Could this be the best opportunity for investors in 30 years?

I spent some time with Mark Pearson of Arcus Invest a couple of weeks ago.  He has been investing in Japanese equities for 30 years and is known for having visited more companies there than anyone else working today.  He told me that in all his investing career he had never seen such an investing opportunity for value investors.  It is bigger in his view than either the dot.com bubble or the aftermath of the Global Financial Crisis.  Of course it comes with a caveat - neither he nor we know how long it will take for the valuation anomaly to correct, ie. the elastic to ping back - and so investors need patience.  But given the overall perception that ‘everything is expensive’, we think investors should be interested. Some of his reasons are global: investors’ quest for quality income in the aftermath of the GFC has pushed valuations to record highs, while value stocks have languished.  In Japan the gap between the former and the latter is as extreme as it has ever been, and additionally value stocks are close to their cheapest ever in absolute terms.  Mark’s small cap portfolio stands on a PE ratio of around 5x. An interesting point he makes is that that future earnings growth among the lowly rated stocks is not appreciably lower than those rated highly.  To believe highly rated stocks will outperform, investors have to expect further valuation appreciation.  Of course it’s not impossible but it seems an improbable scenario given where we start.But some of Mark’s reasoning is more Japan-specific, particularly the transformation in Japanese corporate balance sheets, which is still largely unrecognised by investors.  Here are some statistics to ponder. In aggregate, Japanese corporates have created over Yen 560 trillion of cashflow over the past 25 years, despite very low levels of nominal economic growth.  As a result a debt mountain has turned into a cash pile.  It has been done by a tripling of recurring profit (equivalent to pre-tax profits) margins from 2% to around 6%.  If we drill down, both operating and non-operating margins have improved, but the bulk of the change has come from the latter. What have they done with this cash?  Let’s start with what hasn’t happened.  It hasn’t gone to employees.  Despite the tight labour market, the % taken by labour has stayed at approximately 13%.  It has only modestly gone to Capex, which remains at around 3% of sales.  Some has gone to M&A - there have been some high profile acquisitions such as Takeda’s acquisition of Shire.  Importantly, however, this has not led to an increase in intangible assets, which remain at around 15% of book value for TOPIX companies (cf. US S&P 500 at 70%). Shareholders have been the big beneficiaries.  Both dividends and share buy-backs have risen fast.   Combined, they equated to around 5tr yen in 2004, around 20tr yen today.  And the reason for this isn’t far to seek.  A generation ago, around two thirds of shares were held for corporate reasons by connected entities, whose interest was in stability and corporate relationships.  Now about two thirds are held by independent shareholders who want financial returns. So we have the combination of ultra-low valuations and a vast improvement in both corporate quality and shareholder friendliness.  If you can afford to be patient, our view at Linchpin is what’s not to like? ___________________________________________________________________________ This blog is intended for professional investors, and nothing within it is or should be construed as constituting advice as defined by the Financial Conduct Authority.  If you are in any doubt about this, please consult your legal advisor.  The information contained in this blog has been obtained from sources believed reliable, but we do not represent that it is accurate or complete, and it should not be relied upon as such.  Linchpin IFM Limited has a consultancy agreement with Arcus Invest.

Has Japan fallen off the map again?

It is six months since I blogged about Japan.  In March I asked whether Abenomics needed a re-boot, as Japan seemed to be sinking back into deflation and Abe’s three arrows to have run their course after six years. Six months later, rather than Japan struggling to re-join the world, it looks more as if the world has decided to join Japan.  Growth in much of Europe is zero, and bond yields globally are also falling towards or beyond zero.  Inflation is still on a different trajectory but the policy prescription is likely to be similar. That is because monetary policy loosening over ten years still has not got western economies, with the exception of the United States, anywhere near where they wish to be.  For political reasons, governments of left and right are having to look for other solutions.  A combination of some fiscal relaxation combined with more radical monetary easing seems to be the preferred flavour. As so often at times of change, the more flexible and less dirigiste Anglo-Saxon economies are in the forefront, whether the next government be of the left or right.  Europe will almost certainly be a laggard because it finds change difficult, full-stop.  I see Japan somewhere in the middle.  It has already taken Quantitative Easing further than other countries, with the Bank of Japan lending against a broader range of assets and even purchasing equity ETFs. In one sense Japan’s high participation rate (nearly 80% of all working-age adults are employed) masks the problems.  If you are employed, deflation benefits you because costs come down.  On the other hand, the Japanese economy is entwined with China’s more closely and if command-led China goes down a more radical route to support its economy, Japan will have little option.  Also, as a society, Japan has little problem with radical change once it has been decided.  Witness both the Meiji Revolution and the aftermath of the last war. Bringing this back to markets, what might fiscal and more radical monetary easing mean?  At the economic level, it should of course help domestic-focused company profits.  More importantly, though, will surplus cash go into ‘safe’ assets, driving highly-priced companies to even more extreme valuations?  Or will ‘free’ money encourage some risk-taking, helping the long tail of cheap companies?  Which matters: if the first, we will likely see a continuation of current market trends; if the second, something more akin to normalisation, with the valuation stretch reducing. If Japan has fallen off the map, it is no longer alone.  And I would put a little money on it embracing change rather faster than some other developed countries.  Could the forthcoming rugby World Cup and next year’s Olympics act as a catalyst?​

Watch out for the rise!

Sorry if you thought we mean stockmarkets rising.  We don’t.  We mean liquidity.  Here end-June data from our friends at CrossBorder Capital is showing a significant jump, much in line with our predictions over the last few months.  It’s happening where investors aren’t looking – in Asia and the private sector.  In Asia, the PBoC has clearly taken its feet off the brakes again, perhaps in consequence of the slowing economy as per yesterday's headline.  There’s a sub-theme we’ve mentioned before here too – the Bank of Japan seems to be easing in line with China, bearing out our view that Japan has for several years now targeted currency stability first and foremost rather than foreign currency. The real theme of the latest data is the surge in private sector liquidity around the world but particularly the US.  This is not all good news, as it may be corporates building up cash before an economic downturn.  But it does increase the likelihood of steeper yield curves.  In theory that fits neatly with our general view predicting a bullish steepening with short term yields falling alongside US rate cuts.  However, the facts don’t all fit.  Historically, this late-cycle environment is associated with rising term premia, suggesting that longer term bond yields may in fact rise, and a bearish steepening.  At the same time, one of the worries we have had over the past few months, the fragility of corporate bond markets, seems to have eased off a bit, so the bulls expecting the US to cut rates may be premature.  So, while we expect the curve to steepen as liquidity supply increases, we are less confident which end of the curve will move. QE4 is starting but it seems that the US Fed may be the laggard rather than the leader this time round.  It suggests that Emerging Markets will, at some point quite soon, have a run of some sort but once again not all the facts fit.  CrossBorder flows of capital are running clearly away from emerging markets, and particularly the larger ones such as China, into safer havens mainly in Developed Markets.  Liquidity may well be on the rise, and highly valued US equities may be underpinned by that, but we’re not sure that adds up necessarily to further gains in global indices. If you’d like to see the underlying data, please contact the team.​

William looks at the prospects for 'value' if there is more qe

Regular followers of our blog will be aware that we think the Federal Reserve has given up on interest rate normalisation, and will meet any serious threat to either the economy or the financial system with rate cuts.  It’s noteworthy that US 10-year yields have fallen from 2.7% to just above 2.0% in the past three months and we expect them to go lower. What does that mean for equity investors and value investors in particular?  They have suffered from QE, as lower discount rates have pushed up the valuation of longer duration assets such as growth stocks, and also from investors’ desperate search for income in an ultra-low bond yield world.  In May 2019, some 11% of global stocks traded at more than 30x and a further 12% at below 10x.  In Japan, the numbers were 16% and 22% respectively. That tells a story of investors buying quality and growth and shunning value.  Will it continue if we do indeed find ourselves staring down the barrel of QE 5, 6 and 7?  At the moment, we don’t see much to stop the trend continuing.  The shortage of safe assets is pushing bond yields down and we suspect that genuine ‘quality’ equities, i.e. those which can credibly promise steady income growth over the long term, will benefit in turn. However, no trend lasts for ever and there are things in the offing which will ultimately lead to change.  The first is that, almost universally, the highly rated companies are large global entities in sectors such as consumer goods, pharma and increasingly technological.  The threats will come from increasing friction in global trading, and determination by governments to clip their wings and stop them becoming too powerful.  Who remembers the currency controls in place in the UK until 1979? The second, at the other end of the spectrum, is the growth of private equity.  The FT reported this week that there is US$3.5 trillion of ‘dry powder’ waiting to be invested.  Some of that will be aimed at the unloved and lowly valued tail of listed companies, which should in time give valuations a fillip. In conclusion, another phase of loose monetary policy may look like the 2009-2017 period to start off with and indices may well carry on rising.  But we believe it will be just a little more friendly to the value end of the spectrum too.

Does Abenomics need a reboot?

My favourite commentator on Japan, Peter Tasker, has written a blog asking whether it’s all about to go wrong for Japan.  His evidence is an interview on Reuters by the guru of Koichi Hamada suggesting that ‘the public is better off having prices fall, not rise…’ and that now is time for the next consumption tax rate rise.  If you don’t follow Japan, all you need to know about that is that previous ones have proven highly contentious. Hamada may just be accepting reality.  Nominal GDP growth in Japan has been negative again over the past two quarters and the country is also flirting with deflation anew.  As the employment participation rate (16-64 year olds) stands at 77%, his comments are consistent with what’s happening – if you are in employment, deflation is beneficial. The bigger point Peter makes is that Abenomics needs a reboot.  After six years the effects are fading, along with QE round the world.  Peter’s recipe is to cancel the consumption tax rise, to target bond issuance rather than the yield curve, and to wait patiently for tight employment to have its effect on inflation.  I’d add to that the boost that the Rugby 2019 World Cup and 2020 Olympics will give Japan.  And the stockmarket?  I’ve been lukewarm for the past 12 months and remain that way.  There’s scope for upside if some of Peter’s suggestions are followed.  And in the long-term there’s still plenty of good news on corporate governance, despite the Nissan/Ghosn furore.  However, I suspect some patience is required.  At home, corporations are still saving rather than spending, and abroad economies are slowing and the yen looks like strengthening.  Plus, of course, if the Bank of Japan were to target bond issuance, it might sell some of the equities it has purchased over the past nearly five years. ​

Too early to put the pedal to the metal in Japan?

We’ve had our feet off the pedal on Japan for much of 2018, as regular readers will know.  It’s not that things were going wrong with the economy, more that stockmarket investors - or was it really buying by the authorities for political rather than investment reasons – had gotten ahead of themselves. We pointed out in 2018 that there was a structural change for the better in profit margins and that the very low level of leverage meant that could be boosted significantly by borrowing.  We also pointed out that Japanese valuation disparity was relatively greater than other major markets, indicating an inefficient market.  Add in Prime Minister Abe’s seemingly secure tenure and relatively looser monetary policy in both Japan and China, and the combination should have made a profitable hunting-ground for active investors. It didn’t turn out that way and we now have the added weight of the Nissan saga - casting doubts on corporate governance improvements in Japan - as well as a sharp increase in the yen.  We are not surprised that on Christmas Eve the Nikkei index fell to a bear market territory reading of more than 20% below its 2018 high. We are still refraining from treading hard on the metal but our reasons are more macro than micro.  Our biggest concern is that investors will use the yen as a safe haven if global markets take another leg down.  Currency volatility has been suppressed over the past few years and investors are probably underestimating the risks. The positive story on Japanese earnings is still very much in place, notwithstanding the gloss may have come off governance.  Active investors will probably enjoy good profits from Japan over the next couple of years but our hunch is that there will be a better entry point coming up quite soon. To find out more about our specialism in Japan please click here.​

China smelling of roses?

One of our themes over the past few years has been to pay more attention to China when trying to predict the future market environment and less to the USA.  That’s not just because the Chinese economy is now 70% the size of the US (compared to just 11% in 1997) and its central bank’s balance sheet is 1/3 bigger than the Federal Reserve.  China has also been extending its hegemony across the world in many ways, from its Belt and Road infrastructure vision across western Asia to its policy of encouraging use of the yuan rather than the US$ for global trade contracts. The contrast between the monetary policies of the two countries is particularly stark right now.  The Federal Reserve, followed by most ‘western’ nations, is running very tight policy, whereas the People’s Bank of China and most Emerging Markets (EM) are relatively loose.  In data terms, provided by our friends at CrossBorder Capital Limited as at 30th September, the DM index is at 6.5 (range 0-100) whereas the EM is at 54.7. For markets this has a strong implication that the US$ is likely to strengthen against the Chinese yuan, because other things being equal central bank easing equates to more supply.  We’d expect the Japanese yen to move somewhere in between the two, as another long-held thesis of ours is that Japan’s orbit is now at least as much influenced by China as America. It is also a much more positive background for EM.  Many commentators assume that the strong US$ will continue to be a negative for them, but we’d comment that yuan weakness will be a just as large, if not larger, positive for them (and incidentally Japan).  We also note that crossborder flows into EM have rebounded sharply since the low point in June 2018, suggesting greater confidence than newspapers would lead readers to believe. Given the dire liquidity background just now, we continue to expect a more substantial correction in markets than we saw last week.  If China continues its current loose monetary policy, those countries connected to it economically may just come out smelling of roses, at least in market performance terms. To learn more about CrossBorder’s research on liquidity please click here.​

Value investing in Japan will have its day in the sun again

A Nomura report claimed a couple of years ago that ‘Japanese value investors are extinct.’  That is not quite true but, since the Global Financial Crisis, only the most determined investors have kept going.  Relative returns from value stocks actually bottomed out in 2016 but there is little sign of any escape from the value trap which scornful commentators like to refer to.   The cause is not hard to seek: Japan has endured ultra-low interest rates for nearly 30 years and negative nominal economic growth for the first 20 of them.  Investors have responded by putting a huge premium on those stocks who have been able to demonstrate growth and/or a sustainable yield.  The dispersion between growth and value has therefore risen to extreme levels. And yet, and yet… since 2001 Japan Inc. in aggregate has consistently generated positive free cash flow, the economy has generated positive real growth over the past three years and where else in the world can you find thousands of companies on a Price to Book of less than 1.0? One clear message from history is that when relative valuation measures become stretched (for example 2001 and 2008) there are excellent returns for value investors who are prepared to stick to their last.  We believe that will happen again but, as ever, patience will be required to benefit. Our friends at Arcus Invest, one of the Japanese value survivors, have written a further instalment of their regular white papers - Fortune Rota Volvitur (loosely translated as ‘value investing will have its day in the sun again’) - on this subject with much more detail.  Please let us know if you would like to see a copy.​

...
...