Five Samurai Stocks…and Two Oil Tips by Money Week

London, England: Merryn Somerset Webb : The Japanese market had a great run in 2003, but the rally seems to have stalled in recent months. Is it over?

Robin Geffen , managing director at Neptune Investment Management: We do our research on a global sector basis with no bias towards countries. We carve the world up into separate industrial sectors and then decide which we like and which we don’t. Then we pick the best stocks in those sectors around the world. Last year a lot of those stocks were in Japan.

In February 2003, there were a number of sectors – industrials, electronics, even one or two of the banking stocks – that looked really good value to me. However three months ago we halved our exposure to Japan and then a month ago we halved it again. The fact is that we cannot find – with a few exceptions in the steel sector and one Japanese financial company – any stocks which stand out within their sectors. It is true that lots of the smaller companies are doing very well but as soon as you start travelling up the ranks in terms of size you just can’t find value anymore. In March last year the Japanese market looked great, particularly given that it was such a play on China. But now with China slowing the fundamentals just haven’t come through. I think there’s a massive losing streak to come.

Ian McCallum , executive director, fund manager and head of research at Bedlam Asset Management: We do a global fund too and came to the same conclusion as Robin last year – we just filled our boots with Japan. We looked at firms like Komatsu which is in the same business as Caterpillar and found that not only did it have massive market share in China and lots of free cash, but it looked a lot better in terms of valuations too. That was the kind of thing that pushed us into Japan last year. But, unlike Robin, we’re still there. We aren’t finding the value in exporters any more. Anything that exports to China is suffering in the slowdown – sales at Komatsu are down 60% in August/September. But we can still find the value in terms of growth and price among more domestically geared companies.

Rupert Foster, chief executive of FCFM Capital: How much worse can it get for exporters to China? You’d think sales 60% down was near the bottom.

Ian McCallum : It can get worse. China’s in a bubble. There is massive over investment and hence over capacity – inventories are back at 1996 levels. If you speak to the guys who actually go in and build the widgets there you’ll find they’re not making any money. Genuinely not making any money. That’s why being in the exporters in Japan doesn’t work anymore and why our exposure to Japan is all to companies exposed to domestic restructuring.

Robin Geffen: But mainly in the smaller companies?

Ian McCallum: A cross section. There’s good restructuring going on from Kirin Beverages – which is huge – right down to the very small companies. We’re stock pickers, so we’ll buy anything that looks good. But we also look at the macroeconomic environment. Nothing operates independent of it. But that side of things looks pretty encouraging to us. Corporate debt as a percentage of GDP is now 75% – that’s down from way over 100% and makes it clear that the corporates have restructured significantly. It took 14 years but now Japan is a very simple, economic restructuring story.

Rupert Foster : It’s really an amazing achievement that Japan Inc doesn’t get enough credit for having turned cash positive in a time when the underlying environment was so awful. After a decade of deflation and recession, levels of return on equity and assets are back up to 1989 levels. If you look for restructuring in terms of big slash and burn plant closures, you don’t see that much. But if you just look at the incremental improvement in the figures in terms of costs and the like it’s impressive.

Robin Geffen : I wouldn’t say that debt at 75% of GDP is impressive. It’s a panic number.

Ian McCallum: It’s more like 110% in the US.

Robin Geffen : Yes, I hate the US too. Of our whole global equity fund only 5% is in the US.

Ian McCallum : The point about Japan is that it is chucking up cash like there is no tomorrow. Profitability in terms of return on equity is back up to 1989 heights and that’s been driven by all the cost cutting that has been done. I’ve just been staggered how genuinely endemic restructuring is across the board. Even in an era of falling prices companies have managed to increase their profit margins. So imagine what they could do if prices started to rise. The gearing effect of the end of deflation on profits would be just ginormous.

Robin Geffen: And that’s possible even with oil at $50?

Jonathan Allum , Japan strategist at KBC: That isn’t that big a deal. Japan’s done a pretty good job of dealing with high oil prices over the years.

Robin Geffen : Yes, but not in this game. Oil prices have virtually doubled in a year and no one’s accepting it. You’ve got companies from airlines globally through to manufacturers in the Philippines budgeting for $25 a barrel. But what happens when oil is still at $40-50 in a couple of quarters? Then there’ll have to be some kind of mental adjustment all round. That’s not going to be pretty.

Rupert Foster : Surely the issue is not the oil price itself, but the extent to which the companies can pass it on to the consumer. If they can do that straight down the line it isn’t such a problem. And at the moment, a lot of Japanese industries can do that – given that demand for their products is high. But there are capacity constraints all round. It seems to me that the overall capacity utilisation data supports the case for Japan. Clearly there’s still over capacity in areas such as construction and retail – there’s way too many shops in Japan so no one makes any money. But in other areas – say steel – there is now limited capacity and the Japanese are reaping the rewards.

Jonathan Allum : Generally this is the case through much of the old economy, including obviously steel and chemicals. There hasn’t been any capacity added for as long as anyone can remember – it hasn’t been needed. But the Japanese, be it by luck, judgement or simple idleness also never cut their capacity in – say, shipbuilding – as we did in the UK and in the US. And suddenly by some quirk of fate the entire world wants steel ships and there aren’t many places you can get them – just Japan and Korea. No wonder order books are backed up 3-5 years and profits are soaring. The Chinese may be about to start having a go at it. But building shipyards is a long, long road to go down undefined it’s much easier to put up a microwave oven factory again.

Robin Geffen : Okay, but that’s not the case with the likes of petrochemicals. There’s massive capacity globally.

Jonathan Allum : But there are massive Asian markets for these products.

Robin Geffen : I’ll accept that with steel. China still needs piles of it particularly given the massive construction going on for the Olympics. They are not going to embarrass themselves with a whole load of stadiums that fall down, so you’re going to have steel beams and the like coming from Japan. Steel looks fine as an investment. But I don’t see the case for big exports of chemical products out of Japan to the rest of Asia because there is excess capacity there too. There’s no pricing power.

Rupert Foster: But you’ve got to remember that Japanese chemical companies produce a lot of their chemicals in Singapore or wherever. They’re not really domestic industries. In fact, this is another one of the long-term reasons to look at Japan. It is as much an Asian financing operation as anything else. Still, I have to agree with Robin that the market is on the way down but I think it is a purely short-term cyclical thing. The long-term structural case is good, but right now year-on-year growth is slowing globally and it’s hard for Japan to fight that cyclical slowdown. Too many of its companies are exposed to it and self-sustaining recovery is not quite strong enough. I’d expect the market to trend down on a short-term cyclical downswing.

Jonathan Allum : I agree. One important thing here though is that I don’t think Japan will hit a new low on this downswing. If the US consumer packs up completely or China implodes, all bets are off. But otherwise I think that thanks to the restructuring that we have been talking about, the low last year was the bottom. The longer term is bullish. We are just in a short-term bear market now.

Merryn Somerset Webb : So when will it be over?

Rupert Foster : Hard to say, but I think it will run at least until November.

Robin Geffen : I’d feel a lot more comfortable about the market if I saw some foreign buying. The market only went up last year because American money arrived.

Jonathan Allum : Is that a historically valid reason for being suspicious? It was the Americans who bought in first when Japan kicked off in the 1980s. Domestic buyers followed.

Robin Geffen : Yes, but it worries me that if all the American money decides to leave Japan the market will hit a new low. American money all moves at once. You only need one top strategist to say that its time to get out and they will all rush for the door.

Jonathan Allum : I think that there is something else going on in Japan. There have been three big jumps in the market over the last decade or so and none of them lasted so most don’t expect this to either. So with the market up 40% they’re taking profits – but everyone’s so keen to be ahead of the curve that they’re just jumping out regardless. This isn’t like the other times. This time, the fundamental data isn’t going down – just share prices.

Robin Geffen : I would still argue that even if you are all right and you see a Japanese domestic recovery of monumental proportions, there is every chance that US consumer spending will collapse and China have a hard landing. Then do you honestly see the Japanese market going up?

Jonathan Allum : If the whole world catches a big cold, then of course Japan will too. But I do think that the vulnerability of Japan to the US at least has diminished.

Rupert Foster : The only other bearish thing I can think of at the moment is the continual problem in Japan of announcement risk – the government announcing something like a rise in taxation or tightening monetary policy for example. This kind of thing is always a risk in Japan.

Jonathan Allum : Koizumi [the Japanese prime minister] has said taxes won’t go up on his watch – which gives you three years – but after that, who knows? In terms of monetary policy, I think the Bank of Japan has made it as clear as is possible that they are not going to tighten for quite a long time. One final point I want to make is that if you compare Japan with the US or the UK at the moment, the striking thing about the current recovery – however strong it may be – is that it is not driven by the public sector. In fact, the public works spending has been going down for ages – that makes the recovery entirely a private sector phenomenon instead of the great Keynesian mish-mash the last few cyclical recoveries have been.

James Ferguson , a stockbroker in Tokyo for 20 years, now setting up a Japan hedge fund: Something else worth mentioning is the importance of intellectual capital to the new Japanese economy. You’ve got companies such as Asian Sasaike, which makes car transmissions, taking on the Americans at an intellect level. They’ve got the money to do the R&D. It takes three to $4 million to develop a new transmission. Ford and GM just don’t have the money to do that. So Asian will slowly take market share. I would go so far as to argue that Japan could be the next Britain or perhaps the next US. The next big de-industrialising nation. It’s moving into the tertiary sector and making its money from intellectual property. That’s where the upswing is. Think computer games, cartoons, pop music, and fashion.

Rupert Foster: Japanese pop music?

Jonathan Allum: I listen to it.

James Ferguson: Do you know what the most dangerous thing in the world is? People like us talking about pop music.

Merryn Somerset Webb: Lets talk about a few specific companies.

Ian McCallum: One of my current favourite stocks is Warabeya Nichiyo. This provides prepared lunch boxes for Seven-Eleven stores, making it a good geared play on Seven Eleven’s current expansion. It’s seeing strong free cash flow and growth. It’s cheap as chips!

Jonathan Allum: I’d go for Kanematsu. Like other general trading companies, Kanematsu used to be in too many businesses, without too much success, and was largely reliant on borrowed money. With the help of debt forgiveness, it has slimmed down, cut debt, cut workers and become generally more efficient. And its stake in a major LNG project in Indonesia is a genuine, and undervalued jewel in its crown.

Rupert Foster: Anritsu is a telecoms equipment company that is heavily geared to the global roll out of 3G. Then, if I was going to choose something to short it would be Olympus. Its global domination of the endoscope market is ebbing away and it isn’t making any money in the digital camera market.

Robin Geffen: I can’t bring myself to tip a Japanese company so I’m going to suggest some non-Japanese firms. The first is a French exploration and production company Maurel et Prom and the second Russian oil company Sibneft. The oil price is going to stay high – the fact that Japan doesn’t have any oil will be the final nail in its coffin – and these are both undervalued.

James Ferguson: Japan Radio’s earnings are forecast to grow more than 30% next year putting it on a p/e of only 11 times. That’s way too cheap for that kind of growth. I’d also look at Sumitomo Metal Industries which is forecast to make over 13 yen per share this year, 50% more than it made in 1997, its peak earnings year of the last decade. Back then, it traded at around Y300, on a 30 times multiple. Yet it trades at just Y135 today, a mere ten times earnings.

The Daily Reckoning