It’s Time to Buy Japan

population's peak. If we put immigration potential to one side, the Japan, Italy, Germany, Spain, etcter. As far as we can see, all of those populations of peak and fertility rates in Africa that is supposed to be the big driver of global population are falling much faster than people expected as well. So if ten years ago the main worry was population explosion, today we're actually thinking more empty planet.

deflationary environment. And there's an ongoing conversation about whether aging populations and falling populations are inflationary or deflationary, and I think you and I both veered towards thinking that it's one of the drivers behind the inflation rey environment because you have a well off, older population demanding all sorts of things and a much more limited supply.

People have been carping about how there's too many people, and lots of people still believe that Malthusian crap put forward by Airlick in the population bomb that I guess I don't see the point of investors worrying their heads about it simply because it's it's such a it's way out in the future, and there are so many more things that affect affect individual investments before that. I just don't think, and I certainly don't see it as a theme.

It's like I don't think. I mean, yes, okay, you can invest in agent populations in that they'll need more medical care, but in and of itself, that's not a recently by a specific farmer company. You should other things.

at every individual's every individual person's purchasing pair. And I've just been looking up on the World Bank website to see what's happening to Japanese GDP per head in terms of purchasing power, and it's been incredibly.

you wonderful. Why is that specifically? But there's a lot of other interesting.

over again. So let's talk first about why it is that John and I have been in this is unusual, by the way, completely wrong for so long.

And I think we have to kind of go back to where Japan was in you know, the end of the bubble, which was basic Christmas Day in nineteen eighty nine when they raised interest rates over the previous nearly forty years after Second World War, Japan had gone through this of huge economic boom and it was obviously reindustrialized.

You had amazing companies like Sony, You've had, you know, the rise of video recorders, of consumer electronics, and you're also at the same time saw this massive domestic property bubble where you know, the end of that bubble in Japan, the price of kind of a meter of land in you know, or apartment in Tokyo was three hundred and fifty times higher than it was in Manhattan. I mean,

this is absolutely bonkers level of bubble. And so but obviously, if you're sitting in an apartment, you know, worth fifty million dollars in nineteen eighty nine, that's a lot of money today. In nineteen nine, that was huge, and you know, so the spending was out of control, The amount of leverage people took was out of control, and a bit like America before the GFC, the belief was almost that

the real estate prices could only go up. And for fifty years they had so the belief that, you know, you could lever up, and you know, from the bank's point of view, you know, well if they couldn't pay you for some reason, well the land price would have gone up so much that you could always just sell the asset and you'll be fine. And so you ended up with these sort of interlayered companies who had basically borrowed money against their collateral weather as stocks or land.

They then invested in not only other companies, but also in projects that maybe not caught their business because of everything you did seem to work during the bubble. And it was only once the capital starts stopped flowing when the bubble burst and people suddenly realized that the land prices were extraordinarily high, their stock prices were extraordinarily high, and as everything went into reverse, you had to repay this debt. But suddenly the assets weren't there, the cash

flowers weren't there. And Japan, unlike most countries, chose to save its way out of a bubble, which is, I guess is the opposite of what we've seen in the West, you know, after GFC. But it's really, I think probably the only country in history that I can think of that has actively chosen to save its way out of a bubble.

through a debt deflation. And those sort of business executives who are the most aggressive at the end of the bubble are likely not to be here anymore because their companies went bust, and so there's been an enormous survivorship bias amongst those executives who are still here, companies who are still here, and you can see that and perhaps

in some of the banks. You know, the biggest bank in Japan is Mitsubishi UFJ, but that's a combination of Mitsubishi, Cocasai UFJ and you know, and so many other banks. And the same thing is true for you know, SMBC. The same thing is true for Misoho, which is you know,

at least made of three very large banks. They used to be many, many different companies have been forced to merge and consolidate and rationalize, and in the process, obviously that's created a lot of managers, the aggressive ones have lost their jobs. And that's I think something that people, perhaps I don't understand is that there's been this very strong survivorship buyas. So for a long time, Japanese companies were really just focused on surviving, being very very risk

averse and not taking any risks. And to some extent, it meant that wasn't maybe the best and the most aggressive managers who have thrived like they might maybe in the US, but the dullest and the safest. And I think what perhaps we're finally begin you see is that that's changing, and that there are new companies coming through, whether it's an internet or services in retail. You know that you are seeing a newer generation of managers who are coming through, who are perhaps a bit more attuned

to what's happened in the rest of the world. But it means that a lot of Japanese companies have used those that last of thirty years as an opportunity basically to just hoard assets and hoard cash.

that you've seen in Japan. So companies weren't able to rely upon the banks to finance them, and to some extent they've had to build up, you know, or either generate their own cash flow to pay for things, or they've had to sort of save up effectively build their own cash pile. And then you then go out and you know, run their businesses they wanted to. But it does mean that this incredible conservatism, as perhaps we move engineer where inflation is let's say more than zero, is

something that begins to weigh on them. And the second point about it is it's not just the cash the return on the cash is, you know, positive or negative.

Is that if you start think about the cost of capital, which is something that Tokyo Stock Exchange is beginning to ask companies to do, suddenly realize that actually, for your cost of capital or equity in Japan is say ten percent roughly, then actually your cash is not returning you zero, it's actually earning you minus ten once you're adjust for

the carrying cost. So if you think about companies with twenty five thirty forty percent of their equity is basically net cash, then actually it means you know that they're overall the return you have to generate from your core business to get a good roe is actually incredibly high.

And that's one of the things that you know, the say Tokyo Socket Change right now is the new president is particularly focused on and he's saying, we don't think Japanese companies understand what their cost of capital is properly, and we would like them really to look at this and to understand more about what the cost of holding the assets they use to run and operate their businesses. Are and maybe some companies have actually got far too

many assets. And I think that this is really part of this big change in kind of corporate governance that has been going on since the days of you know, O shinzo Abe, which you know was perhaps kicked off kicked it all off with the shareholder governance and corporate governance codes. And we think that you know, the this is just taking time to gather and gather momentum and

to bear fruit. But we're now moving into a phase where this is actually becoming much more real and the conversations you have with companies are becoming much more meaningful.

that you can see out there. But you also have a number of perhaps some of the very large cap global companies have been perhaps operating a more global fashion have been more competitive, So you know, I think the real opportunities more in the medium and smaller sized companies, and perhaps more in the domestic companies than is in

some of the global companies. There there are some very big names like Panasonic or Kaserah, for example, where focus on shareholders has certainly not been a priority, and where companies have not been very disciplined, and where there's a lot of potential for change.

There's been some talk about him seeing Japan as a beacon of stability in a geopolitically difficult world.

for much bigger groups called Kretzu. So we'd say Mittspishy, I've got Mitspishi Trading, but you also have mits Spishi Bank, it's Specih Chemical and Mitspecie Electric, Mitspishly Heavy Industries, mits Spishi Motors as used to be. So there are many many companies within that broader group that.

and companies wasn't to their shareholders. It was to the group as a whole, because that's where their customers were, that's where their you know, let's say directors were from, that's where the personal relationships were, that's where the bank who provided their money came from. And perhaps it's if you think about Japan as a culture, it's a group culture, so the group is very important. I mean foreigners in Japan called gekokagin, which you know, kind of translated means

outside people. So you're outside and if you're outside, you're nothing. So if I were to meet someone, you know, I am you know, David, but I'm really Zenyl non Mitchenson. I'm the Mitchison from Zenyl, and I derive some status from being part of ZENYL. If I was a member of a big Japanese group, I could drive a lot of social status from being part of that group. And people within the group are much closer to me than

people outside the group. And it's those different degrees of relationship that have really driven a lot of those those issues and changes in Japan. That the alignment within the group is very, very strong, and I guess all of the reforms around shareholders and corporate governance have been around trying to increase the alignment between shareholders, and one of the other sides would be is they break down That those groups have kind of broken down a little bit.

So yes, say Honda effectively dissolve this relationship with the number or reduced its relationship with an i'm ris key suppliers because they weren't able to compete because they couldn't get the right components and the right products and technology. So they actually exited a number of positions they've reduced

their alliance on. That's on those group companies, and it's a bit the same as some of the German companies went through some of the nineteen nineties of this unwind of what boutschland are gay and those group relationships and structural relationships broke down are slightly straight away from the trading companies slightly, but.

safe project management skills. But also they formed partly like a role a little bit like private equity in Japan as well supporting new ideas and new ventures in Japan. So they're very very connected in Japan, and they were trading very cheaply. But what Warren Buffett has been doing is he's actually been borrowing money in yen and then

buying some of these companies. And partly what he's noticed is that the I guess, the spread between what these companies are yielding in dividends and buybacks versus the funding cost in yen has been massive. He's really saying equities in Japan compared to the price of Japanese financing are ridiculously cheap. That you know, you can borrow for one percent and you can get a five, five, six seven

percent dividend yield, which for him was really attractive. He's also, as a kind of indust operator able to go into those companies who have these incredible connections throughout Japan and say, are there any other areas where we can do business together? So he's also got like as well as that purely financial play, he's also got this operating play where he may be able to find assets that other people want to sell or where he can be introduced and they

can do other forms of business. But he's clearly you know, his starting point is, you know, these are really cheaply priced assets. The cash flows are really good, the balance sheets are strong enough, and you know that their priced far below the intrinsic value that they offer.

other areas. So these trading companies are kind of middle men in the Japanese market, basically easing the transactions between large groups and say smaller either industrial companies or pharmacists and people like that. So there's a lot of opportunity for these companies within an economy as big as Japan

to kind of create quite a lot of value. And what we're seeing is a lot of these companies historically have been quite inefficiently run, and they're now beginning to consolidate, and in the process, they're also realizing they've basically been using far too much of their balance sheets, so very very inefficient working capital management, or companies holding enormous cross shareholdings amongst their business partners, and they're realizing that actually

this isn't necessary to run their business. And so some of these companies might be trading for let's say, the value of their equity portfolio, which we think is probably too cheap.

But as a result, they've historically held a large number of shares in drug companies, in medical equipment companies, in pharmacy companies, so basically so they've deployed their capital in

trying to build these relationships. And as that kind of emphasis on capital relationships is becoming weaker and pressure from shareholders becoming stronger, they're recognizing that actually the cost of holding this capital and these relationships is very, very high, and they say it's a process where these companies will gradually sell down their shareholdings. But they're also finally accepting that the amount of assets they have is too big

for their business size. And so the question we're having really today is you know, this is your asset base, what is necessary for your business? And then what is the best way to deploy that extra capital? So is it maybe to do M and A, is it to grow your business organically? Is it maybe to do a big dividend, or to buy back shares if the sh are very very cheap. But the conversation, which has kind of been catalyzed by the TESE is really what is the appropriate size of your balance sheet?

But actually at the same time, Japanese profitability has grown a lot, so actually companies now have even kind of more cash than they had at the beginning, so they haven't been distributing all of their cash, and the balance

sheets have kept on growing. We still find that companies often don't really understand why they're doing a buy back, but they do know that they should be doing a buy back, and what was say, what we've begun to see is companies say, Okay, we accept we've got too much money basically, and we are going to pay out one hundred and twenty percent of our profits over the next few years, or we're going to target more than ten percent ROE. And with the reason our ROE is

low today is because we've got too many assets. So some companies are beginning to understand that this kind of excess non operating assets are actually hindering their returns because the shareholder base has broken up a bit and you have more active investors pushing companies incredibly hard on their balance sheets and on their capital, and that's pressure is beginning to make it self felt, not just in those companies who under direct pressure, but under companies who fear

they may come under pressure. And I think that that's causing them, along with strong encouragement from the Tokyo Stock Exchange itself, for them to really look again at their capital policy. And that's one reason this year we've seen so many companies hike their dividends, do buybacks, and kind of commit to higher levels of return going forward.

in line with earnings, but faster than that. And there's clearly quite a few companies that we own where there will probably be let's say, extraordinary returns of capital as they downsize their balance sheet and bring them in line with with where the operation entity is. And there's definitely quite a few companies where you know, you talk to them and they have you know, ROIC targets, which obviously

is a Japanese companies. ROIC is not a new concept, but something that most companies in Japan are not really familiar with.

business to exceed the cost of our capital. And when use of run the numbers, either their profits have to grow extraordinarily, which we would be quite happy about, or they need to shrink their assets, and that would probably mean in many cases big dividends. And so company I think of at the moanent is actually committed to return one hundred percent of its profits over the next three

years in dividends. But also it would probably mean that they have to sell and shrink, you know, non core assets, and that's something that you know, in Japan hasn't ever

happened before. So companies in Japan have mostly grown their assets and have sort of often struggled to get out of businesses that weren't doing very well, so I think probably at the moment the focuses is on the balance sheet, so bringing the balance sheet to the right size for the operating company, and you can see that for example, Sony has announced that it's going to spin out its financial service business, and this is probably the first really big example of a this kind of tax free spin

The government has been propos has talked about, but they've kind of accepted it it. You know, the market of discussion is that possibly Panasonic will do the same thing with their battery business, which is one of the main supplies for Tesla. But obviously that battery business is quite different from a lot of their other businesses and actually know to fund its growth because of the big growth in evs over the next couple of years, it needs

to be spending a lot of money. But a lot of the other bits of Panasonic probably you know, a very very different and so if you were to look at to say, a careering company that did something very similar, their battery business trades a completely different way than the

rest of their business did historically. And I think this is one of the issues Japanese firms have had, is that you know, the internal needs of these different companies have been very very different, and the managers have struggled to combine, say, managing some business that are in decline, some that are very very successful, and some that need

perhaps lots and lots of growth capex. But they've sort of struggled to decide how to allocate resources internally, and they haven't been able to be very dynamic in terms of how they approach things because you've had to form this consensus. And so creating more focused or agile companies should improve the decision making and it should allow I guess investors to say, we really like this high growth business,

will pay a high price for that. We not that you know, we don't really like this other business, but it's very stable and the dividends are great. And there could be some businesses that maybe should be owned, say by private equity, or should merge and consolidate with other companies, and perhaps they're in sort of a managed decline where you focus on generating cash flow and you focus on generating efficiency rather than trying to grow the business any longer.

So these trying to do all of those things inside one group is very very hard. And if we were to look at Japanese firms. There's definitely a clear kind of empirical evidence that more focused companies have better returns.

passive management. So so you know, whether it's an ETF for something, an active fund that's basically passive, so there's no view and obviously with costs, that means you're probably underperform, or you've had people had quite strong style biases who you've gone for growth managers who invest in the new, dynamic changing companies in Japan, which there are quite a lot, but obviously.

had a pretty horrible five years before then. So you know, so it's been a very tough market because you know, you've either had that sort of style that you're investing in your investors want you to buy or want to own, and so you've ended up with investors having a growth manager and a value manager, and they've both performed well when their style has been in favor, but when their file style is not in favor, they haven't. So by combining the two you have still ended up with an

average return. But it's very hard because you've got to pick you know, the market and the style at the same time to get it right. But I think the second factor as well is that the companies that benefit most from this pressure and the corporate governance reforms are almost the companies that you wouldn't have bought because the

management didn't care because returns were very, very low. So you you kind of almost have to find those companies who are wanting to change or willing to change and really chase those, you know, look at the try and find those companies and find the catalyst for what that change is going to be. Now, sometimes that's you meet the management team and they talk to you about what they would like to achieve. Sometimes you see there's a succession change between an old manager and a young manager

who's coming in with different perspective. But it's about those companies who are changing and improving much more than it is about some of those, you know, perhaps those legacy companies. So it's been I think very hard for managers to always to catch those unless they're explicitly focused on that, and very few managers have that kind of mandate.

the business. So even though it's quite a small business, they have you know, they just have nine different products. They've got still water, sparkling water, and tea in a small, medium, in large size, so for each production line they have

really really big scale. And they are now in the process of expanding their footprint, building more capacity, as they said, filling out so geographically to Japan, and they're also going to conduct we imagine some more m and A, and we actually introduced them to one company they ended up buying, or a subsidiary of another company they ended up buying.

And it's really a good case in point where they were able to go to an asset that this other firm was struggling to run and make it only marginally profitable. They were able to buy it for a far below replacement cost. They think they'll make a twenty percent return under their business model. So it's really a case of these assets moving from a sort of a week a week in so not the best owner, to a better

owner of those assets. And in the process both parties of one one company didn't know got cash, they didn't have to close down the facility, they didn't have to lay off the workers, and the other company was able to acquire this asset and run it in a much much better way, in a much better model, and make really really good returns on it. And we think that that kind of focusing in Japan is going to be

a really powerful force. It's not an ultra high growth company, but it's probably going to grow between ten to fifteen percent a year with very high profitability, and we think that ultimately this will be reflected in a much higher multiple for the company than it currently trades. That what is current multiple it is currently well, depending on it's

currently doing a big share share placement. We think we can get it down to a low double digit multiple and we think it will probably end ultimately trade between twenty to twenty five times, So we think it can double again.

drinks technology. That could be a big area which they could again roll into the existing customer base across the whole of their their footprint throughout Japan. And there's a lot of sort of small incremental things they can do to grow the profitability on it.

literally they've gone nowhere for thirty years. They want them to start going up, and so I guess there is a risk that, you know, if they're not achieving that, then they may look for some other measures and try to go back to a kind of more state directed,

bureaucratically driven mode of kind of command and control. And there's definitely no elements in the Japanese kind of corporate structure, whether it's the kind of Japanese version of the CBI, the caden Ran or you know, the Ministry of Trade in Industry or Ministry of Finance, who are very you could say conservative but almost reactionary, and that they want

to stay on top and to control everything. Actually, all of this change in dynamism is undermines their power to control things, and that means that you know, then don't have the same level of influencing control that they used to have. And I think you know that they like running the show, and I guess if there's a sense that it's really not working, that they will try to reassert themselves and some of the companies who are under pressure.

I mean, it's not nice if you're a CEO and a nasty activist fund appears at a five percent or big shareholder and your shareholder list and then starts asking you to run your business better, to hand over the cash. I mean, it's your cash, not the shareholders. And you know, the way of thinking for them is that you know, this is that the managers is the managers and company to some extent more than it is the shareholders, and that change of who owns those companies isn't yet fully embedded.

And there are some really bitter struggles at the moment over governance, and it's it's not entirely clear that you know you're always going to win, and there you know, there are some really really dirty fights going on around and other things.

of course to David Mitchinson and tie John Steppe. And finally, your weekly reminder, and it's an important reminder sign up to John's daily newsletter money distilled for the link is in this show notes