GMO’s Edward Chancellor penned an insightful column in the FT last week titled, Japan Begins to Look Pretty Cheap. We often find ourselves sitting on the same side of the “investment table” as Ed (we’ve had numerous conversations about the frothy property market Down Under) and this time is no different. But before we go on and on about the merits of an investment in Japanese equities, we’d like to remind our readers that you can here Ed’s thesis first hand at CFA North Carolina’s Annual Forecast Dinner held in Charlotte on January 11th. And now, back to our regularly scheduled Japanese Program.
The Spectacular Japanese Secular Bear Market kicked off in 1989 with the bursting of economic history’s largest real estate bubble. More than two decades later, the Japan Bear has lasted twice as long as any other secular bear market on record. A 20 year economic landscape branded by zombie banks, frightened management, bridges to nowhere, repeated bouts of deflation and broad-based despair has wreaked havoc on investor confidence. It’s hard to blame them as the country has been trapped in recession for 102 of the 239 months through yearend 2009. That’s a solid 10 points better than Ted William’s .344 career batting average!
The predictable result is that Japanese Households despise equities, preferring the “safety” of domestic government bonds. As illustrated above, only 4% of Japanese household assets are invested in equities today. In other words, there is plenty of room for upside, even before we consider the fact that Japanese assets are extremely underrepresented across global institutional portfolios as well.
Confidence levels clearly make the case that the Japan Bear is approaching a secular low and may have started a bottoming process. The Nikkei’s first decade of underperformance has been followed by a decade-long basing pattern. Technicians would point to any upside breakout from such an extended base as an indication of much higher prices to come.
Experience has taught us that calling major secular turning points in any market is difficult at best, so we prefer to leg into investments over time as long as we have an appropriate margin of safety. With many Japanese securities trading below book value, and even below cash value, we believe the risk-reward in buying Japan today appears very attractive. The trade would feel even more attractive with the identification of potential catalysts.
Increasing government instability has been a hallmark of the Japanese economy throughout the secular bear market. At the same time, a strong Yen has put downward pressure on economic growth and corporate earnings in recent years as many manufactured goods have become unprofitable for export. But Japanese policy makers appear to be running out of time and there are growing hints of an impending inflection point.
Recent elections have shown that the Japanese wish to break with the past, at the same time that the BOJ has begun to intervene in the currency markets for the first time since 2004. If successful in creating a new credit cycle to reflate the economy, stocks should perform exceptionally well as they have during previous spurts of reflation. Given the depressed levels of trend growth for the economy, current profit margins should spike higher with the slightest acceleration in real growth as excess capacity is soaked up. And as interest rates begin their ascent, there is plenty of room for household asset allocations to shift out of bonds and into stocks.
Most portfolio managers in the business today have learned to avoid Japan. It is difficult to have any other view after losing money consistently during a 20 year bear market. But just as secular bears begin their journey from an environment of irrational exuberance and excessive speculation, they always end in excessive risk aversion and a complete and utter void of confidence, much like we see in Japan today.
A weakened Yen and a bond bear market would provide the spark that Japanese stocks so desperately need. And with households already finished adding to their mountains of zero-yielding JGBs as the elderly begin to spend down assets in retirement, a declining savings rate should ultimately result in a growing pool of bond sellers. While “the smart money” bets on the collapse of the Japanese bond market, it would appear that the Japanese equity market provides a much cheaper form of insurance as a massive reallocation towards equities takes place.
Soc Gen’s Dylan Grice recently suggested that where there is a credible risk and insurance is cheap, investors should buy insurance. If nothing else, this should have been the greatest lesson over the past several years. He recently speculated that the high risk of runaway inflation in Japan could send the Nikkei to 63,000,000 in 15 years!! Grice argues that Japan exhibits similar characteristics as Israel during its massive inflationary period (1972-1987). During that period, Israeli spending was too high and the government chose to print their way out of the problem. Sound familiar? We know, we know, The Ben-Bernank is not printing money. But just for the record, inflation averaged approximately 84% during this period in Isreal and drove the following move in stocks, which surged by a factor of 6500!!
We’re pretty sure Ed’s tempered enthusiasm for Japanese equities is not based on the potential for a move to Nikkei 63 Million. More likely, he simply sees value in the shares of Japanese companies, which should also provide a cheap hedge against the ultimate “exit strategy” for the BOJ – hyperinflation.
Today, shares of Nintendo represent one of our largest investments as expectations are as low for the company’s products as they are for a Japanese recovery. Roughly a third of the company’s market value is comprised of cash on the books, and management has consistently delivered innovative new consumer technologies decade after decade.
We wouldn’t count them out this time and believe Japanese exporters should do particularly well in a weakening Yen environment. Nintendo’s brand strength, consistent profitability and fortress like balance sheet are also consistent with GMO’s passion for “high quality” stocks. We’ve owned Japanese ETFs in the past and are looking to initiate many of these positions again. In full disclosure, we’ve flirted with Japan on and off for the past several years, so this is not the first time the market has tickled our contrarian whiskers. Wisdom Tree’s Japan Small Cap Dividend Fund (DFJ) yields nearly 3% and trades at roughly 80% of book value. In addition to exporters, we think the higher beta of small cap Japanese stocks should provide more bang for the buck in any rally in the region. Similarly, their Japan Hedged Equity Fund (DXJ) trades at 6.5x cashflow today, while providing investors with an embedded currency hedge. This is an important point as a falling Yen would be one of the catalysts to drive stocks higher.
Investors looking for something a bit sexier than ETFs might consider Dividend Swaps on the Nikkei. One of Ed’s newer colleagues, James Montier, produced an excellent white paper on the inherent value in these vehicles today. In short, the asset class is already priced for a depression and is more highly correlated with inflation than almost any other asset class as dividends are paid in nominal dollars (or Yen for that matter). While the focus of James’ article was on the European market, it would seem that long dated Nikkei dividend swaps are even more inverted than the EuroStoxx while also providing the cheap insurance against Grice’s move toward Nikkei Quadrillion. While shorter term dividend swaps provide investors with a cozy “pull to realised” effect, we think the greatest upside potential (and most effective long term hedge) comes from the long end of the curve due to the sharp downward slope of the term structure.
Once again, if you’d like to join us for dinner in January, and listen to more of Ed’s thoughts on the world, please feel free to reach out to Sheri Gillette, or myself. Ed will be speaking about the Identification of Bubbles over dinner. As a primer, we’d suggest listening to CNBC’s recent interview with Jeremy Grantham. I’m sure we’ll also touch on GMO’s Asset Class Forecasts, China, Sovereign Debt, and any number of interesting topics. We’ll have plenty of time for Q&A as well. Details are below. We hope to see you there!
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