James Sullivan imageThe last few weeks have led to a fair bit of contemplation and consideration of markets, and the themes within our portfolios. One area which has taken up much of our thinking is that of Japan, an area to which we have a grown up weighting (up to 14%).

In some ways, we are part of the problem, and that is what is causing self-reflection and in part, regret.

The story of Japan is well told; cash on balance sheets weighing on shareholder returns, and pay-out ratios miserly or tentative at best. It is not my intention in this note to get bogged down in the details of what has gone on in corporate Japan since their financial crisis, it would be raking over old coals.

Rather I want to focus on the attitude foreign investors have towards this dynamic.

We have invested, in recent times, in two investment vehicles that set out with the objective to agitate for change; petition company Boards to release the cash hoards and increase pay-out ratios through buybacks or dividends amongst other initiatives including but not limited to better governance and alignment of interests, so it is right to acknowledge it’s not all ‘smash and grab’ tactics.

Of the two investments we made, we sold one at a profit, and retained one which currently trades around its IPO price of 100p. The ideology is aggressive and exciting and we saw it as a way of injecting some adrenaline into our Japanese theme.

However, given the past few weeks, we have to question if it is right that we collectively strive to turn Japanese risk aversion into something more akin to the leveraged markets we have become more familiar with in the West, and notably, to the extreme, that of the US?

We have become sanitised by companies dependent on leverage, tossing out dividends with little or no cover and buybacks fuelled by cheap debt. Why wouldn’t we embrace that, as on the surface, it appears to have worked just fine for the past 10 years. To the turn of the year, the S&P 500 was up 256% in 10 years, with the Topix up 135% over the same.

However, a market rally underpinned by debt and an expansion of multiple is nothing but a honey trap. Over that same period, the rating on the US market expanded from 2.1x P/B to 3.6x whilst the same multiple on the Topix largely trended sideways.

It does not sit comfortably right now to know we, in part, supported investments that try to impose upon Japanese companies a business model that is less conservative than they are comfortable with because of western investors’ misgivings about cash. Let’s not forget cash has not been king for a long time, and therefore the virtues of cash either in a portfolio or on a balance sheet have been easily dismissed as opportunity cost by most investors.

However, right now, the optionality of cash is king. It’s not often one can say that with conviction.

There is little more powerful than deploying cash into a market that is trading at or below intrinsic value. The Topix trades at 0.9x p/b, and companies in Japan have the resources to buy back their own stock at this level, making absolute sense. Additionally, the current market volatility will throw up M&A opportunities like we’ve not seen for a generation; the Japanese should they desire, are well placed to take advantage of those in distress.

There is a lot to improve across the Japanese corporate spectrum; cross shareholdings, lack of independent directors, poor alignment of interests etc. but perhaps it is time to loosen the chokehold and permit them a more conservative approach to balance sheet management.

We should embrace the fact they offer us something different. Besides, it would be boring if all markets were the same.



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