The suggestion he might be doing cartwheels down the streets of Tokyo might be bestowing the late Benjamin Graham with an unlikely athletic prowess.
Nevertheless, were he alive today, the legendary value investor would be salivating at the incredibly low valuations to be found in the Japanese stock market.
We have been running a monthly screen looking for profitable stocks trading below book value with net cash on the balance sheet. This screen highlights a mere three stocks in the US, 10 in the UK and none in Continental Europe.
By contrast, at the end of July there were 426 stocks within Japan’s Topix index that fulfilled these criteria, representing a remarkable 25.5% of the market. And the truly extraordinary thing is only four of those stocks are in the top 100 by market capitalisation – 422 of them are mid and small caps. That is where the real opportunity lies in the Japanese market.
Within our own fund, one third of the stocks held are profitable with net cash and trade below book value. Value in itself is not a reason to buy a stock market, but it can provide a helpful tailwind when a market does start to rise. At some point, these stocks will be re-rated. And when they are, they will not just rise by 10% or 20%, we think they could double or treble.
Although there is a belief only Japan’s largest firms pay any attention to shareholder returns, many of these mid- and small-cap companies are already raising dividends again and buying back shares.
Income seeking
Within our portfolio Sankyo and Casio have already undertaken share buybacks in recent weeks, while 13 of our 60 companies have indicated they will raise dividends this year. Indeed, we believe it is fair to say investors can now look to Japan if they are looking for income. The yield on the Topix index is now comparable to that on the S&P 500 index, a situation that has rarely been the case over the past 30 years.
Furthermore, we expect dividend growth over the near term to be higher in Japan than the US. This is for one simple reason: corporate Japan is generating record amounts of free cashflow. More than half of the companies we own are producing free cashflow yields of more than 5%.
For example, Daiichikosho, a manufacturer of karaoke equipment and operator of karaoke parlours, has a free cashflow yield of over 17%. It trades below book value, has a dividend yield of 4.5% and its business model is unaffected by global macroeconomic trends.
Cashflows
Allied to powerful cashflow generation, half of Japanese listed companies now have net cash on their balance sheets. In comparison to the US and Europe, where companies have just set out on the path to major debt reduction, the deleveraging exercise in Japan finished three or four years ago. With cashflows plentiful and with Japan Inc. unencumbered by the heavy debts amassed by their US corporate counterparts during the credit bubble years, we expect that the yield on the Topix will outstrip that of the S&P 500 by the start of next year.
Many of our mid- and small-cap stocks tend to fall outside the coverage of sell-side analysts. That is the main reason why they are so cheap; nobody is looking at them. This presents opportunities, but also risks. For example, in May, many of the companies we hold announced their results for the year to March 2010 and forecasts for the coming year.
In many cases, the results surpassed expectations, but the forecasts looked very disappointing. As the stocks are not widely covered, stock prices fell when these announcements were made. However, it has since become apparent that, in the vast majority of cases, the forecasts were extremely conservative.
Animation studio Toei Animation is just one firm guilty of providing an excessively circumspect outlook. The company recently recorded strong earnings numbers for the previous financial year but issued subdued estimates for the current financial year, causing the stock to sell-off.
We queried these forecasts during a recent meeting with company management. Incredibly, despite enjoying its most successful ever animated feature at Japanese cinemas last year, the firm has budgeted for precisely zero sales when the same film is released on DVD this year! For most film companies DVD sales generate the bulk of profits from a release, so to anticipate no revenue whatsoever is clearly taking accountancy prudence into the realm of the ridiculous!
This unwarranted pessimism is typical among the management teams we meet and fails to reflect the bright earnings outlook for the companies within our portfolio.
Our significant exposure to mid- and small-cap stocks means our portfolio has a strong domestic bias, albeit we do own large-cap exporter Honda, which is undeservedly trading at a discount to its peer group. Many investors in Japan tend to dismiss the domestic sector and believe only Japanese exporters are of interest. We believe this is too simplistic; Japan has many niche domestic companies that have managed to raise profit margins during a decade of deflation and yet are priced for bankruptcy.
Domestics
One domestic-facing stock we like is railway company Keio, which recently reported robust first-quarter results and should handsomely beat its full-year estimates, while we also hold fellow railway stock Keisei.
Meanwhile, in manufacturing, Mabuchi Motors, the world’s largest producer of small electric motors used in the likes of car mirrors and locks, is a great stock that is symptomatic of the unloved nature of Japanese stocks. It is much lower rated than Johnson Electric, its Hong Kong-listed rival, even though the two companies are virtually identical in all respects other than that Mabuchi is twice the size of its competitor.
In this tale of two stocks, the overlooked attractions of the world’s cheapest developed stock market are once again writ large.
Scott McGlashan, senior fund manager of the Japan fund at J O Hambro Capital Management
