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Over the last two decades, Japan has suffered under the malaise of deflationary deleveraging after its stunning growth between the 1960s through the end of the 1980s. In 1991, economists were predicting that Japan would overtake the U.S. as the world's largest economy by 2010.₁ Instead, Japan's GDP has stayed largely stagnant over this time period as the country has been trapped in a debt-induced deleveraging cycle.

Japan's GDP has stayed relatively stagnant over the last two decades₂

Despite this lack of growth, Japan still is the world's third-largest economy and the largest creditor nation.₃ The standard of living in Japan remains relatively high while boasting the highest life expectancy of any country in the world.₄ Sadly, a prior visit to Japan in March 2011 coincided with the Great East Japan Earthquake. In the month after our visit, there were questions regarding the impact that the earthquake would have. What has been most remarkable to us as outsiders is the collective strength that the Japanese people have displayed in response to the disaster. A year later, we continue to spend time sticking to our core goal of engaging with companies in Japan that have pristine balance sheets, high returns on capital, dominant market positions, and participate in industries that have secular growth drivers.

The demographic challenge facing Japan has been well documented by several organizations, including the Center for Disease Control and Prevention. Japan's population demographics put it among the oldest populations in the world. According to a 2009 United Nations report, Japan is the world's oldest society, with a median age of 44 years, although population declined by 0.2% last year to 127.8 million.₅ People aged 65 or older comprised 23.3% of the entire population compared with 23% for the year before. As more and more Japanese entrepreneurs head toward retirement, they will need to find successors for their businesses.

Percentages of the population above age 65 in selected countries₆

In Japan there are approximately 2.7 million companies of which 30% are small-to-medium enterprises (SME) that have more than 10 employees or approximately 810,000 companies. Two-thirds of these Japanese SMEs don't have successors for their businesses and will eventually need to have a monetization event.₇ As these companies are too small to go public, the most likely exit mechanism for their founders will be to sell them.

One of our investments in Japan focuses on this niche of the Japanese M&A (merger & acquisition) market. As the size of an individual transaction is relatively small, the larger global banks do not participate in this space. The company has put in place a national network of accountants and financial institutions with which its consultants maintain relationships and generate deal sourcing. This network would be difficult for a small investment banking boutique to replicate, and therefore the company is able to benefit from its unique position in the Japanese market. The firm is doing approximately 100 deals on an annual basis. However, as the number of retiring entrepreneurs in Japan increases, the company will benefit from a secular tailwind. Management believes that it is only worthwhile to focus on the SMEs that are profitable as these are the companies that are likely to attract interest from buyers. Approximately 30% of the SMEs are profitable, and therefore the overall estimated market size for the company is 150,000 companies, which would represent a significant opportunity for the in the years to come.

Japan has historically been an attractive education destination for Chinese students, who have represented the biggest share of international students since about 2004, comprising 61% of the total as of May 2010, according to the Japan Student Services Organization. In 2010, there were more than 86,000 students from China, a 9% jump from the previous year.₈ Several of these Chinese students work in Japan after they graduate from universities. In fact, one of the representatives from the investment bank who helped coordinate our trip was a Chinese national who had done just that.

One of our investments in Japan was also founded by a Chinese national who had come to study in Japan in the early 1980s. T he company is focused on the healthcare space and provides contract research to large pharmaceutical companies. In Japan, the trend for outsourcing contract research is still well behind the rest of the world, as Japan was late in adopting the International Committee on Harmonization (ICH) E6 guidelines on Good Clinical Practices (GCP). Therefore the Contract Research Organization (CRO) market continues to grow in Japan which provides this company a growing market to target.

It currently has the leading market share in a relatively consolidated market, and therefore is able to earn attractive returns on capital, which is what attracted us to the company in the first place. Management is also looking to grow its international business primarily in China, and the founder's Chinese background should prove to be an advantage. 

Japan's CRO market₉

Japan's gross government-debt-to-GDP ratio was 220% in 2011 and its net government-debt-to-GDP ratio was 113% in 2011, bringing it up from 11.5% in 1991 and placing it among the highest in the world.₁₀ Debt service and social-security payments are expected to consume 53.5% of total outlays for 2012, and debt service now accounts for 43% of government revenue. Clearly with this backdrop the government of Japan is looking for ways in which it can cut costs.

Japan's Debt/GDP is expected to be amongst the highest in the world₁₁

One of our investments in Japan is the leader in the business process outsourcing (BPO) industry. The company is a beneficiary of the trend towards outsourcing as it is utilized as a means of cost restructuring within companies. It has also won large-scale projects for government offices as the government has outsourced services in order to reduce spending.

The traditional global business process outsourcing players are not able to compete in the Japanese market due to language barriers. Japanese customers continue to prefer Japanese-speaking operators when they place their customer service calls. Therefore, it has not been possible for companies that have offices in low-cost areas such as India or the Philippines to enter the market.

Our recent trip to Japan was very helpful in allowing us to uncover investment ideas and stay close to a nation that will remain a critical player in the world economy in the years to come.

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