INDUSTRY VOICE:A quick click-through of the 'hot deals' page on my favourite online shopping sites brings up some very tempting offers, probably from inventory clearance or a product phase-out, catering to the many consumers who apparently like to browse through these pages looking for that one item that they didn't know they wanted - until they see the price tag.
Not all of us are such savvy active shoppers, but we do know we probably all spend too much time comparing the latest features and prices on our next mobile phone, or home appliance, or even the latest deal of on-line groceries - succumbing to the convenience of the internet that allows us to quickly compare between similar competitive products so that we can get the best value for the least money.
And yet we are always cautious to part with our hard earned cash, because as critical shoppers, we know from experience that making purchases on price alone may not lead to the most satisfaction. The ‘ah-ha' moment when a quick sort refresh from ‘lowest price' to ‘customer rating' reveals that the product we have in mind has far fewer stars than the next cheapest candidate - is just another piece of evidence that research in shopping pays off more often than not.
While this may seem like a crude analogy, in the investment business we seem to go through some fairly similar decision-making processes. We sometimes call the former bargain hunting an ‘absolute value' analysis - where we judge the specific risk-return we might generate from a single investment, not necessarily comparing against in-kind opportunities, but simply against our required rate of return. Conversely, in the latter case above where we are comparing the merits of spending between similar purchase options seeking the lowest price, we say (in a slightly distant parallel) we are conducting ‘relative value' analysis within a group of comparable investment choices.
These efforts tend to overlap considerably in the course of our work, but nonetheless, we do pause to think what type of business might warrant its stock to trade at 100x earnings, or the creditworthiness of a new bond priced at 80 cents on a dollar. On the other hand, we don't always stop to think about the default risk of a business when we compare minute spreads amongst the highest quality issuers, nor do we debate small differences in P/E ratios among global sector comps despite high valuations. The point here is that despite the obvious overlap in usage, the criteria is fairly distinct.
A common basis for both of these approaches is quite simple however, and that is to maximize returns for minimum risk. Usually this leads the efficient markets to converge prices to reflect a reasonable approximation of required returns for a given level of risk, thus allowing us to choose, on either an absolute basis (e.g. can I take the risk of a struggling enterprise that may cease as a going concern in return for 20% returns per annum), or a relative basis (e.g. do I prefer the investment prospects of a premium stock for operational quality over slightly higher expected returns of a discount stock that may improve over time).
Theoretically, this type of equilibrium should have a similar, if not exactly matching effect on the cross-border markets, given the abundant solutions necessary to hedge most, if not all, exogenous risk. But sometimes, reality seems to defy the theory - I can give you one example: Japan.
Just 20 years ago, we used to debate why the Japanese markets commanded such a high valuation premium. Price to earnings were quoted to be cheap in the high 20s and 30s when the S&P 500 traded at 16 times EPS. Growth wasn't terribly high either, while governance and engagement were non-existent at that point. That was then, when things were a little odd.
Fast forward to 2019, and things have changed significantly - for the better. Better margins, better growth prospects, better management, better shareholder engagement. But puzzlingly, prices have been left to stagnate. While we can purposely ignore the relative valuation of U.S. stocks trading at triple their companies' net assets and a 30% premium over the comparable TOPIX index*, it's harder to ignore strong fundamentals and market-beating growth prospects for businesses trading at 5x, 8x, or 10x earnings at prices significantly below their net worth. In another light, for many Japanese stocks we may now have meandered across the realm of researching relative value, into that of picking up absolute value.
(*If it hasn't changed by the time you read this, S&P500 trades at 3x book and 16x forecasted earnings or 6% earnings yield equivalent to 320bps over 10-year treasuries, while TOPIX trades at 1.1x book and 12x forecasted earnings or 8% earnings yield equivalent to 800bps over 10-year JGBs. Admittedly, these forecasts imply significantly better capital efficiency (ROE) in the U.S. but we would also note the conservative forecasting habits of Japanese markets against a slowing U.S. outlook.)
As informed investors, there is no doubt that one should ponder both ways a market where global blue chips are on sale at mid-single digit earnings multiples, or 80 sen on a yen, or both. We might perhaps question if market forces may indeed be functioning properly in some sectors or businesses - are bank balance sheets truly worth their adjusted book? Will parts manufacturers manage to maintain operating margin at lower capacity utilization with a slowing Chinese economy? These are valid concerns that require thorough bottom-up research. And yet if one were to shy away because of price risk on short-term supply demand, that is also understandable for certain managers with a related product mandate. But for the long-term global equity investor, market volatility on sound fundamentals is an opportunity that creates market inefficiencies which are critical to generating alpha. And I see no other excuse to not look seriously at this cheap corner of the developed markets.
Many investors and allocators apparently believe it to be a very difficult if not impossible task to make productive investment calls on Japan. While I have slight reservations for this assertion, I do agree on one observation: very few managers have the resources to form a proactive view, while reactionary investing will often result in a losing streak, particularly if you have institutional-sized positions. If that is the case, it's all the more important that investment decisions are executed on a structural, anticipatory perspective. While reversion-oriented strategies don't always generate long-term gains per se, trend-following by nature has its limits in value generating assets such as common shares; that means the time to research, and possibly buy prudently, is now.
Tokio Marine Asset Management (TMAM)
TMAM is a Japan/Asia equity specialist with over 30 years' market experience and approx. $60bn AUM as at September-end 2018.
For more information about uncovering investment opportunities in Japanese equities, please contact Business Development, Tokio Marine Asset Management (London) Limited, authorised and regulated by the Financial Conduct Authority (FRN 487699).
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