Many investors I admire are starting to focus all their energies on Japan, and for good reason. Never before have I encountered such bizarre circumstances regarding the economics of an entire country worth of businesses. It seems the profit motive in Japan is almost non-existent… I’ll come to that later. One blog I follow closely has written at length about Japan’s many great value investments (see here and here and here). I suspect Geoff is looking mostly into net nets that have historical profitability & I believe I’ve found many of these net nets he’s considering.
However, I won’t consider investing in most of them, as exciting as it would be to own some of the famous “Graham net nets”. The problem is that Japan isn’t the United States, at least in terms of returns on capital. Japan has probably the worst returns on capital I’ve ever seen. Virtually every business is shrinking & pre-tax returns on assets seem to be stuck around 3%. That is a horrible way of doing business (it has to do with their culture, as well as their economic & deflationary environment). For a funny little side note, take a look at this diagram of Japan’s corporate governance from Sharp. Unbelievable how bureaucratic it looks, and from what others are writing, it seems this is common practice for corporate governance for Japan. No wonder they aren’t earning any money.
So unlike the U.S. where businesses suffering hardship can come out of a slump and stock prices jump accordingly, Japanese net nets are almost all suffering businesses that can’t grow their businesses out of it. The returns on capital are simply too low. Now, it would be a different story entirely if I had the money to buy out some of these net nets & extract the “last cigar puff” for myself, but at my current size, it makes more sense to me to try & find those businesses with good returns on capital & trading at extremely low prices. Luckily, I’ve found three so far, the average price to “owner’s earnings” is at about 3, and all are sufficiently capitalized (one has western brand names, much like a Coca-Cola bottler operating in another country, only it’s a different company). Although, as I’ve been told but haven’t had the fortune of watching personally, net nets are “supposed to shoot up” much more in a bull market when compared to the more stable companies, I’d say why not buy a security that is near-guaranteed to return to me many cash flows over the next 5 years so as to give me above 20-25% annualized? It requires more scrutiny to find companies like that, but the rewards are worth the extra work. Japan appears cheap at first glance if you look only at balance sheets, but long-term returns to be expected of companies like that are suspect. My argument against most Japanese investment ideas is those returns on capital; if Japanese equities don’t rise as a whole market in the next few years, the economy continues shrinking along with the value of their currency, and the company shrinks alongside its stock price, you may be holding a company worth considerably less in a few years when (and if) Japan’s economy fixes itself. The counter-argument would be that maybe those assets will be liquidated & paid out to shareholders, but it’s not what I want to be betting on.
A similar proponent of what I’m thinking is in this article here. Also, if you start the Buffett video at 10:15, you can see what his thoughts regarding Japan are. Over a longer time horizon, those marginally profitable net nets won’t do much for an investor, even if purchased at 50% of net working capital or lower.
Unfortunately, I’m not going to have full disclosure on what I’m looking through right now (as it takes a lot of work), but I will share once my positions are established. I will also share a list of profitable net nets for those of you who don’t buy my return on capital argument. Who knows, maybe I’ll be wrong on this one… I’m just looking to learn from the experience & fine tune my investment ideas. It is quite interesting & I’ll be in touch. My new account is being set up currently for international markets, so by next week I’ll be fully invested & have a post or two for you about Japan.
So if you do consider Japan, please be careful of this return on capital problem.