Made in Japan: A New Bull Market

Japan has now been through a 20-year bear market. Tokyo’s Nikkei – think of it as Japan’s Dow Jones Industrial Average – put in a new low last year. Even though it’s rallied a bit since then, it’s still down about 75% from its all-time high in 1989. That’s a brutal bear market.

After all that, there is still no shortage of bad news on Japan. There are plenty of problems, including a ballooning pile of government debt. Some think a debt crisis is inevitable.

Yet even the most ferocious of bear markets eventually ends. So naturally, the question is: Is now – finally – the time to buy Japanese stocks? I’ve come across lots of interesting bits on Japan of late that got me thinking that answer is yes.

There is James Montier’s new book, Value Investing, which is really just a compilation of stuff he’s written before. Nonetheless, there is enough entertaining and thoughtful research to make it worthwhile. In rereading some of these pieces, I came across Montier’s piece on Ben Graham’s net-nets.
Graham was an important investment thinker in the history of our craft. He created the idea of a net-net, which is a company that sells for less than its net working capital – current assets minus current liabilities – alone. Meaning, you pay nothing for the company’s fixed assets. It’s a kind of bedrock of value, a figure so low and ridiculous that no one would sell a business for that price. Turns out these are often good investments.

The problem with net-nets, though, is that they are a kind of financial snow leopard – often sought, seldom seen. But in a September 2008 piece, Montier set out to find today’s net-nets. He found more than half of them in Japan. As he writes, “This clearly suggests Japanese small caps are one of the best sources of bottom-up ideas available.”

In March 2009, Montier updated his findings and found more net-nets than ever. Again, more than half were in Japan. He called Japanese small caps among “the cheapest assets on earth.”

Then, too, I remember going to the Grant’s Spring 2009 Investment Conference and listening to Jean-Marie Eveillard give a presentation. Eveillard, if you don’t know, is a revered figure among investors. He is most known as the pilot of the First Eagle funds, for which he began managing money in 1979. The French-born Eveillard, born in 1940, is an old-school value investor. Graham’s legacy inspires Eveillard, as he often mentions him.

When managing money, Eveillard was known for holding onto quite a bit of cash when he couldn’t find compelling investment ideas – unusual in the mutual fund world, where managers are usually fully invested. And he also invested in gold long before it was popular.

In Eveillard’s presentation last Spring, he too talked about how cheap Japan’s stock market was. He pointed out that book value was “very hard” in Japan, since many of the assets were in cash. “To say the Japanese stock market trades below book value is to say quite a bit,” Eveillard said. Right now, the Nikkei trades for a price-to-book ratio of about one-to-one.

Eveillard ran through some examples of companies he liked – Fanuc, SMC, Astellas Pharma and Shimano. These are dominant businesses. Several of these had cash in excess of 50% of their market caps. They traded for only slight premiums to book at a time when the S&P 500 traded for four times book.

In a November interview with Steve Forbes, Eveillard was still talking about Japan. He said investors were “thoroughly disgusted” with Japan’s market, an environment that creates cheap stocks. He also talked about how Japan’s companies have tons of cash. “Americans used to make fun of them,” he said. “Those idiots are sitting on tons of cash that yield nothing.” Now – after the trials of 2007-08 – many American companies wish they had held onto some cash.

But Japan’s companies hold too much cash. In general, Eveillard is forgiving of this excessive conservatism and sees it as a potential strength in today’s environment. “Nothing is perfect,” he says, “and that’s a sin which I have been willing to forgive – excess conservatism, as opposed to excess aggressiveness. Today to have a very sound balance sheet is a tremendous advantage. It is one of the strengths that will allow some companies to gain at the expense of other companies burdened with debt.”

Over the last few years, he has been one of the lonely voices talking about investing in Japan. In fact, I talked to a good friend of mine – of the contrarian bent – who advises pensions and endowments on investing. I asked him if he had any favorites as far as getting exposure to Japan’s stock market. “There really isn’t much out there,” he told me. “It’s not like investors are clamoring to get into Japan.”

Then there is Bill Bonner, my publisher and editor of The Daily Reckoning. His famous Trade of Decade in 2000 was to buy gold and sell the dollar, a trade that worked out brilliantly. In the early days of 2010, Bonner put on a new Trade of the Decade: Sell US Treasuries and buy Japanese stocks.

Finally, there is some historical precedent for surprise. Over the holidays, I read Keyes Beech’s book Not Without the Americans. Beech was the dean of Far East correspondents, having worked the beat for over 50 years. His book came out in 1971 and he’s been dead since 1990, but his book gives valuable perspective on Asia’s development.

If you think things are bad in Japan now, you should take a minute to imagine what it was like in 1945. As Beech writes:

The country was literally in ruins. Its major cities were leveled by American warplanes. Its industrial plant was either destroyed or obsolete. Its once great merchant fleet lay at the bottom of the sea.

One expert at the time described Japan as “10 men in a boat with food for seven.” It could hardly be bleaker. Yet within 20 years of its crushing defeat, Japan was the third largest economy in the world, behind only the US and Soviet Union. It was four times bigger than it was before the war. The Economist called it “the most successful sudden economic growth story of all time.”

Within two decades Japan had the highest growth rate in the world. It made half the world’s ships, produced more steel than Britain and had the second largest auto industry in the world. All of which would have been unimaginable in 1945. And it did all this with nary any natural resources.

I’m not saying Japan will repeat this miracle. I’m passing on more evidence that the consensus is often wrong and one should expect surprises.

Bottom line: I wouldn’t count Japan out. And bear markets do end. Twenty years is a long time. I like the new Trade of the Decade. To participate, you have several choices. You can invest in the Japanese Smaller Capitalization Fund, ticker JOF, which has lost a third of its value over the last decade. The iShares MSCI Japan Index Fund, ticker EWJ, has done even worse, but it is another fund that aims to capture the returns of the Japanese market…for better or worse.


Chris Mayer
for The Daily Reckoning

The Daily Reckoning