Unlike the previous month, factors were less of a driver of the market with no noticeable difference between growth vs value although there was a slight cap bias toward small caps. There was wide industry dispersion where energy and utilities were up over +30% while tech was down -17% in Japan (none of which we have significant exposure to). However, the biggest driver of the market was the sudden U-turn by the market after hitting lows in June/July due to a change in expectations regarding future actions by the Fed. As I had mentioned in the previous monthly, I was confused with the abrupt reversal in sentiment regarding the tightening cycle. Although we all assume the tightening to proceed, the market must have been hoping (naively) that they’d step off the gas, and maybe even put it in reverse, if the economy slowed. But I don’t think anyone actually expected dovish commentary from Jackson Hole. The chief investment strategist at State Street summarized it best when he said, “the biggest surprise here is that investors were bracing for Fed Chair Powell to talk tough on inflation, yet are reacting negatively after he did exactly that.” (Excerpt from the WSJ, Aug 27 edition). So much for efficient markets. In hindsight, the July-to-mid-August bounce was nothing more than a bear market rally. It wasn’t the first and probably won’t be the last if history is any guide.

 

In this environment, we actually concentrated our portfolio even further by reducing or eliminating some of the more economically sensitive names or those that have performed well during the last few quarters but are expected to face tough hurdles in the second half. We now only have 13 names (vs 16 at the end of July). August was earnings season and most of our stocks performed well after the Jun quarter results came out. Most notably, Macromill, our top holding, returned +16% MoM after strong guidance for the next fiscal year (their fiscal year ends in June) which was even ahead of our forecast (and well ahead of consensus). Of course, they (or more importantly, their clients who are the digital advertisers) are also sensitive to the economy so we’ll have to monitor how much share gains of digital advertising vs traditional advertising can offset a slowing broader economy and the tighter advertising budgets. But they are still trading at ridiculously cheap multiples of 13x forward earnings on a business that we believe will be able to grow bottom line by 20% per annum for the next 3 years. It remains our largest position and we have not made any changes to it.

 

The other surprise was another company that we’ve held since inception, but one who has been able to transform their business in just 2 years during the pandemic. It is a company that has top share in staplers (yes, the thing you use to, well, staple piles of paper together). When we launched our fund (right before the pandemic), we believed the markets to be somewhat rich (and, in retrospect, not the ideal time to launch a long-only fund). Therefore, we had tilted our portfolio heavily toward safe, stable businesses that were cash rich. This company had a near global monopoly of staplers in copy machines and 70% market share of manual staplers in Japan, a country that was (and still is) much too dependent on physical paper. Of course, they don’t just make staplers, but the company’s strategy was to focus on office and construction tools where they can also sell the consumables (and, therefore, they also have top share of the actual staples), thereby generating very high margins. 2/3rd of the market cap was in cash, and they had a 50% payout ratio, but the stock was only trading at 13x multiples . This seemed like a wonderful little niche company to hold if one thought the market was rich. Of course, the pandemic changed the landscape and we all stopped going to work to staple stuff. But in just two years, the company spent enormous resources on accelerating their industrial tool products, particularly for the US. Pre-pandemic, 60~80% of their earnings were driven by office tools. Now, 70% is driven by industrial equipment, mainly their rebar strapping tool that has top global share and yet penetration rate in the US (the primary growth market) is still only 20~30%. And, as per their strategy, they also sell the patented tie wire that is used to tie the rebars.

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They came out with a highly aggressive 2-year target earlier this year, but in just the first quarter of that plan, they’ve already had to revise up their guidance for this year (and with the exchange rate where it’s at, they’re probably above that too). We stuck with the name during the difficult pandemic as we watched them rapidly transform themselves. Due to liquidity constraints, we could only build it to a 5% position (which was, when we launched with 20 names in the portfolio, an average position size). But it finally bore fruit this quarter and we expect this to continue. Coverage is light (just one sell side analyst), but we are trying to educate the management team on better balance sheet management. Cash still accounts for 50% of their market cap, but the only reason this figure fell was because the market cap has risen. They are a small conservative company that, until recently, made money on staplers, label printers, and hydraulic nailers, so we expect it’ll take time for them to address their balance sheet. But in the meantime, we can enjoy their growth as Biden’s Infrastructure Investment and Jobs Act should help accelerate growth of their rebar tying tool. While the position is small, it accounted for 20% of our outperformance this month.

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We expect more volatility to come but I think we are positioned where we want to be and will likely make only minor adjustments as we enter the fall.

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Masaki Gotoh

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“It’s amazing how productive doing nothing can be.” – Kevin Flynn (played by Jeff Bridges) in Tron Legacy.

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​Recently, I won the draw on Amazon Japan for a Playstation 5 (not for free; it’s a lottery to have the right to purchase it). As a Prime user, I was entitled to one draw and, amazingly, I won (I NEVER win things like this). I figured I’d double my money by selling it on Mercari (a popular C2C marketplace in Japan), but my sons found it before I could sell it and begged me to keep it. And so, I now own an expensive gaming machine even though I, myself, am not much of a gamer. I used to be a casual gamer when I was young. My parents bought me an Atari 2600 when I was very young but, early on, I upgraded to PC games and even spent time trying to make a few (unsuccessfully). I’ve also owned a Super Nintendo, Sega Genesis, and the first Playstation, but my gaming history largely stopped there (I did get a PS2 but used it as a cheap DVD player and I did buy a Nintendo DS/Wii but that was only because I was invested in the stock over 15 years ago). So, when I broke out our new PS5, it was too complicated for me with way too many buttons on the controls; of course, my children understood how to use it instantly. But because I struggled, I only bought one racing game (which doesn’t require the use of the many buttons if I play it in “easy” mode). And I also ended up downloading very old games from the past (thus wasting the massive computing power of the machine; I clearly don’t deserve to own a PS5). But that’s when I remembered TRON, a Disney movie well ahead of its time (and was later adapted to a fun arcade game I spent many quarters on as a kid).

 

My sons and I decided to watch the original TRON and the sequel Tron Legacy over the weekend and, I have to say, it was amazing to rewatch. I had forgotten how much I enjoyed the films with its very cool special effects. What really captivated me was how early they were in forecasting the future. The first film was made in 1982, well before the Internet, but they visualized an information highway where data and programs would move about connecting people. And, of course, the real vs digital alter ego that is the essence of the series is exactly what the Metaverse is now (or going to be). Also, the Tron Legacy sequel makes theological and philosophical inferences, particularly with regards to transhumanism which may be where we are headed next, if one believes in that sort of thing.

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I won’t go into specifics but, for those that haven’t seen the series, it’s about a computer whiz named Kevin Flynn that accidentally “enters” the computer world in the company he used to work for while looking for proof that the hit games being sold by the company were actually stolen by another, now very senior person of the company. In the digital world, he ends up playing the very games that he developed (as a physical representation of a digital program) in order to obtain proof of that theft. In the sequel, Kevin Flynn is now the CEO of the same company, but spends most of his time in the digital world, attempting to create a utopia within cyberspace. He discovers a species naturally born within the digital world that could potentially fix all the ills of the real world. “Biodigital jazz, man”, as Flynn would say.  However, the programs in cyberspace see utopia as perfection (being the logical constructs they are) and anything imperfect, such as a random species from nowhere, must be destroyed. The cyberutopia becomes a dark world where Flynn must now hide as he is the only one who can open the portal to the real world. The leader of the program constructs wants to leave cyberspace and direct his armies to the real world to remove it of its impurities. And that is why Flynn chose to do nothing and hides for a period of 1,000 years in cyberspace (equivalent to about 20 years in the real world) before his son, who has been seeking his father, inadvertently opens that portal connecting the real world and cyberspace. Unlike the wild and crazy Flynn in the first Tron, he has become much more serene, even Godly, when his son finds him as he had turned to meditation and Buddhism, presumably to stay sane while he was alone for so long.

 

Doing nothing was extremely productive for Flynn. He kept the real world (and his son) safe from the perfectly logical, cold programs that he, himself, developed to help create what was supposed to be the perfect world. We learn that perfection is not utopia and it’s the imperfections that makes life so beautiful. But it was at the cost of extreme solitude.

 

Admittedly, I’ve felt similarly for several years with our value-based investment strategy. It has been painfully lonely for the last decade and the market can be cold. But it is, at the same time imperfect and it is when we find those pockets of imperfection can we enjoy the fruits of that discovery. Right when the tide looked to have turned late last year and the value darkness turn to light, the war in Ukraine, high inflation, and all of its compounding after-effects have made the future unclear. While I do believe that the world won’t be reverting to the cheap-money-driven, growth-at-all-cost investing strategy of the past several years, I don’t want the opposite either, a deep depression where neither growth nor value work (we are, after all, equity investors). While the future is uncertain and there may be some short-term pain (whether it is a soft or hard landing recession), I do think we’ve made progress toward a more normalized world where inflation will (eventually) be at 2% with positive real rates so that stable, but not exorbitant, growth can return. I’m guessing it’ll take at least a couple of years before we reach that equilibrium.

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And, in the meantime, there will be bouts of extreme optimism and pessimism. Like Flynn says to his son, “You’re messing with my Zen thing, man”; the market will be fickle.  I’ve always preferred markets to be more volatile than the underlying fundamentals (which is why stocks get overly cheap and rich and provides the imperfect opportunities we seek) … but not to this extreme. So, I too will try to stick with my Zen thing and ride out these short-term waves of irrationality. As I write this (Thu Sep 8), I notice that Japan is up over +2% after a strong US rally last night, presumably because it’s simply been down so much in the last three weeks. But I’m sure it’ll pass.

So, if you’ll excuse me, it’s time for me to meditate.​​