The Ideas Report For Serious Investors

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By Greenbackd

Regular readers of Greenbackd know that I’m no fan of “the narrative,” which is the story an investor concocts to explain the various pieces of data the investor gathers about a potential investment. It’s something I’ve been thinking about a great deal recently as I grapple with the merits of an investment in Japanese net current asset value stocks. The two arguments for and against investing in such opportunities are as follows:

Fer it: Net current asset value stocks have performed remarkably well throughout the investing world and over time. In support of this argument I cite generally Graham’s experience, Oppenheimer’s Ben Graham’s Net Current Asset Values: A Performance Update paper, Testing Ben Graham’s Net Current Asset Value Strategy in London, a paper from the business school of the University of Salford in the UK, and, more specifically, Bildersee, Cheh and Zutshi’s The performance of Japanese common stocks in relation to their net current asset values, James Montier’s Graham’’s net-nets: outdated or outstanding?, and Dylan Grice’s Are Japanese equities worth more dead than alive.

Agin it: Japan is a special case because it has weak shareholder rights and a culture that regards corporations as “social institutions with a duty to provide stable employment and consider the needs of employees and the community at large, not just shareholders.” In support of this argument I cite the recent experiences of activist investors in Japan, and Bildersee, Cheh and Zutshi’s The performance of Japanese common stocks in relation to their net current asset values (yes, it supports both sides of the argument). Further, the prospects for Japan’s economy are poor due to its large government debt and ageing population.

How to break the deadlock? Montier provides a roadmap in his excellent Behavioural Investing:

We appear to use stories to help us reach decisions. In the ‘rational’ view of the world we observe the evidence, we then weigh the evidence, and finally we come to our decision. Of course, in the rational view we all collect the evidence in a well-behaved unbiased fashion. … Usually we are prone to only look for the information that happens to agree with us (confirmatory bias), etc.

However, the real world of behaviour is a long way from the rational viewpoint, and not just in the realm of information gathering. The second stage of the rational decision is weighing the evidence. However, as the diagram below shows, a more commonly encountered approach is to construct a narrative to explain the evidence that has been gathered (the story model of thinking).

Hastie and Pennington (2000) are the leading advocates of the story view (also known as explanation-based decision-making). The central hypothesis of the explanation-based view is that the decision maker constructs a summary story of the evidence and then uses this story, rather than the original raw evidence, to make their final decision.

…

All too often investors are sucked into plausible sounding story. Indeed, underlying some of the most noted bubbles in history are kernels of truth.

As to the last point, arguably, the converse is also true. Investors have missed some great returns because the ugly stories about companies or markets were so compelling.

There are several points that are not contentious about an investment in Japan. The data suggests to me and to everyone else that there are a large number of net current asset value bargains available there. The contention is whether these net current asset value stocks will perform as they have in other countries, or whether they are destined to remain net current asset value bargains, the classic “value traps.” My own penchant for value investing, and quantitative value investing in particular, makes this a reasonably simple matter to resolve. I am going to invest in Japanese net current asset value stocks. Here are the bases for my reasoning:

• I believe that value investing works. I believe that this is the case because it appeals to me as a matter of logic. I also believe that the data supports this position (see Ben Graham’s Net Current Asset Values: A Performance Update or Lakonishok, Shleifer, and Vishny’s Contrarian Investment, Extrapolation and Risk). Where a stock trades at a significant discount to its value, I am going to take a position.
• I believe that Graham’s net current asset value works. In support of this proposition I cite the papers listed in the “Fer it” argument above.
• I believe that simple quantitative models consistently outperform expert judgements. In support of this proposition generally I cite James Montier’s Painting By Numbers: An Ode To Quant. Where the data looks favorable to me, I am going to take a position, and I’m going to ignore the qualitative factors.
• I believe that value is a good predictor of returns at a market level. In support I cite the Dimson, Marsh and Staunton research. I am not dissuaded from investing in a country simply because its growth prospects are low. Value is the signal predictor of returns.

The arguments militating against investing in Japan sound to me like the arguments militating against any investment in a NCAV stock, which is to say that they are arguments rooted in the narrative. I’ve never taken a position in a NCAV stock that had a good story attached to it. They have always looked ugly from an earnings or narrative perspective (otherwise, they’d be trading at a higher price). As far as I can tell, this situation is no different, other than the fact that it is in a different country and the country has economic problems (which I would ignore in the usual case anyway). While the research specific to NCAV stocks in Japan is not as compelling as I would like it to be, I always bear in mind the lessons of Taleb’s “naive empiricist,” which is to say that the data are useful only up to a point.

This is not to say that I have any great conviction about Japan or Japanese net current asset value stocks. Far from it. I fully expect, as I always do when taking a position in any stock, to be wrong and have the situation follow the narrative. Fortunately, the decision is out of my hands. I’m going to follow my simple quantitative model – the Graham net current asset value strategy – and take some positions in Japanese net nets. The rest is for the goddess Fortuna.

Posted by manualofideas at 12:26 PM | Permalink | Comments (2)

By Greenbackd

In his Are Japanese equities worth more dead than alive?, SocGen’s Dylan Grice conducted some research into the performance of sub-liquidation value stocks in Japan since the mid 1990s. Grice’s findings are compelling:

My Factset backtest suggests such stocks trading below liquidation value have averaged a monthly return of 1.5% since the mid 1990s, compared to -0.2% for the Topix. There is no such thing as a toxic asset, only a toxic price. It may well be that these companies have no future, that they shouldn’t be valued as going concerns and that they are worth more dead than alive. If so, they are already trading at a value lower than would be fetched in a fire sale. But what if the outlook isn’t so gloomy? If these assets aren’t actually complete duds, we could be looking at some real bargains…

In the same article, Grice identifies five Graham net net stocks in Japan with market capitalizations bigger than $1B:

He argues that such stocks may offer value beyond the net current asset value:

The following chart shows the debt to shareholders equity ratios for each of the stocks highlighted as a liquidation candidate above, rebased so that the last year’s number equals 100. It’s clear that these companies have been aggressively delivering in the last decade.

Despite the “Japan has weak shareholder rights” cover story, management seems to be doing the right thing:

But as it happens, most of these companies have also been buying back stock too. So per share book values have been rising steadily throughout the appalling macro climate these companies have found themselves in. Contrary to what I expected to find, these companies that are currently priced at levels making liquidation seem the most profitable option have in fact been steadily creating shareholder wealth.

This is really extraordinary. The currency is a risk that I can’t quantify, but it warrants further investigation.

Posted by manualofideas at 12:22 PM | Permalink | Comments (0)

By Greenbackd

Since last week’s Japanese liquidation value: 1932 US redux post, I’ve been attempting to determine whether the historical performance of Japanese sub-liquidation value stocks matches the experience in the US, which has been outstanding since the strategy was first identified by Benjamin Graham in 1932. The risk to the Japanese net net experience is the perception (rightly or not) that the weakness of shareholder rights in Japan means that net current asset value stocks there are destined to continue to trade at a discount to net current asset value. As I mentioned yesterday, I’m a little chary of the “Japan has weak shareholder rights” narrative. I’d rather look at the data, but the data are a little wanting.

As we all know, the US net net experience has been very good. Research undertaken by Professor Henry Oppenheimer on Graham’s liquidation value strategy between 1970 and 1983, published in the paper Ben Graham’s Net Current Asset Values: A Performance Update, indicates that “[the] mean return from net current asset stocks for the 13-year period was 29.4% per year versus 11.5% per year for the NYSE-AMEX Index. One million dollars invested in the net current asset portfolio on December 31, 1970 would have increased to $25,497,300 by December 31, 1983.” That’s an outstanding return.

In The performance of Japanese common stocks in relation to their net current asset values, a 1993 paper by Bildersee, Cheh and Zutshi, the authors undertook research similar to Oppenheimer’s in Japan over the period 1975 and 1988. Their findings, described in another paper, indicate that the Japanese net net investor’s experience has not been as outstanding as the US investor’s:

In the first study outside of the USA, Bildersee, Cheh and Zutshi (1993)’s paper focuses on the Japanese market from 1975 to 1988. In order to maintain a sample large enough for cross-sectional analysis, Graham’s criterion was relaxed so that firms are required to merely have an NCAV/MV ratio greater than zero. They found the mean market-adjusted return of the aggregate portfolio is around 1 percent per month (13 percent per year).

As an astute reader noted last week ”…the test period for [the Bildersee] study is not the best. It includes Japan’s best analog to America’s Roaring Twenties. The Nikkei peaked on 12/29/89, and never recovered:”

Many of the “assets” on public companies’ books at that time were real estate bubble-related. At the peak in 1989, the aggregate market price for all private real estate in the city of Tokyo was purportedly greater than that of the entire state of California. You can see how the sudden runup in real estate during the bubble could cause asset-heavy companies to outperform the market.

So a better crucible for Japanese NCAVs might be the deflationary period, say beginning 1/1/90, which is more analogous to the US in 1932.

To see how the strategy has performed more recently, I’ve taken the Japanese net net stocks identified in James Montier’s Graham’’s net-nets: outdated or outstanding? article from September 2008 and tracked their performance from the data of the article to today. Before I plow into the results, I’d like to discuss my methodology and the various problems with it:

1. It was not possible to track all of the stocks identified by Montier. Where I couldn’t find a closing price for a stock, I’ve excluded it from the results and marked the stock as “N/A”. I’ve had to exclude 18 of 84 stocks, which is a meaningful proportion. It’s possible that these stocks were either taken over or went bust, and so would have had an effect on the results not reflected in my results.
2. The opening prices were not always available. In some instances I had to use the price on another date close to the opening date (i.e +/1 month).

Without further ado, here are the results of Montier’s Graham’’s net-nets: outdated or outstanding? picks:

The 68 stocks tracked gained on average 0.5% between September 2008 and February 2010, which is a disappointing outcome. The results relative to the  Japanese index are a little better. By way of comparison, the Nikkei 225 (roughly equivalent to the DJIA) fell from 12,834 to close yesterday at 10,057, a drop of 21.6%. Encouragingly, the net nets outperformed the N225 by a little over 21%.

The paucity of the data is a real problem for this study. I’ll update this post as I find more complete data or a more recent study.

Posted by manualofideas at 09:44 AM | Permalink | Comments (0)

By Greenbackd

Zero Hedge has an article Uncovering Liquidation Value… In Japan? discussing SocGen’s Dylan Grice’s Are Japanese equities worth more dead than alive. The title is a nod to Benjamin Graham’s landmark 1932 Forbes article, Inflated Treasuries and Deflated Stockholders, where he discussed the large number of companies in the US then trading at a discount to liquidation value:

…a great number of American businesses are quoted in the market for much less than their liquidating value; that in the best judgment of Wall Street, these businesses are worth more dead than alive. For most industrial companies should bring, in orderly liquidation, at least as much as their quick assets alone.

Grice writes:

In the space of a generation, Japan has gone from the world economy’s thrusting up-and-coming superpower to its slowing silver-haired retiree. Accordingly, the Japanese market attracts a low valuation. The chart [below] shows FTSE Japan’s equity price to book ratio and enterprise price to book ratio, since equity P/B ratios alone can be distorted by leverage. Both metrics show Japan to be trading at a low premium to book compared to its recent history. So it’s certainly cheap. But does it offer value? The answer can be seen in the chart above, which shows corporate Japan’s RoEs and RoAs over recent decades to have averaged a mere 6.8% and 3.8% respectively. This is hardly the sort of earnings power which should command any premium over book value at all. Indeed, to my mind the question is one of how big a discount the market should trade at relative to book.

The fundamental problem in 1932 America, according to Graham, was that investors weren’t paying attention to the assets owned by the company, instead focussing exclusively on “earning power” and therefore “reported earnings – which might only be temporary or even deceptive – and in a complete eclipse of what had always been regarded as a vital factor in security values, namely the company’s working capital position.” Graham proposed that investors should become not only “balance sheet conscious,” but “ownership conscious:”

If they realized their rights as business owners, we would not have before us the insane spectacle of treasuries bloated with cash and their proprietors in a wild scramble to give away their interest on any terms they can get. Perhaps the corporation itself buys back the shares they throw on the market, and by a final touch of irony, we see the stockholders’ pitifully inadequate payment made to themwith their own cash.

In his article, Grice makes a parallel argument about valuations based on earnings in Japan now:

Regular readers will know I favour a Residual Income approach to valuation. It’s not perfect, and it’s still a work in process, but anchoring estimates of intrinsic value on the earnings power of company assets (relative to a required rate of return, which I set at an exacting 10%) helps avoid value traps. Things don?t necessarily come up as offering value just because they’re on low multiples. The left chart below shows Japan’s ratio of Intrinsic Value to Price (IVP ratio, where a higher number indicates higher value) to be only 0.6, suggesting that in an absolute sense, Japan is intrinsically worth only about 60% of its current market value.

Grice arrives at the same conclusion about Japan as Graham did in 1932 about the US:

But here the tension between “going concern” valuation and “liquidation” valuation becomes important. Let’s just imagine the unimaginable for a second, and that my IVP ratios are correct. Japan currently trades on a P/B ratio of 1.5x, but if it is only worth 60% of that, its “fair value” P/B ratio (assuming we value it as a going concern) would be around 0.9x. Of course, that would only be true on average. Nearly all stocks would trade either above or below that level. And of those trading below, some would trade slightly below, others significantly below. And of those which traded significantly below, some might be expected to flirt with liquidation values which called into question whether or not the “going concern” valuation was appropriate. Indeed, this is exactly what is beginning to happen.

It seems that there are quite a few stocks trading at a discount to net current asset value in Japan:

Grice likes the net current asset value strategy in Japan (sort of):

Not only are these assets cheap but, unlike the overall market, they probably offer value as well. My Factset backtest suggests such stocks trading below liquidation value have averaged a monthly return of 1.5% since the mid 1990s, compared to -0.2% for the Topix. There is no such thing as a toxic asset, only a toxic price. It may well be that these companies have no future, that they shouldn’t be valued as going concerns and that they are worth more dead than alive. If so, they are already trading at a value lower than would be fetched in a fire sale. But what if the outlook isn’t so gloomy? If these assets aren’t actually complete duds, we could be looking at some real bargains…

…

So should we be filling our boots with companies trading below liquidation value? Not necessarily. But I would say the burden of proof has shifted. Why wouldn’t you want to own assets that have been generating shareholder wealth yet which trade at below their liquidation values?

It is interesting that this article echoes another SocGen article, this one a September 2008 report by James Montier called Graham’’s net-nets: outdated or outstanding? in which Montier looked at Graham sub-liquidation stocks globally. Of the 175 stocks identified around the world, Montier found that over half were in Japan.

Now all we have to do is figure out how to invest in Japan.

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The Associated Press reported on January 10th:

Already the biggest auto market and steel maker, China edged past Germany in 2009 to become the top exporter, yet another sign of its rapid rise and the spread of economic power from West to East.

Total 2009 exports were more than $1.2 trillion, China's customs agency said Sunday. That was ahead of the 816 billion euros ($1.17 trillion) forecast for Germany by its foreign trade organization, BGA.

Perhaps the biggest surprise of this news to those who don't closely follow the rankings of the world's exporters may be the fact that China had not overtaken Germany much earlier. China's might as an export superpower has been writ large in the media for years, so much so that a relatively small nation such as Germany should have been left in the dust long ago. Yet, Germany's export strength has been known for decades, and the latest news simply serves as a reminder that there are export nations other than China that are also crucial to world trade. Japan, of course, is one such nation, as are some of the emerging Asian countries, such as Taiwan and Korea.

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Respected value investor Aaron Edelheit of Sabre Value Management posted the following comment on investing in Russia on his blog recently:

"Ikea said Tuesday that it was suspending further investment in Russia, apparently because of pervasive corruption and demands for bribes."

"The announcement came after a rare statement by Ikea's 83-year-old founder in a radio interview that Ikea had decided not to solve problems by slipping money under the table."

"Kudos to Ikea for standing up and going public with how corrupt Russia is, but they should not be surprised, and they should have known better than invest money and time in Russia. Russia is run mafia style and people on the inside and who live there can easily tell you that there is little difference between the Russian mafia and the Russian government. I refuse to invest one penny in that country and this article is yet another reason to stay far away from its corrupt ways."

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Read an article

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We've been doing some work on Japanese equities here at The Manual of Ideas and wanted to share a few quick observations.  As you know, Japanese stocks have been in the doldrums for many years.  They generally trade at low multiples of tangible book value, and many companies have significant real estate holdings that are not accurately reflected on their balance sheets.

We approached our study of Japanese stocks with the hypothesis that we should be able to find some compelling investments given the cheap valuations of a large subset of Japanese public companies.  So far, however, we have remained unimpressed.  A few points:

• Lack of focus. Most mid-cap and large-cap Japanese companies still look more like conglomerates than focused Western-style enterprises.  It's almost as if major Japanese firms exist in an era pre-dating the age of specialization.  For example, did you know that Sony has a life insurance arm and even owns a bank?
• Murky corporate governance. Many Japanese companies' org charts look like org charts of government entities in the U.S., with checks and balances and committees galore.  The bureaucracy of Japan Inc. seems stifling.  For example, Sharp argues that it is a corporate governance leader, yet its org chart  could be mistaken for that of a Chinese commune.
• Little regard for returns on investment. Japanese companies routinely spend as much as 10% of annual revenue on capex, despite being in businesses with single-digit EBIT margins. While the companies include ROE calculations prominently in their annual reports, the firms exhibit little focus on improving ROE. Most companies keep making incremental investments despite ROEs in the mid single digits.
• High-cost production base; currency mismatch. Many Japanese exporters have still not fully embraced outsourcing of manufacturing to low-cost locations, preferring instead to produce goods within Japan. This not only increases costs but also exposes the companies to yen appreciation (which has recently obliterated profits at many Japanese exporters).
• Clubbish Board rooms. So far, we've had difficulty finding female Board members at major Japanese companies. Not that we're in favor of quotas or similar concepts, but it does seem that the lack of diversity in Japanese Board rooms is emblematic of a lack of willingness to open up the culture and embrace new ways of doing business.

To be sure, Japanese stocks do not appear to have much downside. They generally enjoy significant asset protection, and their businesses appear sustainable.  However, investors are likely to achieve impressive returns from investing in Japanese stocks only during short time periods of revaluation of price-to-book or enterprise value-to-revenue multiples. Assuming constant multiples, investors are likely to be disappointed, as they'll be earning returns similar to the companies' returns on equity. The latter generally range in the low to mid single digits and appear unlikely to rise any time soon.

So as not to disparage Japan Inc. unduly, we also point out that Japanese companies have many good things going for them, including access to a highly skilled, hardworking labor force; superior technology and manufacturing processes; and a forward-thinking attitude on environmental matters.

A final note:

We are beginning to understand what Warren Buffett meant when he told University of Florida students some years back that he had not found any investable companies in Japan.  Buffett said something to the effect that Berkshire Hathaway could borrow money in Japan at only 1%.  He then reasoned that all he needed to do was to find a company that would give him more than 1% per year over the long term.  He concluded: "So far, I haven't found anything."

The following is the full video of Buffett's University of Florida speech.  If you've never seen it, don't miss it.  It is one of the best ways to spend an hour. Buffett's comments on Japan start around the 10-minute mark.

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Watch a panel including Tom Russo of Gardner, Russo, Gardner and Guy Spier of Aquamarine provide insight into global investing, ranging from global mega caps to small caps (from Darden Value Investing Conference, November 6, 2008):

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