Dec 2024
[…] As we had highlighted over the past year, the beta-led rally of 2023 continued up to CQ1 of 2024. However, the post-COVID optimism came to an end as reality set in and the supply chain bottleneck that caused long lead times and overstocking lead to excessive inventory levels. We had highlighted how order growth had turned negative over 2023 yet both the topline and bottom line were strong as companies had worked through their backlogs, with the added kicker of a weak yen and price hikes contributing to strong earnings growth. The market hope, I suspect, was that orders would return before backlogs were diminished. But demand remained weak throughout most of 2024. Additionally, the delta from the widening price-cost gap had begun to wane or even reverse as price hike fatigue began to set in while input costs marched higher. Additionally, container freight rates in 2024 had risen significantly on a dollar basis and thus even more so on a yen basis. And the full year effect of the wage hikes became an additional burden whose pace of increase had been unseen in Japan for 30 years. If it weren’t for the continued weak yen that helped the topline of exporters (even though most of the gains are translation gains, not transaction gains), I suspect we would’ve fared significantly worse. While I don’t know the specific number, I estimate about 60% of the weighted average revenue of the Nikkei 225 constituents are generated outside of Japan and the 250-day moving average of the currency weakened by about 6.7% in FY2024 vs a yen-based revenue increase of just +3.9%. Despite the fact that the JPY continued to weaken from Mar fiscal year end by another 4.6%, the Nikkei 225 was actually slightly down since the end of March on both yen and dollar basis (note, I use Nikkei 225 in this analysis as I don’t have the processing power to calculate similar figures for the 2000+ constituents in Topix [this was written before the change in Topix constituents to below 1700]).
As such, I would argue that FY2024 had not been a fundamentally strong year. However, it was a strong “governance” year. Payouts among the Nikkei 225 constituents (excluding those with negative earnings) rose an index-weighted average of +16%, +12% from dividends and +4% from buybacks despite net income rising only +6%. This compares to the previous year’s +6% rise in payouts, +3% from dividends and +3% from buybacks, while net income rose +19%. While I loathe to use the forbidden four words, this time WAS different. I have many theories as to why that is which I won’t elaborate here, but after 25 years of analyzing Japanese public equity markets, I don’t think I’ve seen a change as significant than what had occurred in the past 2 years.
I believe this momentum to continue, although the delta will probably not be as high. There are a couple of factors to this. First, it was primarily the large caps that have led the change. The tables below show the PBR/ROE of the broad Topix index with it’s 2000+ constituents [at the time] and the same figures for the top 100 names, second 400 names, and the remaining 1500+ names.
The top 100 names accounts for about 67% of the broad market and its PBR had risen along with its ROE (although still at a pathetic 10%; a proper analysis should probably exclude financials but, again, my processing power is limited and I must accept what Bloomberg computes). As a comparison, the S&P 100’s ROE was about 20% and valued at PBR 6.0x (interestingly, last year’s ROE was slightly higher, but PBR was 5.1x and the year before that, it’s ROE was even higher at 21% but PBR was 4.3x; in other words, ROE had been relatively flat, but PBR had risen over 40%). Back to Japan, the PBR of the next 400 names had actually fallen from 10 years ago while it’s ROE has been flat. And with the remaining 1500+ small cap names, the PBR had similarly fallen but ROE had actually risen. The phenomenon was similar in the US with the S&P midcap 400 index’s ROE rising from 8.9% 10 years ago to 10.7% while it’s PBR had been flat at around 2.5x. The Russell 2000’s PBR and ROE have both fallen during the same time horizon (I would also note that the ROE of the Russell 2000 has been consistently below that of the Topix small caps, although its PBR had been over 2x over the past decade whereas Japan’s small caps were barely at par).
The mid/small cap companies still have some ways to go to the “implicit” target of 10%. Why 10%, I have no idea, nor why it should be satisfactory for all industries, but most everyone seems to think that is the magic number. I have no doubt that the JPX will continue to drive this change, but the financial literacy of Japanese companies falls almost exponentially as market cap declines. While this is my personal view, there is also a simple fundamental reason why this should be; it is simply that mid/small cap companies have fewer resources. CFOs are still rare even among large caps (and well-educated ones, even more so). Fewer global investors own smaller cap companies, thus not receiving the necessary knowledge base from its shareholders versus their more forgiving (indifferent?) domestic institutional, retail, and cross-shareholding counterparts. And even if they did, I suspect their English aptitude is lower. Furthermore, in an environment where labor costs are rising, IR is probably not a primary focus of headcount increases, particularly in such small/mid cap firms that have historically been able to ignore or, at least, lower the priority of shareholders. It’s no wonder that some companies have decided to throw in the towel and delist. The operational hassle of staying listed has risen and will continue to rise if the 2025 JPX agenda is any guide. In any case, the incremental upside will likely be slower.
Secondly, now that large caps' ROE are at 10%, I don’t expect them to shoot for higher targets. I’ve noticed that companies who have naturally high ROEs, simply because their industry commands much higher profit margins with fewer assets, seem to spend less space in their deck about balance sheet efficiency. Presumably, the check-the-box Stewardship Code signatories aren’t pushing companies who already generate “sufficient” ROEs.
And finally, I suspect most companies still don’t quite understand ROE. Ever since the JPX had “requested all listed companies … to take action to implement management conscious[ness] of cost of capital and stock price”, companies have provided a nearly copy-and-paste template of their PBR breakdown with ROE x PER which explains how they intend to raise both. I suspect there is a consultant out there that is providing this template because it looks nearly the same with most every company. Worse yet, some of them are simply wrong. As an example, I’ve seen one that said their PER is low due to high leverage so they plan on bringing down that leverage, which may be true but, all else equal, this would also reduce ROE so they should discuss improvement in asset turns and improving their balance sheet efficiency, which is generally not mentioned, assuming somehow that ROEs can be maintained with lower leverage.
What management should be thinking about is ROIC and ROE (and the JPX is satisfied with a discussion of either or both). But seeing that most companies don’t have a CFO nor do they truly comprehend ROE much less ROIC, I’d say we are still in the 3rd inning or so. While that may sound depressing, we hadn’t even started the ball game in Japan until 10 years ago and spent most of the last decade hitting foul balls with the game standing still in the 1st inning. So, the speed at which we’ve moved along in the last 2 years is incredible. It’s also a matter of perception and whether the glass is half full or half empty (or rather 1/3rd full or 2/3rd empty).
As such, I think investors should be very selective. The valuations for small/mid-caps are, as per above, attractive. The weak financial literacy requires some handholding with management teams, but with those willing to listen. We have 2 very small-cap companies who had only a textbook knowledge of ROE whom we have converted to ROIC metrics for their business. By doing so, they need to consider how to spend operating cash flow to raise or maintain their ROIC, thus thinking more carefully about capital expenditures. We also had them maintain their (preliminary) ROE targets such that excess free cash flow would not be wasted by sitting on the balance sheet (something ROIC would not capture). Of course, this is not unique to small caps, and we have similar discussions with our mid cap (and even large cap) companies. And I should repeat that since we only invest in high quality businesses, we can feel assured that operating cash flows will continue to rise through topline growth via market share gains and, most recently, through price hikes that can more than outweigh the inflationary environment to come. This growth can help secure much needed resources such as labor or innovation, creating a virtuous long-term cycle.
Despite all of the reasons to worry about 2025, I am excited about the opportunity set in Japan more than ever, as long as one can stay focused through what may become more violent cycles in years to come.
Masaki Gotoh
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“If things get hairy, just remember the most committed wins.” – Elise Kraft/Sharon Bridger, played by Annette Bening in The Siege (1998).
I had a very busy New Year’s holiday season, despite the unusually long break. It was a 6-day national holiday, although if one opted to take Dec 30 off (as I’m sure many had done [I had not]), it would’ve been a 9-day holiday. During those 6-days, I had to take the family to the in-laws and then to a 4-day ski camp. Additionally, as TriVista Capital is one of the judges for Nikkei’s Integrated Report Awards, we each had to read 5 integrated reports of randomly selected companies. I got stuck with 2 unlisted credit unions which meant, not only do I need to read the reports, but I had to research how the Japanese banking hierarchy worked and why such credit unions are needed in the first place; it was absolutely fascinating to learn though, being unlisted, it doesn’t help much with my companies except to conclude that there is probably very little purpose for regional banks to exist.
Additionally, I will be speaking at a conference that is promoting emerging managers and was asked to share my experiences (by the way, as defined by Japan, TriVista is still an emerging manager so there is, of course, a promotional aspect to this charitable gesture). Given that my history with partners had been largely with the non-Japanese E&F community, I decided to reread Dr. David Swensen’s “Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment”. Also, as I asked to change the title that the forum chose from “… Perspectives from Emerging Managers” to “… Reminiscences of an Emerging Manager”, I also decided to reread “Reminiscences of a Stock Operator “ by Edwin Lefevre which I hadn’t read since when I received my offer from Goldman in 1997. I figured I could find a good quote that I could throw in the presentation somewhere (I did). Between this, I also spent time on the phone nearly every day over the entire holiday with differing parties regarding one of our portfolio companies.
As such, I had very little time to relax. So, as I often do late at night after everyone is asleep, I had a few extra glasses of Champagne that my wife selected for me (or, to be accurate, allowed me) to drink, and rewatched an old movie. Probably because it was near Christmas and also that I had just watched the 3rd installment a few months back, I received many “Die Hard” series suggestions from the streaming services I subscribe to (yes, Die Hard, at least the first two, is a Christmas movie, in my view). But I also received other Bruce Willis suggestions, and “The Siege” was one of them which I had watched many, many years ago. It features an all-star cast with Denzel Washington playing a strong, honest, by-the-book, FBI anti-terrorism expert (similar to many other characters he plays but I like him a lot, all the same), Annette Bening (another one of my list of favorite actors with great performances in movies like The Grifters, Regarding Henry, Bugsy, American Beauty, and Being Julia) who plays a somewhat unconvincing CIA agent handler, and Bruce Willis, a hard-core, even sadistic and racist general who, after several terrorist attacks in New York, takes command of the city after martial law is declared. It was an easy-to-watch, fun action movie where, as you would expect, the good guys win. However in 1998, it was 100% pure fiction; in 2025, it feels frighteningly real.
There are a lot of great quotes in this movie by all three actors. Bruce Willis’ speeches were commanding, Denzel Washington’s intensity was dramatic, and the witty comebacks from Annette Bening were short and memorable (like “It’s easy to tell the difference between right and wrong. What’s hard is choosing the wrong that’s more right”). But the quote above struck a chord.
It hasn’t been an easy 5 years. We are blessed by having great partners who have supported us from day 1; while some had to move on due to organizational and personnel changes (and our underperformance in 2023 certainly didn’t help during those transitions), they have continued to support us to this day. While one of our original three TriVista partners decided to move on for a career change, we have an awesome team of tight-knit professionals whose integrity and honesty I trust implicitly. Needless to say, they are all really smart and very hard-working. We have many other non-financial supporters including people in the Tokyo Metropolitan Government, the JPX, and members in the media. I have a wonderful network of like-minded managers across the world investing in Japan.
But the markets have been unkind. I can’t think of another time during my financial history where a shock event had affected the global economy and the equities market for as long as and with as much uncertainty than COVID. I’ve lived through the Asian Financial Crisis, LTCM, the Dot-com bubble, the Great Financial Crisis, and the Great East Japan Earthquake but, in retrospect, none had such a lasting effect. Arguably, the GFC led to our current state, and one could even argue that they are all related (except the earthquake). But COVID was a truly extraneous shock which culminated into a 5-year disruption to the “normal” order of events. I’m guessing that the dramatic changes in politics and the global conflicts during these 5 years wouldn’t have changed the outcome much but only accentuated them, whether it be through the massive subsidies (which both politically and economically made sense), the huge swings in commodity prices, or the sharp rise in shipping costs. The human race was probably lucky that a vaccine was developed and distributed so quickly, but the impact to the economy was damaging with some irreversible outcomes (both good and bad).
The entire world was essentially shut down in 2020, started to recover in varying speeds and timing in 2021 depending on the country, which then kickstarted the business cycle in 2022 only to find that the global supply chain was much more fragile than expected, driving massive inflation and a huge rate hike cycle that was sharper and higher than the lead up to GFC (and on a global scale) throughout 2023, which in turn lead to oversupply as production caught up to the artificial demand created when customers were scrambling for product/service in 2022 creating an inventory destocking cycle which appears to have largely been worked down by 2024. So, on the business cycle front, I believe we are finally back to “normal”. However, this is where politics and the current state of interest rates vs inflation may affect the demand side of the cycle. And the current state of global affairs is one that could truly affect both the supply side and demand side in the coming year or two (and perhaps longer).
But throughout these 5 years, we’ve adamantly maintained our fundamentally based, quality-value philosophy. Many times, especially in 2023, I had become uncertain as stock momentum was clearly against our strategy. But what kept us from wavering was our commitment to fundamentals. We might have gotten the valuations wrong or we might have jumped the gun (both buys and sells) a few times. But we remained committed to finding high quality businesses at low valuations, which generally is equivalent to “unpopular”; the key is trusting that this unpopularity isn’t structural and how long it stays unpopular. Of course, many of the (popular) beta-led high-flyers in 2023 were very high-quality businesses and they continue to be to this day. But they were not cheap and driven by hope which, at least for a short period of post-COVID recovery, was right. But it was hard to believe or justify that this recovery period was the norm. Furthermore, our research process is long while changes to market expectations are exceptionally fast, probably coming from that cheap money from 2009 up to 2022. While we have rectified that issue but adding more global growth-cyclicals to our wish list, our bias currently remains stable and domestic.
Despite all of these comments, I have no idea if we can outperform or underperform in 2025 or any other year for that matter. I could make an argument for a strong 2025 and one for a market crash, but that is not what we do; we don’t make macro bets. Of course, we closely monitor the global business cycle as this obviously effects the businesses that we own. And obviously, we would prefer to buy/add near the bottom or on its way up and not when it's falling and the end is uncertain, so timing is not arbitrary. But there is a reason that we like cheap, contrarian, unpopular companies. Not only does value provide downside protection, but our stock selection looks for upside from more idiosyncratic reasons and less from the cycle and rarely from valuations or multiple expansion. We do offer help (occasionally insist) in order for the company to gain recognition and perhaps think about their balance sheet better, and if that were to culminate into multiple expansion, we would certainly not mind. It’s just that we aren’t dependent on it because we invested at cheap multiples to begin with. Our growth comes from market share gains and their ability to increase value and raise prices regardless of the cycle.
The bulk of our current portfolio is made up of such names. And we have quality companies on standby waiting for better visibility. And we will continue our deep commitment to this core fundamental investment philosophy, in both good times and bad. As 2025 looks like it might get particularly hairy, we must stay committed to succeed.
