Apr 2023
April continued the trends seen during the 1st quarter including high dispersion but low market volatility and low turnover, both in the US and Japan. Both the US VIX and its Nikkei 225 counterpart were near post-pandemic lows. April volumes were also near a 20-year low in Japan while US volumes (including OTC) were down -27% YoY. In Japan, the PBR/ROE reversal game continued with the primary non-industry factor drivers being low-beta, low-ROE, high dividend yield, low EPS growth, and low PER, few of which our portfolio has (our beta is slightly below the market, but ROE is higher, div yields are inline, EPS growth is higher, and PER is actually higher [although our EV/EBITDA is lower]).
Of course, none of these excuses comforts us with the fact that we continue to underperform the market, whatever the reason. But putting aside relative performance of our portfolio for the moment and if I take a step back and look across our names, there is not a single name that I am uncomfortable with, whether it be its business and competitive advantage, valuations, or forward growth potential. Admittedly, some of the catalysts that we were hoping would begin to play out have been pushed out, but they are not structurally damaged. With 20-20 hindsight, we probably leaned too far cautiously in terms of weightings or factor exposures across the portfolio, but as I’ve pointed out several times this year, we have seen nothing that would make us feel otherwise (except that the stock action of technology and cyclicals are strong, even if their fundamentals remain uncertain, if not cloudier). And our margin-of-safety continues to expand, despite their forward earnings growth potential. Our portfolio-weighted forecasts (which tend to be conservative) has normalized earnings at nearly +60% vs the trailing 12 months (and this +60% excludes 2 names, together accounting for 20% of the portfolio, whose trailing 12 month EPS were negative [and thus infinite growth], one due to a large asset impairment loss [and the stock went up on the news] and the other is a revenue model change to a subscription based service, causing near-term earnings decline [we began our investment well after the service began and after EPS first turned negative]). While the number of years to reach our normalized earnings varies by company, the portfolio-weighted EPS CAGR is +12% (excluding any potential buybacks). Even if our forecasts are absolutely wrong and earnings are flat vs their trailing 12 months, our PER is 14.1x vs trailing TOPIX at 15.7x (TOPIX mid-caps 16.9x, TOPIX small-caps 14.3x). I still believe that we are headed for a recession or, at least, a significant slowdown (and not just because the Sage said so). I also believe that the markets are too optimistic, and equities will go down before they go up as I think it should. As Dominick Cobb, the main protagonist in the movie “Inception” said, “Downward is the only way forward.” As such, while it is terribly frustrating, I have very strong faith in our existing portfolio companies that we can easily outgrow this cycle and would even add to many of them (as well as others) if I could.
But if I were to take yet another step back, there’s an argument that the TOPIX trailing PER of 15.7x (and trailing EV/EBITDA of 5.6x) are themselves extraordinarily cheap, many of whose constituents clear both our “Q”uallity hurdle as well as our “V”alue hurdle (as the Sage also apparently believes, at least with the trading houses, which, by the way, we tend to avoid but not for the reasons Mr. Buffett likes them). As we are fully invested and still waiting for the EPS growth of our existing names to be fully realized, we cannot add these other cheap, high-quality names in our portfolio without selling our existing names, something I certainly do not wish to do given the potential outlined above. And this opportunity has nothing to do with the sub-book trade which I would argue has gotten ahead of itself anyway as most stocks trade below book for a good reason. To explain simply, I take an excerpt from my last quarterly letter to our LPs here:
“[T]his may surprise all of you, but Japan’s EPS growth, if one strips out inflation, has actually been HIGHER than the US. I happened to read that in an article and decided to check myself using EPS figures (EPS before extraordinaries, EPS of continuing operations, and just the simple EPS) of the Topix 1000 (which is closer to our investment universe than all of Topix) via Bloomberg from 2003 which was as far back as was available [which coincides with the bottom of the IT bubble collapse] and inflation data from the IMF. I compared that with the S&P 500 which includes, of course, Apple, Microsoft, Amazon, Nvidia, Google, Tesla, Meta, and Berkshire Hathaway, to name a few. And the compounded annual growth rate after stripping out inflation was +8.5%~+9.2% for the Topix 1000 vs +6.3%~+8.0% for the S&P 500 depending on which EPS you use, while the index returns were 78% and 245% respectively [NOTE: this does not include dividends, but dividend yields have generally been higher in Japan post-GFC]. And this doesn’t consider the higher rate of buybacks in the US which probably pushed EPS a few notches above earnings growth rates (one of these days, I’ll do a more scientific analysis of this). Consider what might happen to Japan should inflation really stick, buybacks become normal, and valuations become more aligned.
I leave you with that thought.”
Masaki Gotoh
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“I think positive emotion trumps negative emotion every time. We all yearn for reconciliation, for catharsis.” – Dominick Cobb, played by Leonardo DeCaprio, in the “Inception”.
I, myself, do not believe in fortune-telling. But I do know that it is big business here in Japan, as well as many other Asian nations. There are famous street fortune tellers who have clientele line up for hours to divine their future. Even CEOs of some major corporations seek advice from fortune tellers. I remember my ex-wife went to some astrology-like class once a week or so and studied up on … well, whatever astrologists study. It had something to do with the characters of your name, birthdate, and probably something about the heavens. I figured it was a harmless (and not egregiously expensive) pastime as long as we didn’t use those “visions” to make important decisions (although I think she did use her “knowledge” when we were choosing our daughter’s name). And, sure, I think I have a deck of tarot cards somewhere in my basement, but it was all just good fun.
One very popular type of fortune-telling is based on blood type. Apparently, there is a theory, or rather belief, that a person’s blood type indicates one’s personality (and, thus, can help when finding your partner). Some people take this very seriously as if there was some scientific evidence that proves this. I have not read it. Maybe there is some evidence of correlation, but I’d guess that it’s not statistically significant and, even if there were, I’m almost certain there is no causal relationship. Human personalities are extremely complex and I’m absolutely certain one can’t separate it into just 4 distinct groups.
Still, it’s a common part of the mating ritual to ask what blood type your partner-to-be is. I had always thought I was type B, but that’s because in middle school, I was in a science class that required us to test it ourselves. Many of us were too afraid to prick our own fingers, but fearing a failing grade, we’d do the quick prick during the last 10 minutes of class and rush through the blood type checking process (which I absolutely do not remember). My results came out type B- but, knowing that is rare, I figured I must’ve mixed up some chemicals by mistake and told myself that I was type B+. So, all through middle school, high school, college, and my Hitachi days, I’d tell anyone who asked that my blood type was type B (and you’d be surprised how many Japanese people ask when you’re young). Anyway, they’d inevitably say, “Yes! You seem like a B”. They say that type B persons are extremely curious by nature and reacts instinctively. They are spontaneous but forgetful and makes decision impulsively. They dislike being tied down or following the herd but are open to many different types of people, views, and ideas. They are creative, out-of-the-box thinkers and have many diverse interests but are easily bored and completely ignores where there is no interest. They are introverted and take time to gain their trust but easily attached once the bond is made. They are emotional but very pragmatic, and generally an optimist. I used to say, “Yes, I am like that!” and believed my blood type was B.
Later, before going to Kellogg, I had to do a blood test and so I asked the doctor if he’d check my blood type. It turned out I was actually type O+ which, by the way, is the most common type in the world. OK, so now the blood type personality theory says that I have a lot of vitality and focus on specific goals to completion and unsatisfied otherwise. Type Os are romantic but a realist and thinks very straightforward to the point of oversimplifying. They are strongly bound to family and close friends but cautious and distrustful of others. And so, they strongly value relationships and trustworthiness. They, like type Bs, tend to be optimistic so, within their group, their bright personality helps lead the group. They are individualistic and assertive but are also laid back because they’re not very organized. They often lose track of time, especially as they value their time alone, and yet dislikes actually being alone. And while they have a strong desire to succeed in their goal, they can also accept defeat quickly. So then, I said, “Yeah, I have a lot of those too. I must be O.”
My father is type B but my mother is type A. According to the blood type personality theory, this is the second worst combination you could have (the #1 worst combo being a type A father-figure and type B mother-figure). Type A personalities are very logical persons and need a strong sense of purpose (as opposed to a goal). Similar to type O persons, they pursue that purpose but more obsessively and hate half-hearted efforts. They are very particular to detail, and dislikes change, opposition, or conflict. They can control their emotions (although occasionally prone to outbursts) and are very sensitive to other people’s feelings. They are very humble and just all-round nice, caring people that can look across the group to balance the team. They like rules, structure, and order and are particularly strong with organizational skills. They take responsibility very seriously and expect others to follow protocol, both written and, more importantly, unwritten ones, making them good leaders. At times, they can be stubborn and short-tempered as they allow little room for gray areas. They work hard and very meticulously, and they get better as they master their work, enduring the pain in order to do so. And, unlike type B, they are perfectionists and pessimists (but deep down, they want to break out of their shell). These traits are also very typical Japanese. In fact, unlike the rest of the world, the largest blood type group in Japan is type A (this is also true of many countries in mainland Europe).
My mom fits the type A personality perfectly. My parents’ home is perfectly clean; you can literally eat off the floor (although she wouldn’t let you). The refrigerator is filled with small Tupperware of various leftovers perfectly aligned with a little bit of everything. And if something needs to get done, she won’t forget and will get it done perfectly. But she rarely goes out of the house and is constantly complaining about life. Despite being outwardly calm and neighborly, she’s also a hypochondriac and always worried about her health, money, family, China, North Korea, politics, and just about everything else. Conversely, my dad is on the extreme of type Bs. He decides everything on the fly and is very forgetful. I’ve missed 3 flights in my lifetime for arriving late to the airport and they were all with my dad and, each time, he said, “don’t worry, we’ll be fine”. Unlike my mom, he is very active and cares about how he spends his own time. Because of work and school, I only have time to visit my family once a year so my parents can see their grandchildren, but it’s not infrequent for my retired father to say, “I’m playing golf that day, can you come another day?”. He has a lot of friends because he’s a fun guy to hang out with and has interests about everything and everyone and never holds a grudge. He lived alone in China for several years working at Sharp and marched along one of the anti-Japan demonstrations because he thought it’d be a new experience. Retired now, he volunteers to help Chinese residents or tourists learn about Nara prefecture where my parents are retired and is ignorant of the political tensions. As another example, I remember one of our annual summer family road trips in the US where he picked up a random hitchhiker in the middle of nowhere (and my mom was sweating the entire time). One can understand why an A and B don’t mix. I’m surprised they’ve been happily married for so long … well, at least not unhappily married. I suspect my dad simply doesn’t notice when my mom was irritated with him (which was and is generally all the time), but that’s also what’s kept them together.
But I think to myself, “I’ve got some of my mom’s traits too”. People who know me well will tell you that I can be extremely stubborn and short-tempered. I also follow the rules, although I won’t blindly follow them and want to understand the purpose if I feel uncomfortable about it; I assume someone much smarter than I had a good reason why that rule or process or law exists, so I just want to logically understand what that is. Admittedly, my attention to detail could improve, but I, too, take my own responsibilities obsessively seriously (although that thoroughness does not extend to others around me, which is why I’m a terrible teacher). And while I probably am a bit overassertive, I believe myself to be fairly humble. Similarly, there are many O traits that I do not have, such as the fact that I don’t like to oversimplify things and, while I like to win, I don’t accept defeat that easily either (I’ve never forgotten any of my major losses). I don’t know many type AB people but I’m sure I have some similarities with them too. So, I doubt there’s much to this blood type personality theory. But most significantly, I am both an optimist like my dad and a pessimist like my mom.
And that’s why this year has been particularly difficult. I’m extremely “unhappy” that we are “losing” (to the benchmark). I understand why but it doesn’t comfort me because I haven’t accepted it. I trust my work and that of my colleagues and I can logically see that we should prevail. But I worry that maybe we are wrong, or maybe we are missing something. The market seems to think so (at least in the short run). So, I worry constantly. I run multiple scenario analyses in my head, whether it be on a single stock level, a portfolio level, or firm level. I think about risks and possible responses when I wake up, while I’m in the shower, and even while I’m playing with my kids. I especially think about it during my time alone in the evenings or over the weekend and holidays while my kids are playing. And all of that thinking brings me to the same conclusion; we should not be doing much with the portfolio … and we haven’t. While the pessimist in me is constantly worrying, the optimist in me knows that we’ve done the work to maintain our long-term conviction and we’ll eventually prove our worth. And I have strong conviction about our team, which is what matters most.
Positive emotion should trump negative emotion. And I, too, yearn for reconciliation. But it takes time and endurance. I hope it’ll be a lot shorter than the time Cobb’s team spent in level 3 of the dream world.