.⁶

Source: JP Morgan Private Bank and Japan Ministry of Finance

As bleak as some of these figures are, Japan does have a few fiscal advantages. First, unlike any other major developed country, its sovereign debt is funded almost entirely internally, so it is not reliant on the kindness of strangers. Just 6% of Japanese debt is funded outside the country (compared to 75% for Germany, for example).  Japan is also the world's second-largest owner of foreign reserves after China, including the global number-two holder of U.S. Treasuries, which it can freely monetize.

Deflation

Meanwhile, price deflation has almost certainly slowed Japan's economic growth in the past several years. Its persistence has weighed on consumer spending, and delayed capital investment, becoming a self-perpetuating phenomenon. Why purchase consumer goods or make capital investments today when either can be done for less tomorrow? 

There are, however, some signs that deflation may be easing, or even turning into mild inflation. Throughout 2010, declines in Japan's Consumer Price Index became less severe, and prices actually rose slightly in the fourth quarter.

Is Deflation Easing? Japanese CPI, 2005-Present

Source: Bloomberg

During our two visits to Japan in the past year, we found little anecdotal evidence of deflation, a view that dovetailed with the answers from the companies to which we posed this question. We were told that, while apparel and electronics seem to get cheaper every year, they were doing so all over the globe. We also heard that food prices in Japan are rising, and input costs seem to be stabilizing.

Demographics

Whereas many emerging markets are characterized by young, growing populations that portend a productivity boom, Japan's populace is just the opposite: old and shrinking.

Nearly a quarter of Japanese are older than 64, which is about three times the global average and nearly twice that of the U.S. Put another way, for every working-age Japanese citizen, there are 0.56 citizens⁷ not contributing to the economy (i.e., younger than 15 or older than 64), and this ratio is expected to reach 0.67 in nine years.⁸  Absent a proactive immigration policy, this aging profile translates into a shrinking population. From a current level of approximately 125 million, Japan's population is projected to drop below 100 million by 2046, below 90 million in 2055 and down to just 45 million in 2105.⁹

Aside from the three Ds, Japan also has among the highest corporate tax rates in the world at 40.6%, which helps to explain why Japanese companies tend to "under-earn." There is, however, talk of lowering rates to 35%, which would of course boost reported profits. To the extent that such a change also incentivizes companies to produce higher profit margins, it could also significantly—and positively—affect valuations through the multiplier effect.

Is Tohoku the Long-Awaited Catalyst?

While media coverage of the Tohoku Earthquake has appropriately focused on the human side of the catastrophe, it has incorrectly, in our opinion, implied that the disaster spells near-certain doom for the Japanese economy. On the contrary, historical evidence shows that advanced economies such as Japan's, with functioning governments and an educated citizenry, tend to rebuild with surprising speed and, counter-intuitively, can emerge stronger from such adversity.¹⁰

Source: Economic Behavior in Adversity, Jack Hirshleifer, University of Chicago Press, 1987.

Indeed, Japan has had plenty of experience with cataclysms, from Hiroshima to Tohoku, and perhaps the most relevant and instructive is the Kobe earthquake in January 1995. Kobe was at that time world's sixth-largest port and a key engine in the Japanese economy. With an estimated 6,500 dead and $125 billion in damage, most prognosticators estimated that it would take years for Japan to recover from the Kobe quake, and accordingly the Nikkei sold off 25% over a few weeks following the disaster. It was no small surprise, then, when:

• Kobe's manufacturing capacity was back to 98% within 15 months¹¹
• Kobe's exports recovered to an 80% level within 12 months¹²
• Over the next two years, Japan's overall GDP growth surpassed expectations¹³
• Even currency effects were relatively short-lived: the Yen rallied 20% by April, but normalized back to 100-per-US dollar before summer was out.

Much of the commentary on the Tohoku catastrophe seems to treat as a given that Japan will be cast into a deep, long-lasting recession. But we should not forget that the destruction of physical capital is not counted in GDP, while re-construction is. Given these facts, we believe it is even possible that Japan may entirely avoid a multi-quarter recession. It may also help that many of Japan's leading economic indicators were until recently pointing upwards, and retail sales seemed close to bottoming.

To bring this discussion closer to home, consider the more recent post-cataclysm recovery of another advanced economy: ours. After the tragic events of September 11th 2001, it seemed unthinkable that New York City would be back to normal within even a year, though it mostly was within weeks. New Yorkers, and indeed all Americans, suffered a blow to our optimism and confidence, while paradoxically the economy—both local and national—was showing unmistakable signs of optimism and confidence. In fact, far from starting a recession, 9/11 actually ended one (as measured in GDP growth).

So while accounts of the destruction of towns, buildings and cars in Japan create high ratings and multiple page views, it is not physical capital that primarily drives economic recovery and growth. Rather, it is human capital, especially in the form of productivity and innovation. And Japan's got plenty of that!

The Opportunity

In contrast to the aforementioned challenges, Japan offers unusually strong corporate balance sheets, with many of its smaller companies generating consistently high returns on capital. Having de-leveraged through the two lost decades since the Nikkei bubble burst in 1989, fully half of Japan's 2,400 largest companies are completely debt free.¹⁴ In fact, most of the companies with which we met have significant net cash and returns on capital in excess of 25%. Japanese companies also tend to have long operating histories by Asian standards and a relatively high continuity in management teams.

In the context of Japan's slow-growth economy, many investors have wondered how Japanese companies will manage to grow. Part of the answer actually lies outside of Japan. Faced with mature markets and demographic challenges at home, many of Japan's better companies have effectively re-positioned themselves to profit from Asia's faster-growing emerging markets.

China recently edged out Japan as the world's second largest economy, but this has not stopped Japan's export-oriented managers from capitalizing on this change to tap into a large, highly accessible growth market. In fact, Japanese exports to China are surging, and last year China eclipsed the US as Japan's number one trading partner.

Certain companies and industries in Japan are better positioned than others to withstand the country's challenges. For example, we met for the second time in Japan with two companies of note:

• A pharmaceutical company exposed to a healthcare vertical that is expanding at greater than 10% in its emerging-market export areas and at a respectable 4-5% in its home market, driven by Japan's aging population
• A convenience store chain with 60% of its store base positioned strategically outside Japan in Asia's emerging markets. We believe this company is at inflection point for profit growth after absorbing the expensive start-up and expansion costs that have kept competitors at bay

Weighing the challenges of reconstruction and the 'three Ds' against the numerous opportunities in the form of well-managed smaller companies with good balance sheets, high returns on invested capital and what we think are highly attractive valuations, we see Japan as potentially fertile ground for discriminating small-cap investors such as ourselves. Japan remains a critical part of the global economy and its equity markets. In 1989, Japan represented 47% of the world's market capitalization;¹⁵ today, weighed down by pessimism and now Tohoku, that number is a mere 7%.¹⁶ We are of the view that over the next few years as Japan heals, the valuations of Japanese companies will recover at least some of this lost ground.

If you are interested in donating to Japan in support of disaster relief, may we suggest visiting The American Red Cross or Japan Society.

¹ Bloomberg
² Ibid
³ Mike Churchill—Churchill Research, Bloomberg
⁴ Hayman Advisors
⁵ Ibid
⁶ Hayman Advisors
⁷ Hayman Advisors
⁸ Ibid
⁹ The National Institute of Population and Social Security Research, http://search.japantimes.co.jp/cgi-bin/ed20100115a2.html, http://news.yahoo.com/s/ap/20110101/ap_on_re_as/as_japan_population
¹⁰ JP Morgan, Eye on the Market, 3/15/11; Eduardo Cavallo and Ilan Noy, "The Economics of Natural Disasters: A Survey," IDB Working Papers Series, No. IDB-WP-124, May 2010; and Jack Hirshleifer, Economic Behavior in Adversity, University of Chicago Press, 1987
¹¹ Ibid
¹² Ibid
¹³ Surowiecki, James, "Creative Destruction?", The New Yorker, 3/28/11
¹⁴ The Economist
¹⁵ Marc Faber, The Gloom, Boom and Doom Report, May 1999
¹⁶ Bloomberg