Staying Focused on the Fundamentals

Jul 27

The keys to successful investment in Japan

By Jesper Koll

“I f you get the earnings right, you’ll get the investment right.” This was the advice given to me by one of the greatest investors of all time, Julian Robertson. He is the founder of the famous Tiger Fund, which, throughout the 1990s, battled with investment shark turned philanthropist George Soros for the top position as the world’s biggest and best-performing hedge fund manager. To be a successful investor, cut out the noise and don’t get distracted by smart-sounding stories or headlinegrabbing advice. Stay focused on the fundamentals.

Local Success

Applying this rule to Japan, the first questions we must answer are:

How does Japan, Inc. make money?
Where do its earnings come from?

Importantly, the answer is “not from Japan.” For companies listed on the Japanese stock markets, about 64 percent of corporate profits are created from global sales and operations (i.e., exports or offshore production and sales). From a top-down macro perspective, a successful investment in the Japanese stock market is far more dependent on global economic fortunes than on what goes on at home, in Japan.

In fact, Japan’s dependency on the world has gone up since the start of Abenomics in 2012. Ten years ago, about 50 percent of profits came from global markets. The rise from 50 to more than 60 percent is primarily due to Japanese banks and financial firms. Over the past decade, they have become more active overseas— particularly in Asia.

It is a little-known fact that Japanese banks have been the largest provider of credit in non-China Asia for three years running. At the same time, banks’ domestic profit margins are being squeezed by the cap on bond yields forced by the central bank. If interest rates are not allowed to rise, banks cannot grow their profit margins. To get bullish on Japanese financials in general—and banks in particular—we need to see an end to the Bank of Japan’s current policy of yield-curve control (i.e., allowing 10-year bond yields to rise).

Currency Sensitivity and the Hedge Imperative

Further, Japan’s major dependence on the ups and downs of the global economy makes Japanese profits highly sensitive to the currency. When the yen rises, overseas earnings translate into lower yen-based profits. When the yen drops, the yen profits get a nice windfall. Statistically, for every ¥10 of depreciation, Japanese corporate earnings get a boost of about eight percent (if the depreciation is sustained for six or more months). In other words, the weaker the yen, the better Japan’s corporate profits; and the better Japan’s corporate earnings, the higher the stock market.

For global investors who calculate their returns in US dollars, the combination of Japan’s high dependence on global growth, and the inverse relationship between the currency and Japanese earnings, dictates one very clear piece of investment advice: always currency hedge your yen equity positions. Chances are high that yen-denominated Nikkei gains will translate into much lower US-dollar gains because, basically, the Nikkei only goes up during periods of yen depreciation and dollar strength.

Here we can learn from another master investor: Warren Buffet. Last fall, when he famously initiated his first significant investment in Japanese stocks in more than a decade, he did so on a fully currency-hedged basis. And it has paid off handsomely so far. The yen value of his position is up 20–25 percent, despite the yen being down five to six percent. Without the currency hedge, his performance would be one-quarter to one-fifth less than it is with the currency hedge. In my view, hedging the currency is imperative for best performance if, like Buffet, you measure your returns in US dollars.

Leadership Matters

Of course, this is just the big-picture macro lesson for anyone considering an equity investment in Japan. From here, we’ll have to enter the exciting world of stock-picking, of selecting companies that display high potential for generating rising profits and superior returns.

I am not allowed to go into details and offer advice, but I can leave you with one suggestion: focus on the leader, the CEO. In the end, Japanese corporate performance is dictated primarily by the quality, vision, and aggressiveness of the top-level executives. After decades of misery, Sony Corporation turned itself around when the charismatic Kazuo Hirai took over, and Hitachi Ltd. did so when superstar manager Hiroaki Nakanishi stepped in.

These are just two such success stories. While Japan may well despise and not tolerate the superstar CEO cult so essential to US corporate culture, the reality is that Japan’s consistent top performers and turnarounds can be traced back to an individual star CEO and their leadership style. You won’t find their names in bright lights, in the papers and magazines, or at Davos, but they do exist. Finding them is half the fun and a rewarding part of investing in Japan.