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Was emailed this by the manager of Denali, Kevin Byun. Curious what others think of his reasoning:



Japan is Unlocking the Greatest Opportunities in the World

by H. Kevin Byun


Japan has quietly unlocked the greatest opportunities in the world for value investors.


As a value and special situations investor, the April 1, 2017 tax reforms in Japan hit me like a lightning bolt. Yet there was, and still has been, no market appreciation to this seismic change. This tax reform, for the first time ever, allows Japanese companies to effectuate spinoffs in a tax-free manner. Until then, Japan was the only major market in the world in which tax-free spinoffs were not allowed. Japan boasts the largest field of the most deeply undervalued conglomerates in the world. More broadly, half of Japanese companies trade below book value. As of April 1 of this year, the stage is set for decades of value creation much like the US in the 1980s and 1990s.


Tax reform is part of the Three Arrows policy under the Abe Administration. The three arrows are monetary easing, fiscal stimulus, and structural reforms. Similarly, there are three reasons why Japanese equities are on the cusp of favorable performance. First, shareholder engagement and shareholder rights are increasingly influential. Importantly, the influence of the Bank of Japan, a substantial holder of Japanese equities, is already being felt. The BOJ is mandating the prioritization of shareholder interests and value creation for shareholders. Second, management and board engagement and incentives are modernizing and aligning with shareholders. The Tokyo Stock Exchange has mandated that boards must have two independent directors. Tax reform last year created tax advantaged issuance of restricted stock compensation and we can see an increase in insider ownership already taking place. Third, activism has gained acceptance and is increasingly effective in creating value for shareholders. Investors such as Third Point’s Dan Loeb (Sony, Seven & i, Fanuc, IHI, Suzuki) and Oasis Capital’s Seth Fischer (Nintendo, PanaHome, Toshiba Plant, Kyocera) have had a string of successes in Japan while effectively engaging with management.


Importantly, companies are focused on three key areas to increase shareholder value. First, an increased focus on return on equity. Japan has the world lowest ROE and a higher ROE would result in higher valuations. Second, the sale of non-core assets and businesses. Japanese companies are increasingly selling non-core assets such as cross-shareholdings and land to unlock value. Third, balance sheet optimization. Many Japanese companies have inefficient balance sheets with low returns and will benefit by returning excess capital to shareholders, further increasing returns.


For students of financial market history, one does not need to look far back in time to find precedents close to home. US conglomerates have created substantial value through spinoffs. The iconic conglomerate ITT completed a three part spinoff into New ITT Corp, ITT Hartford, and ITT Industries in 1995 as well as a three-part spinoff into New ITT Corp, Xylem, and Exelis in 2011. Another iconic conglomerate Tyco completed a three part spinoff into New Tyco, Covidien, and Tyco Electronics in 2007 as well as a three part spinoff into New Tyco, ADT, and Flow Control (via a Reverse Morris Trust with Pentair) in 2012. Also, one of the more well known examples is the 1988 LBO of RJR Nabisco, the food and tobacco conglomerate. RJR Nabisco was trading in the low $40s per share before the initial $75 offer from CEO Ross Johnson to the eventual $109 buyout by KKR. There are many ITT, Tyco, and RJR Nabisco equivalents of undervalued conglomerates in Japan.


As a value and special situations investor, I believe we are on the cusp of one of the greatest eras in the Japanese markets and look forward to capitalizing on the opportunities that will create value for all stakeholders.

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This line of reasoning may be correct...the one big problem I see is that is great to have the rule in place, but will Japanese managers act on it?


They are NOTORIOUS for being conservative and hidebound.


Will management want to break up the conglomerates?  I don't know...

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  • 1 month later...

I do not know if there is a correlation there, but we can observe that since 2015, a significant number of companies trading below net cash started to buy-back shares. And when it is significant, it smells quite good, regardless of any laws.


It indeed feels like there are much less reasons today why such companies should trade well below their tangible and liquid assets. And indeed, the gaps have begun to close, or at least be reduced.


Nevertheless, I think that Japan remains one of the best markets (if not the very best) for Graham & Dood minded investors looking for cash generative businesses with rock solid balance sheets at great prices. Sometimes, you can even have businesses with 25-30 % return on unlevered assets trading below net cash and buying back shares in this country! This is unique in today's world in my opinion.

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To be honest, I don't know for sure.


The few japanese people I talked to believe that investing in stocks is dangerous, based on the past losses they experienced.


I also read and heard that investors in Japan focus only on EPS and don't care a lot about net asset values. However, we probably all know that assets, when productive enough, are the generators of the companies' earning power.


That's why I don't really worry about the focus on earnings. We just have to pick the companies we like. At least, the well capitalized balance sheets give the managements great margin for errors, and the only thing these managements need to do is to prove that the cash really belongs to shareholders. And in that sense, what I am seing is mostly encouraging (at least going in the right direction).


Perhaps, disproportionate focus on earnings can partly be explained that around twenty / thirty years ago, a significant number of japanese managements used to buy derivative contrats and get their asset values wiped out. However, I am not sure this fear is still warranted today (as managements mostly became very cautious after learning from those mistakes).

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