James Sullivan on an activist investment looking to unlock corporate Japan’s balance sheets.
It sounds wrong to say it, but we recently supported the launch of a new company, despite not harbouring absolute belief that it will fulfil its primary objective.
The company in question is AVI Japan Opportunity Trust which will invest in predominantly Japanese small companies, whilst engaging with companies to unlock the copious balance sheets, thus enhancing shareholder returns. Asset Value Investors – the investment manager – has a great deal of experience investing in Japan, which has long been a cornerstone theme within the British Empire Trust portfolio (another company managed by AVI).
Cash held on corporate balance sheets in Japan is well known tale, and one which has held back earnings per share and return on equity. It’s no different to a fund manager holding too much cash – the beta is likely to be significantly reduced and long term performance hindered.
Unlike many western companies whose executives are incentivised to see share prices climb, Japanese corporates are rarely so explicitly incentivised to increase shareholder returns. Post the Japanese financial crisis in the early 1990’s, risk aversion was the new normal. Companies hoarded cash and it subsequently became an issue for investors seeking greater earnings per share.
Over half of the companies listed in Japan are sitting on net cash balances, with around a third of the market holding more cash than their market capitalisation. When one considers the amount of corporate debt within the US market which is now extremely susceptible to interest rate movements, too much cash is a nice problem to have. High cash balances can reflect badly on price earnings multiples, but the price to book multiple tells a different story. The broad Japanese market trades close to book value (albeit off its lows) whilst the US trades closer to 4x book. The contrast in value is significant, with the net cash versus net debt factor being a big driver of that value.
Utilisation of balance sheet cash is seen as inflationary; it’s a liquidity event. The government and the central bank have long desired the economy to return to modest inflation, and the introduction of the Corporate Governance Code and the Stewardship Code have furthered the conversation regarding better transparency and shareholder engagement.
With Abenomics in full swing, and the debasement of the Japanese Yen, corporate earnings have been coming through at quite a clip, helping lift pay-out ratios towards western levels of acceptance (circa 40% inclusive of buybacks). That however is a symptom of current earnings being distributed, rather than the existing balance sheet being mobilised. Japanese companies quite literally have more money than they know what to do with.
AVI have been engaging with Tokyo Broadcasting Systems (an existing holding of theirs) in order to expedite the distribution of their cash reserves, and it has garnered a lot of attention in Japan. That attention however, has not tipped over into any meaningful corporate activity. Companies are willing to fend off such engagement in an almost dismissive fashion.
Our somewhat cautious expectation is that AVI will do a lot of letter writing in the years ahead, with limited results. However, Japan is a theme in which we believe in, and we have an allocation close to 10% within our multi-asset funds. The corporate engagement, or activist, element to the AVI Japan proposition is a ‘free option’ for us. If it leads to enhanced returns, then we expect our return on this investment to be very meaningful, if it doesn’t, then we are still exposing our funds to an area of the market we believe to offer tremendous value in its own right.
We like the AVI Japan Opportunity Trust, and if the management prove us wrong, then we’ll like it even more.