As I have been complaining (sorry, “observing”) that our underperformance during 2023 and the first 3 months of 2024 was due, in large part, to the lack of large(r) caps, high beta cyclicals, and tech in our portfolios, our outperformance this month has less to do with good performance by our own stocks but a reversion that benefitted our small/mid-cap, lower beta, and domestic-led portfolio during this month before earnings season fully kicked in. There was a clear daily inverse correlation between the absolute market moves and our relative performance against them. The spread between MSCI Large Growth (-2.6%) vs MSCI Small Value (+0.4%) indices was noticeably wide. Those that have been following us probably know that we are hardly “value” since most of our stocks trade well above book and/or have high ROEs vs their peer group and have historically grown earnings faster than their peers, but it’s a convenient spread to watch because growth indices tend to be driven by high beta cyclicals and tech. By the way, as a side note, I noticed that Topix PBR is now 1.5x despite an ROE of sub-9% according to Bloomberg so Japan ain’t all that cheap anymore.
 
Earnings are well underway with about 30% of Topix constituents (or about 650 companies) having announced their earnings as of yesterday. In terms of market cap, I suspect it’s higher since small/micro caps tend to announce later due to fewer resources to release earnings more timely. I try to monitor as many as I can each day and my 1st glance observations has been that, regardless of the market movement the next day, the stocks have tended to trade as one would expect from their forward guidance which have been more negative than positive, notably in autos and tech, at least for the next day or two. Of course, with the currency where it’s at, there is a huge buffer since most exporters are using 140 or 145 as their forecast rate. Still, even if one were to strip out the negative effect of currencies from their forecast, volumes look weak and margins even weaker. As we had forewarned, many of the reasons for the lack of margin expansion have been inflationary cost pressures amidst greater price hike resistance and increasing labor costs. As such, most companies have weaker forecasts for the first half (Apr~Sep) where visibility is higher and the hurdle should be easier, particularly with regards to FX and the price-cost spread as the effect of price hikes became more significant toward the back half of the last fiscal year. And yet, they have assumed a back half (Oct~Mar) turnaround despite lower visibility, a higher hurdle, and little to even negative FX effect, which may be why May month-to-date index performance, notably in large caps, have been noticeably weaker. This is, of course, a generalization and, because autos and tech have tended to announce earlier, we’ll see if the remaining 2/3rd or 1,500 companies guide similarly.
 
One positive that we have noticed is that many companies have offset their lower-than-consensus forecasts with increased buybacks and/or payout ratios. This is driven from a “request” by the stock exchange for companies to publicly announce their ROIC and/or ROE figures, think about balance sheet management, and explain how they will attempt to reduce their cost of capital and/or raise ROE/ROIC. As they usually do, it is not enforced but, as Japan-watchers have, by now, probably noticed, we do not need enforcement but encouragement by the “authorities”. As such, many companies with March fiscal year ends have started to provide a statement regarding ROIC and/or ROE, even though they still seem to not quite understand it. We’ve noticed that many companies confuse cost of capital and cost of equity and often don’t explain how they came about that figure. And if they do provide ROIC figures, they often calculate their IC using equity + debt, which only makes sense if they are managing their assets wisely and efficiently which is pretty rare in Japan. As such, “net (operating) assets” and “invested capital” are usually not equivalent as should be the case. Furthermore, most companies do not consider the effect of goodwill. We want to understand the underlying competitiveness of the business and the ability to generate future cash flows (and disregard whether past management had paid an excessive premium for those assets). Therefore, we tend to look at return on net tangible assets, a concept probably a little too complicated for most Japanese firms, even the large caps. The JPX doesn’t actually clarify how to calculate any of these figures nor attempt to account for the differing accounting standards and simply asks the companies to think it through on their own. While I would agree that there is no cookie-cutter approach to calculate them, their suggestion only makes sense if the companies had CFOs that understood these financial ratios (and most do not). But, in either case, this is good progress, even if companies don’t quite understand it yet (just like they still don’t understand corporate governance entirely, but they are at least going through the motions).
 
This positive is being offset by many companies who are also starting to announce sales of some of their non-strategic cross-shareholdings (with a lot of leeway as to what is considered “strategic”). This is driven by the need to think about things like ROIC where, as it stands now, IC includes financial assets not being used to generate future operating cash flows. Now, don’t get me wrong; that’s a very positive movement and I whole-heartedly support the unwind of all cross-shareholdings. But this also means short-term supply pressure on the market. This will provide great opportunities for stock-pickers like us, but we do have to be careful about timing as some stocks are heavily cross-held and could take quarters or years before they get fully dissolved. At current stock prices, I’m sure banks would have no qualms about putting that downward pressure on their cross-held stocks, as we have seen with some mid-caps held by some of the more aggressive regional banks.
 
This year will be an interesting year as valuations, hopefully, start to reflect fundamentals better. The earnings season thus far seems to support that view. And so, we continue to watch the markets anxiously to see how the array of supply-demand factors will affect stock prices.

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Masaki Gotoh

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“Ronald Reagan Just Saved Israel From Iran’s Attack” – Headline from a WSJ Opinion piece on Apr 17, 2024, by Daniel Henninger.
 
I remember back in elementary school, right around the same age as my elder son Leo, when President Ronald Reagan announced the Strategic Defense Initiative (“SDI”) or the “Star Wars program” in 1983. Being in the 5th ~ 6th grade at the time I heard about it, I obviously didn’t understand the significance, and it just sounded like a very cool thing. I was fascinated by those animated videos showing satellites shooting down nuclear missiles launched by the Soviet Union using laser beams. I also remember there was quite an uproar on how much it would cost and its viability. But, of course, I didn’t care, and I became a huge fan of the president, though I also remember making a computer program that would root for Walter Mondale during the 1984 presidential race because he had chosen Geraldine Ferraro as his running mate (I guess I’ve always liked the underdog … which may be why I like being a contrarian and value investing?). After Mondale’s massive defeat, my loyalty went back to President Reagan as more details of the Star Wars program unfolded. I remember building a model of it for science class and explained how the different stages of the defense program would shield us from a nuclear attack. It was a terribly infantile model, but I had a lot of fun researching it.
 
Of course, I forgot about it rather quickly and, until I read this WSJ article, didn’t even know that the remnants of the program remained to this day. Apparently, it had gone through several iterations, starting with the original SDI program whose public support collapsed along with the end of the Cold War. The organization responsible for SDI was renamed the Ballistic Missile Defense Organization under President Clinton in 1993 and later to the Missile Defense Agency (“MDA”) under President Bush in 2002. The program long abandoned the space-based system but led to the development and deployment of several ground-, air- and sea-based interceptors. According to the article, “within two years of Reagan’s announcement, Israel signed a memorandum of understanding with the U.S. to develop missile defenses” and Israel’s Missile Defense Organization had, with close support from the MDA, developed a multi-layer missile defense array against such attacks; you can read all about it in Israel’s Ministry of Defense website which is rather fascinating.
 
Now, I do not wish to enter a debate about the Middle East conflict; it is much too complicated for me to make a binary statement of who is right or wrong. All I know is that another conflict was de-escalated, thanks to an initiative that began exactly 40 years ago. The irony is that then-Senator Joe Biden was strongly against the program (as were many others at the time). Who would have known that, 40 years later, the Star Wars program would save so many lives?
 
While the result was nowhere similar to the Lucasfilm it was nicknamed off of, the basis of the original SDI remained intact. It was proposed to protect the United States against attack by ballistic nuclear weapons. It was later expanded to protect the United States and its allies against both theater and global missile threats, and it did exactly that.
 
Now, I’ll be the first to admit that we don’t think about our investments 40 years into the future; I have a hard time figuring out what the numbers will look like 3 months from now. But the rationale of our investments is driven by the quality of the business which, as we always say, outlives the economic cycle, growing stronger with each business cycle as our high-quality businesses take share from their weaker counterparts and grow in their respective areas of expertise. And, barring technological or policy disruptions, that strength should remain the same 40 years from now. We try to specifically qualify what that competitive edge is that is so difficult to mimic, and continually review it to assure ourselves that industry disruptions had not occurred (or the risks are still small or uncertain before such disruptions could affect the business in the future). We also must confirm that management is still focused on what they’ve been doing so well and not deviating from it (or at least not too much). The value component simply helps define the entry timing (as well as the exit or reduction timing based on relative attractiveness and risks compared to other existing or potential investee companies in order to keep the portfolio concentrated). Unfortunately, we are not very good at assessing brand new businesses as there is no history to confirm the competitive advantage. But I would expect existing businesses that we would invest in were already quality businesses 20 years ago and will continue to be 20 years from now.
 
According to most surveys since 2000, Ronald Reagan was the fourth most popular Republican president after Abraham Lincoln, Theodore Roosevelt, and Dwight D. Eisenhower and frequently ranked within the top quartile among all parties. My childish support of him later grew to a real admiration as I grew older and began to understand his economic, domestic, and foreign policies. While I can’t say that I would have supported all of his decisions, I, too, would regard him as my favorite US president. His foresight saved many lives 40 years later because the underlying dangers the world faced 40 years ago remain today.
 
The same can be said about business cycles. The current economic cycle was interrupted by the pandemic and its uneven recovery. The aftermath, which may lead to consistently higher interest rates and inflation, may feel structurally different, but businesses thrived when both interest rates and inflation were consistently much higher in the past (even in Japan). While balance sheet management might be affected by interest rates, the underlying business quality shouldn’t be. And so, I suspect little has changed and we’ll go through the ebbs and flows of the business cycle like always. We just require the patience for the markets (who have been hooked on cheap money) to understand the same. I believe we are in the midst of seeing this unfold and that our foresight will see this through.

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