FREE KIC - NO. 1 OCTOBER 05

Japan has me confused !

The Japanese stock market is back in fashion. Foreign investors have increased their ownership from five percent back in 1987 to a current record high twenty five percent.

A number of commentators believe that Japan will continue to outperform other stock markets for the foreseeable future.

Given that I was a specialist Japanese fund manager from 1987 until 1997 I am often asked for my opinion. So for this the first addition of my monthly opinion pieces, the gFree KICh I thought that I would give an outline of my current views on Japan.

When I was a Japan specialist I came to the conclusion that Japanese companies were not as shareholder value aware as companies in USA and UK. Japanese companies existed in a culture where loyalty to Japanese employees was at least if not more important than loyalty to shareholders. In practical terms this meant that a loss making division of a company would not be shut down if it meant firing Japanese employees. At one meeting with Hitachi I remember putting the case to them that they were unlikely to ever make a decent return in commodity semiconductors  (DRAM). Management gave their usual response that they would at some point in the future. This philosophy could continue as long as each company had another profitable division that could be used to subsidise the loss making division. Hitachi with 250,000 employees has so many divisions that it has muddled along for years with this approach.

If Japan is to consistently outperform I believe that this approach will have to change. I believe that companies like Hitachi will have to take tough decisions that will involve concentrating on areas where they have a competitive advantage and pulling out of areas where they will never be able to generate decent returns.

The commentators that are positive about the Japanese stock market believe that there has been a significant change in the way Japanese companies are run. They point out that

  1. Profits and cash flow have improved in recent years.
  2. Dividends have been increased.
  3. Bank bad debts have been written off.
  4. Prime Minister Koizumi believes in reform.
  5. Hostile acquisitions have been attempted.
  6. Valuations are cheap compared to government bonds.

All of the above is true but I wonder whether this is enough? I would respond to the above by saying

  1. Have profits and cash flow improved primarily because of a booming China?
  2. Dividend yields are still low by international standards.
  3. Have the banks changed their business models in any significant way? (I may come back to this in a later opinion piece)
  4. Where is the evidence that Koizumi believes that reforms should include Japanese companies pulling out of low return businesses?
  5. No attempted hostile acquisition has resulted in a change of management.
  6. Japanese stock market does not look particularly  cheap. (Bond yields should increase if Japan gnormalisesh)

I think it is important at this stage to point out that I am no longer a Japanese specialist. I last visited Japan in 2002 and the last time I was at a conference of Japanese companies was 2003. At that Citigroup conference in London in November 2003 I struggled to find examples of ways in which the companies I met were changing. Konica Minolta was a prime example. They had a tiny market share in digital cameras and were losing money and yet they said they were going to continue to try and turn the division around. Here we are in October 2005 and they are still trying to turn this division around!

As they are currently structured I believe that companies like Hitachi and Konica Minolta are typical of Japan and I do not see the evidence that they have changed. Sony is seen as being at the forefront of investor relations and their new CEO (first non Japanese person) in a recent interview with the FT said that he would like to be more radical in terms of restructuring but could not implement what he wanted to do.

I think that it is particularly interesting that Japan has not played a leadership position in the development of the two newest industries that have emerged in my time covering equity markets. I am referring to software and the internet. Microsoft, Oracle, Cisco, Google, Yahoo and Ebay are not Japanese. These are some of the most profitable companies in the world.

Japan remains strongest in traditional manufacturing. Cars, steel, shipbuilding and consumer electronics is where Japan is strong. Toyota, Nippon Steel, Mitsubishi Heavy and Sony are all leaders but I believe that they will never generate the type of returns that Microsoft, Oracle etc will generate because competition from Hyundai Auto, Posco, Hyundai Heavy and Samsung will prevent their Japanese competitors from generating above average returns.

There are a few companies in Japan that have convinced me that they are serious about shareholder value but they are currently in a minority and even they face serious constraints on how profitable they can be. Canon is a leader in all its divisions and all are profitable but it has a tough time with Dell now having entered the printer business. Takeda Chemical is the largest Japanese pharmaceutical company but it is small by global standards and its pipeline looks limited.

Where is the Japanese equivalent of Wal Mart, Tesco, Coca Cola, Diageo, Nestle? These are industries where brand is more important that manufacturing skills.

Even though Japan is weak in certain sectors like software, food, beverages and retailing I believe that the manufacturing sector does have value within it. The trouble is that this value needs to be unlocked or else these companies deserve to be cheap. (Look at the way a company like Philips has stayed cheap relative to its sum of the parts because it is seen as an ugly conglomerate).

I believe that hostile takeovers or the threat of them is the most likely way to unlock this value.

I mentioned above that there has not been a single hostile takeover attempt in Japan that has succeeded in replacing existing management. What I did not say is that it has resulted in existing management changing the way they did things. A US hedge fund called Steel Partners attempted two hostile takeovers of small cash rich companies. They did not manage to get control but they made a lot of money because management paid out special dividends.

I believe that Japanese management are increasingly aware of the possibility of takeovers but this doesnft necessarily mean that they will do the right thing. I believe that Yamanouchi and Fujisawa merged because of the fear of takeover but has this resulted in a better managed company?

An ever more interesting development was the attempt by a small Japanese company, Livedoor, owned by a young Japanese entrepreneur to take control Of Nippon Broadcasting. Ultimately it failed but it might be an indication that a young generation of Japanese entrepreneur wants to change the way things are done.

In recent weeks we have seen some more hostile activity:

  1. A young Japanese internet company called Rakuten is attempting to take on Tokyo Broadcasting.
  2. Murakami Funds has accumulated a large stake in Hanshin Railway.
  3. An attempt on JEC has concluded with a white knight being brought in by existing management.

If this is the start of a trend and if we eventually have a successful hostile takeover then there might be a period of dramatic change ahead for Japan and the Japanese stock market. As I mentioned I have not been to Japan since 2002 so I am finding it hard to judge whether a young generation led by Livedoor and Rakuten are in a position to throw out the old guard. This would be a dramatic cultural shift for Japan because all the Japanese companies I know have management teams consisting of men over 60 years old!

I genuinely hope that a generation of young entrepreneurial Japanese are about to shake things up in corporate Japan because if the old guard succeed in maintaining the status quo I am concerned that those foreign shareholders who have been driving up the Japanese market will turn in to sellers and drive the market back down.

I have one final observation to make. The old guard control the big Japanese institutional money in the life companies and trust banks. They are not buying the market at the moment. Does this suggest that they believe the old guard will succeed or is it just that they cannot see the writing on the wall?

In conclusion I would like to say the following:

  1. I do not have any investments in the Japanese stock market at the moment because I havenft seen enough evidence that the young generation will succeed in shaking things up.
  2. I have to acknowledge that the hostile activity that has taken place so far is in itself a significant change.
  3. I acknowledge that it may be too late by the time the evidence is clearer but I believe in investing in companies where I have conviction and I do not have that at the moment. I really struggle to believe that I should buy companies like Hitachi in the hope that they will be managed in a way that unlocks the value that I believe exists within them.
  4. I continue to read the research and look at Japanese company websites in order to see evidence of change. (I suggest that it is a good exercise to look at the difference in investor relations websites between Japanese and western companies)
  5. I might visit Japan when I get the chance and meet some old contacts of mine because I have to accept that each new hostile takeover attempt suggests that I might be too cautious.

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Directors: Kenneth Power (Managing) B.Comm, MBS, ASIP, Regular Member of the CFA Institute.
Siobhan Power