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Japanese Research as Promised


rick_v
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Alright guys I have been traveling but just got this data from my analysts and am going to put it all together for you and walk you through the methodology. A few weeks back I promised you all that I would try to analyze the Japanese scenario that Munger believes the US could witness. The people in that camp basically argue that if the Money Supply is expanding at a slow rate or not at all it is better to sit on the sidelines than to invest given that all equity prices will surely get cheaper and cheaper.

 

I thought it would be interesting to aggregate the Nikkei 225 but in US Dollars not Japanese yen for the following reason: The world's money supply doesn't stop growing just because Japan's does. And so I wanted to envision a scenario where I was a Japanese investor say 10 or 20 years ago and what I would have done if I were to deploy capital in that period. Surely, I would look for international companies with diversified streams of cash flows as I always do. I would obviously avoid high P/E ratios, and l would look for companies earning decent rates of return on equity while growing per share earnings.

 

Here we go:

 

The first graph we will look at is the Japanese Money Supply over a period of 20 years. We see very clearly as Munger has mentioned many times that Money Supply grew at a very slow rate (49% in 20 years vs 300% growth in US M2 during the same period).

 

The next graph we see is of the Nikkei Index over that same period. And again, we can see clearly that it has declined by 77% proving what Munger mentioned that a day of reckoning was truly felt by all equity investors! So far this appears to be very cut and dry... Or is it?

 

Was it really that simple? Corporations earned less because of deflation which caused their stock prices to consistently go down? Or was there more to this story?

 

The next step was to figure out what type of valuations were companies trading at before and after the deflation began to take force. This is where things begin to get interesting...

 

The next graph shows the average P/E Ratios of the Nikkei from 1990-Today. (Keep in mind that those huge spikes are errors in the data)

 

If its hard to see, the average P/E Ratio on the Nikkei 225 Index was 43.2 in 1992. Today it's 15.40

 

So at this point I have to start thinking that there is more at play than just a plain vanilla deflation story, at an average P/E of 43.2 the index was clearly overpriced and any intelligent investor could have seen that! The next step was to figure out if these companies actually earned more USD each year during this period.

 

The next attachment is an excel spreadsheet with the total USD Net income from 2000-2009 of Nikkei 225 Companies. (Not the entire 225 due to lack of data for all, Also bloomberg did not have pre 2000 data but I do not think that is so relevant given the results.)

 

The results are very clear: good companies were able to grow their USD Earnings even during deflation.

 

But then why did stocks go down, Why did the Nikkei decline for so long!, why did Nippon Telegraph for example which grew its USD Earnings continually decline over those decades???

 

The next attachment is a PDF detailing the average P/E Ratios for Nikkon Telegraph starting in 1992-Today... I don't think I need to explain this one! I have never in my life invested in a P/E ratio above 20 let alone 53 or 291.

 

So this proves there is more at play than just a simple deflation scenario stocks were clearly overvalued! Then I started thinking... Who cares about how much they earned, what did they earn per share!! And let me look at only the companies which were trading at "normalized" P/E ratios... Did those companies also decline for 10-20 years?

 

The next attachment is an excel spreadsheet with only the Nikkei 225 components that were trading at a P/E ratio of less than 30 in the year 2000. (I know 30 is high but for Japan it wasn't at the time!!) In addition this spreadsheet plots out the earnings per share in USD that these companies earned from 2000-2009.

 

I then chose the easiest target, the one that had the lowest P/E Ratio in 2000: Sumitomo Realty (8830 JP)

 

Sumitomo had a P/E Ratio of only 9.6 in the year 2000 and had USD earnings per share grow from .326 FY 2000 to .973 FY 2009.

 

The final attachment is a graph of Sumitomo Realty Stock from the year 2000 until now.

 

As you can see the stock is up 209% in that period or 12% a year not including DIVIDENDS!!! Further, it has declined a great deal from its peak in 2007.

 

What this entire exercise of futility tells me is that all this Macro BS has no effect on the solid principles of value investing. The market as a weighing machine reflects the long-term value of the underlying fundamentals for good businesses! There was definitely more at play with regards to Japan than just a simple deflation scenario... The initial inflation in the 80's caused companies to trade at ridiculous valuations, valuations that I wouldn't touch with a ten foot pole. Good companies, that were being presented by Mr. Market at fair valuations, earning decent returns on capital deployed with a diversified stream of income generated solid returns for investors!

 

Lets spend more time generating investment ideas! There are definitely more and more each day...

 

 

 

 

 

 

*** I had to re-upload the Nikkei/Eps/PEunder30 file so its at the bottom of the attachments.

 

 

 

 

 

 

 

 

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Excellent research rick_v.  Keep in mind that Japanese companies had two other strikes against them leading up to the two "lost decades".  Their crossholdings drug down the good companies with the insolvent ones.  The greatest drag happened when their government removed the abnormally low peg to the dollar that Japanese companies enjoyed before their market tanked.  Afterwards,  Japanese companies no longer made abnormal profits.

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Guest longinvestor

Excellent research rick_v.  Keep in mind that Japanese companies had two other strikes against them leading up to the two "lost decades".  Their crossholdings drug down the good companies with the insolvent ones.  The greatest drag happened when their government removed the abnormally low peg to the dollar that Japanese companies enjoyed before their market tanked.  Afterwards,  Japanese companies no longer made abnormal profits.

Since about 1990, large Japanese corporations increasingly went global for growth reasons and in preparation for the aging of Japan. As we know Japan does not have a meaningful immigration policy. This large adjustment was quite out of character for the post-war Japan. Not dissimilar to the structural adjustment Germany is making since reunification.

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Take a look at Japan's CPI from 1990 to 2007:

 

http://www.thedti.gov.za/econdb/IMFConJAPANCPICHA.html

 

Aside from a very minor and brief spell at the end of 1995, deflation didn't take hold until 1999.  Even then, there has really only been a few years where at some point deflation went as high as 1% -- I could only find one quarter beginning at the end of 2002 where the rate exceeded 1%, and perhaps that coincided with the recession from the stock bust that we felt here in the US.

 

The CPI is a broad measure -- surely there were areas where prices rose.  What were they?  And surely there were areas where prices fell by quite a bit.  

 

A breakdown of the CPI components would be nice -- does anyone have that info?

 

 

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The point here is that none of this stuff matters.

 

If you find a good business trading at a fair P/E Ratio with solid returns on capital deployed and a diversified stream of income buy it hand over fist!!!

 

From a capital allocation perspective, make sure you have enough capital to weather any potential storm but the bottom line is, sideways and down markets provide better buying opportunities than rising markets. For the last 4 years we have had a crappy market, and so naturally good opportunities should be available. I would love to see more posted on this board as that was the original reason I joined.

 

I have provided several so far...

 

CCME is not my type of a value play, Chinese companies traded on the US are too opaque.

 

 

 

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I really appreciate the Japanese research, rick_v.  I tend to agree that this is a time likely to have better than average and more than average value opportunities, but don't think it makes macro totally irrelevant in this environment, for a few reasons.

 

First, one lesson I learned from the Q1 2009 period is to always maintain a bit more cash than you think you'll need, in case even better opportunities come up.  I was already fully invested, and had to do the hard play of selling $.75 dollars to purchase $.50 or $.40 dollars.  That was hard, and I still feel like I missed opportunities from having been too early.  Since I see the strong possibility of similarly low market levels at least once or twice in the coming few years, I intend to keep more of a cash balance on hand and raise my standards to waiting until there are $.50 dollars that I can clearly identify, rather than jumping in as soon as I see $.75 dollars out there (though I have some of those too of course).  Obviously risks to this as well if the market never dips that low during this period.

 

Second, I consider the macro here to make this an exception to the normal rule of buy and hold, because I see plenty of opportunities for "round trips" in stocks -- buy low, watch them revalue up, but then watch them fall back down.  I think there is something to Katsenelson's theory of us being in a "range bound market" over the next decade overall.  You can make money in this market, but you need to watch for downward revaluations of the multiples as rising interest rates and inflation actually make the real value of securities go down. 

 

 

 

 

 

 

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And, to be clear, I'm not sure what I just said is at all inconsistent with what you were saying, other than the fact that I think macro, while usually almost irrelevant to good value investing, is less irrelevant now, because it's such a huge wave to fight against. 

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As I said, Capital Allocation is key in any investment strategy but I do disagree with your round-trip theory. I have never been able to perfectly time the market. I do love building positions that go against me like APP right now:

 

First buys were 1.40ish kept adding and adding and now have a cost average of .92 cents per share. That position is already in the green even though every day we just hear more and more bad news while the company is quiet. I would expect that there should be some type of resolution there any day, whether it involves a buyout or a debt restructuring. At 150m$ enterprise value, APP is too cheap!

 

 

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As I said, Capital Allocation is key in any investment strategy but I do disagree with your round-trip theory. I have never been able to perfectly time the market. I do love building positions that go against me like APP right now:

 

First buys were 1.40ish kept adding and adding and now have a cost average of .92 cents per share. That position is already in the green even though every day we just hear more and more bad news while the company is quiet. I would expect that there should be some type of resolution there any day, whether it involves a buyout or a debt restructuring. At 150m$ enterprise value, APP is too cheap!

 

I understand why you might have said this, but I don't see this as market timing -- more like taking some profits out when you've gotten them right, and preparing for possible opportunities.  I claim no ability to predict when they will come, but I do think having ample free cash on hand is wise.  Market pricing, not market timing. 

 

On APP, I understand looking for investments where the first reaction is "ugh", but on a quick perusal I can't see much that is attractive right now.  What am I missing?

 

 

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Great work Rick.  After reading your comments I was wondering how the debt levels of the US and Japan compared before each crisis.  I was certain that Japan would have had lower debt at the time their crisis begain but I found charts from the following link that shows Japan having a higher total debt to GDP level than the US.  This was surprising.

 

http://www.thoughtofferings.com/2009/09/mystery-of-japans-private-debt-levels.html

 

 

http://1.bp.blogspot.com/_up3_ViopRks/SrjW_k2An4I/AAAAAAAACns/sVSMD5pm5dI/s400/USDebtToGDP.png

 

http://4.bp.blogspot.com/_up3_ViopRks/SrjW3CgZAoI/AAAAAAAACnc/VXOrRA_aNVk/s400/JapanDebtToGDP.png

 

I believe there is still one large negative to the current crisis vs the one Japan has been going through.  During the first decade of Japan's crisis (1990s) the world as a whole experience huge growth and Japan was able to take advantage of this by increasing their exports significantly to help offset the slowdown locally.  Japanese growth has become stagnant since 1997.

 

This time around the debt problem affects most western countries so unless Asian consumers start spending more than they have traditionally, there maybe additional unforseen challenges worldwide.

 

 

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During the first decade of Japan's crisis (1990s) the world as a whole experience huge growth and Japan was able to take advantage of this by increasing their exports significantly to help offset the slowdown locally.

 

True but both the real estate and the stock markets bubbles in Japan were much larger than in the US.  That's important as well.

 

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Good work! Thanks for sharing.

 

A little tidbit on the extent of the Japanese stock bubble: the dividend yield on the Nikkei was at 5.0% in 1970 and at the bubble peak in late 1989 it had a dividend yield of only 0.45% and is currently a tad above 2.0%.

 

Even at its peak in 2000, S&P 500 yield dipped only to 1.0%.

 

Vinod

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