This has been a frustrating month for us. The risk-on, growth-over-value trend from January continued until around mid-February across the world. The S&P 500 Growth index outperformed the S&P 500 by +0.6% during February. This trend was true globally EXCEPT Japan. Value outperformed the broader index by +1.1% (or, nearly equivalently, growth underperformed by -1.1%), and this was true across all market caps within Japan (with it being more acute in small and mid-caps).
 
So why did we underperform so much? In the academic, “Fama-French”-y world, there are only 2 non-market factors, size (market cap) and value (book / price; growth is essentially a non-value stock). For simplicities sake, I too often quote these factors, particularly since there are publicly available indexes that categories stocks into 6 independent buckets, large/mid/small cap and value/growth. Since the constituents of these very basic factor indexes are weighted by market cap, the size factor implicitly outweighs the value factor within each index (i.e. the higher market caps within the small- or mid-cap buckets have greater impact on the index performance, further obscuring what the “factor” return was). And so, they don’t really capture the value/growth factor return. I could pay MSCI for their outrageously expensive Barra model which tries to isolate the factor return through a little bit of standard matrix algebra; I could even do it myself if I had the time (and machine power) to build a factor modeler, which isn’t all that complex. But, even then, it is highly imperfect since it is still dependent on what variables are used to define the factor. In general, the Value factor is defined by companies with low multiples for forward PER, PBR, and usually an EV metric like EV/CFO or EV/EBITDA. Unlike Fama-French, Growth is an independent factor which often uses growth of historical and estimated revenue and earnings. In theory, a company could have both traits, but it is generally standard practice to bias or eliminate companies with high value characteristics within the growth factor and vice versa, thereby attempting to isolate these factors separately. We don’t think that makes particular sense since these growth metrics is a fundamental trait while these value metrics has to do with price; unless one truly believes in efficient market theory (and that everyone values companies exactly the same within the same time horizons), these traits could, and often do, coexist. But this simplistic approach does help to understand overall market trends, especially in a highly factor-/industry-driven market like Japan, especially as there are more players in the Japanese equity market who try to capture the short-term ebbs and flows, in between the longer term fundamental trends that change much less frequently (if at all), as compared to their US counterparts.
 
Using these standardized definitions, however, our portfolio has a mix of everything. Our weighted average PBR of 1.5x is well above the market at 1.2x (for simplicity, I’m using Topix), our forward PER (14.2x) and EV (6.4x) is also slightly higher than the market at 13.4x and 6.2x respectively (if you believe market forward estimates which has EPS growing over 8% this year). Because Topix is market-cap weighted, the market figures are biased to the upside as valuations fall with size. So, our portfolio wouldn’t be classified as Value in the traditional sense. How about Growth? I won’t try to guess what the forward growth of the market is going to be, but our 10-year historical revenue growth was +6.6% CAGR vs the market at +3.0% (in the case of revenue growth, small caps have grown slightly faster than large caps at +4.0%). EBITDA growth of our portfolio was +11.3% vs the market at +4.8% (small caps +5.9%). But we certainly don’t feel like a Growth portfolio either. Our correlations to the Topix Growth index are lower than that with the Topix Value index (although the reverse was true in 2021). In either case, we don’t select companies on historical growth. While our definition of quality, based on sustainability and gains in market share, inherently implies above GDP growth, it is certainly not to the magnitude of your typical growth stocks.
 
But what I am fairly certain of is that we do have a Quality style bias. While our definition of Quality is not quantitative, the general definition used by the indexers and factor modellers often define Quality quantitatively using metrics such as high ROE, low D/E, and low earnings variability. Our 5-year average ROE is currently 12.4% while the market is 7.7%. Our current D/E is 46% vs the market at 131%. And our beta of 10-year EBITDA variability vs the market is 0.84 with only 3 of our 13 names above 1.0, 2 of which have D/E in single digits and the other whose 5-year average ROE is 19% (and only 36% D/E, i.e., the ROE isn’t driven by leverage). To be fair, given our high concentration and the fact that we don’t own financials (who have low ROEs and, by definition, high leverage), we should at least compare each stock by their respective sectors. But the results are similar; the average sector-relative ROE (using GICS level 1) is 8.1% vs our 12.4%, D/E is 84% vs our 46%, and EBITDA variability against individual GICS level 1 industries is 0.89.

So, I think we can confidently say that our portfolio has a Quality tilt. And Quality had a bad month in February, underperforming the index by -3.0%, the widest magnitude among the different factor indices (at least those MSCI Japan style indices that I can retrieve from Bloomberg). Now I am certainly not suggesting that this is the only reason that drove our underperformance. There have been plenty of months in the past where Quality underperformed while we outperformed (and vice versa). However, it certainly “felt” significant in February. To be more precise, it was the high Value AND low Quality factors that seemed like they were massively outperforming, particularly low PBR + low ROE, two factors we lack significantly. And there is a specific reason for the outperformance of stocks with these two characteristics.

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From July of last year, the JPX has been holding a working group to discuss issues surrounding the new Prime/Standard listing. The initial section change was taken very negatively by the market and the media. While this is my personal interpretation, I think they wanted to address this frustration by the market participants. I know there were many managers, both domestic and overseas, that had publicly and directly complained to the JPX about the new listing standards (we were annoyed but didn’t concern us). Along with METI, the FSA, and the larger members of the domestic investment community, they had begun discussing the problems surrounding the new listing standards, and one of the 6 initial themes had to do with the low market PBR, noting that over half of listed companies were trading below book. They specifically cited the low ROEs (over 50% below 8%) and the lack of understanding by management teams of these listed companies with regards cost of capital. It took 10 years after Abenomics started before we finally had begun to see concrete steps to raise ROEs, possibly starting with tighter listing standards in order to force the issue. Now, I know they won’t go that far; otherwise Toyota and all of the banks would need to be delisted. But just the suggestion has caused low PBR/low ROE stocks to rise significantly. In the past month, the media has picked up on it and there have been Nikkei, FT and Bloomberg articles, sell-side reports, and even local television business news outlets noting this trend. I’m probably not exaggerating when I say that I notice reports by the sell-side almost daily, most of which include a screen of low-PBR and low-ROE, or low-ROE companies that are held by vocal activists. We believe it is this trend which has led to the huge drive of “low-quality” (based on low ROE and low PBR stocks).

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However, while the PBR-ROE correlation is well documented, not all low ROE companies are alike. Is it the low “R” or the high “E” that is causing the low ROE? Is it temporary or structural? A company that makes razor thin margins because they have no scale, or their products aren’t popular, or they have a weak sales force, or their factories are out-of-date, or they are losing to cheaper imports, or due to a whole slew of fundamental reasons shouldn’t go up just because their PBR happens to be sub-book and ROE lower than the cost of equity. Perhaps the ROE is low due to continually high inventories or other working capital issues that can’t be resolved overnight. Also, it goes without saying that not all companies have a cost of equity of 8%. We generally focus on CFROI vs WACC, but it is MUCH too early to start discussing cash flows. Japan is finally starting to think about the balance sheet; it’s too early to start confusing them with working capital (although we do own one company whose selling point is that they have a negative cash conversion cycle!. Unfortunately, there is no coverage on the name). Most sub-book companies deserve to be trading there for a good fundamental reason. They would generally not be quality by our definition and deserve to maintain low PBR valuations.

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Even if the reason for the low ROE is due to a large cash hoard, many companies are still unwilling to release it. They may agree to a higher dividend payout ratio, but that only helps reduce excessive increases in future book value; it addresses the flow but not the stock. And even if they were to reduce the accumulation of excess cash through higher future dividends (thus increasing “R” with slower increase of the “E”), most Japanese companies prefer to raise payout ratios slowly (setting a minimum floor) in order to continually raise dividends throughout the cycle (they almost universally say that they want to pay “stable” dividends, regardless of the EPS of any single year). Also, they often feel paying a one-time special dividend only helps existing shareholders (those on ex-date) most of whom will unlikely stay shareholders. In another case, we know of a company (who already has very high ROEs, but theoretically should be much higher since their ROICs are extraordinarily high) that refuses to raise the payout ratio because the founding family owns too much of the stock and it would be the family that gains the most (which certainly doesn’t bother us but it seems to bother them; in this case, we’ve suggested giving more shares to their employees and have them benefit from higher dividends, but they’ve preferred to increase cash bonuses to employees).

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A fundamentally high-quality business (as we define it) may have low ROEs and low valuations due to 1. a temporary decline in earnings due to, for example, cost inflation that they are currently addressing through price hikes, 2. weak communication skills reducing their valuations because their long-term strategy is not well understood, communicated, and/or believed, 3. bad governance that risks the long-term sustainability of the franchise, 4. bad balance sheet management with too much cash on the balance sheet, or a combination thereof. These problems can all be addressed. #1 is just a timing issue and where we’ve often invested (and occasionally make suggestions on the business). #2 is an IR problem. As one IR officer at a company recently told me, “PBR is just PER x ROE. I promise to deliver double-digit ROEs. If we are still trading below book when we do, then it’s my fault for the low PER valuation and you should fire me.” We (or other shareholders or sell side analysts) could assist in getting the message across and help their IR efforts; this is something we are spending more resources on in recent times. #3 is something that a hostile activist might address. We would generally prefer to avoid such actions directly, though we would applaud their efforts. We wouldn’t mind assisting such activists non-publicly, but IF AND ONLY IF the business is high-quality. #4 is the easiest to resolve, especially if the JPX gets serious, and one that we have been pursuing more actively. But we address not only low ROE companies, but any high-quality business with excess cash (or other non-business resources such as cross shareholdings or land). The flavor of the month, though, is low PBR/low ROE.

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I perfectly realize and understand that there were stock-specific reasons that our underperformance has persisted. Many of the catalysts we are waiting for will, unfortunately, be realized during the latter half of the year and, as such, we must be patient for these fundamentals to play out. In the meantime, we have to ride out the fads, whether it be low ROE or high growth. But, with regards to the sudden interest in returns on capital and cost of capital, we feel this is also a huge opportunity, 10 years in the making since our late PM Abe-san began the initiative. Let’s make sure to get it right this time. We will definitely continue to work toward getting management to understand.

 

Masaki Gotoh

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“That man is a creature who needs order yet yearns for change is the creative contradiction at the heart of the laws which structure his conformity and define his deviancy.” – Quote from “Sisters in Crime: The Rise of the New Female Criminal”, by Freda Adler, criminologist.

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While the context of this quote comes from a book on the liberation of women in the area of crime, more generally, it makes me think about conformity vs individualism. The terms are not really mutually exclusive; the antonym of conformity is deviancy. But conformity is taken negatively, especially, I would argue, in the US where individualism and the freedom of civil rights is valued above all. Having been brought up throughout my entire childhood in the US myself, I agree that it is one of the basic tenets that makes the country so attractive to the rest of the world. But it does, you must agree, have its drawbacks when taken too far (which seems to be more persistent in recent, polarized years). The Rule of Law seems to have been taken to the extreme (despite the fact that those Laws were written by men, most of them many centuries ago when the world was a much bigger and less complicated place). But even in the US, there are still plenty of times when the Rule of Men dictate actions; take any of the sanctions being levied against Russia or China. I don’t endeavor to judge these edicts from a moral perspective but, logically speaking, there should be nothing illegal about investing in Russian bonds or selling advanced equipment to China. The US is not at war with either country. The sanctions exist because, at this point in time, the US government happens to not like Russia or China, mainly because they are growing too big too quickly and aggressively (the same could be said about Japan in the late 80s). At least for Russia, there happens to be a good reason for the sanctions after Putin chose to invade Ukraine (a non-NATO member). But the pressure to reduce investment in Russia started well before the war. With the current increasing cases against China, there really isn’t a particularly good legal excuse. At the risk of oversimplification, China is bad, we (the West, led by the US, and its allies) are good, so we will punish them by weakening them.
 
So, the Rule of Men exists even in the most litigious country like the United States. Japan also is dictated by the Rule of Law. But as I’ve alluded many times in the past, the Law, here, is very vague with A LOT of room for interpretation, much more than the US. But we are not a very litigious society. We are concerned with what others think, and it is the sphere of social and moral influence from others that defines our Rules and those spheres are much wider than most Western cultures. The sphere of influence comes not just from family and friends but extends to your neighbors, school or workplace, and your neighborhood at large. And it doesn’t end there. When you are sharing space with a stranger on the train, in restaurants and stores, or any other public space, the pressure is felt, albeit slightly less so. In fact, it covers the entire country, but abruptly ends at the border, although it is also extended abroad temporarily when there are other Japanese, whether acquaintances or strangers, near your presence who are included in this sphere of social and moral influence. Let’s call it the Rule of the Community. And what makes it even more complex is that not only are the Rule of Community not written anywhere, but they also differ slightly depending on which sphere you are referring to. These spheres often overlap so one must instantly decide which Rule to use when they do (usually the more restrictive one, but not always). And the Rules often change over time without any decree. It is based on tradition and conventional etiquette that has evolved over time and continues to do so. And failure to follow these Rules leads to social banishment, like they may have in medieval times when one faced banishment from one’s village for breaking social norms. In Japan, “they” just make life uncomfortable for you (whoever “they” might be; it’s starting to sound like the X-Files). This, therefore, leads to conformity, which helps maintain the peace.
 
Take, for example, the whole mask issue during the pandemic. No one was fined for removing your mask here in Japan. While some places may have refused service such as airlines (and there have been a few legal battles related to this refusal), it was, on the whole, followed because it was the social norm to do so. Even after coming back from our trip overseas earlier this year when we, of course, removed our masks during the course of the trip (and thankfully at that), we immediately put them back on during the flight back to Japan and have kept it on, grudgingly, in public settings ever since. The government issued a statement about one month ago that mask-wearing “can be decided by individual discretion” from March 13. The interesting point about this official announcement is that we never had a mask-wearing mandate in the first place, just guidelines and suggestions. The government told you precisely where you don’t have to wear a mask, such as when you are outdoors and 2 meters apart from others OR when you are not talking, and indoors when 2 meters apart AND not talking. They did provide guidelines suggesting that we keep our mask on in restaurants when we aren’t eating (very few people follow this one) or when we are speaking with others (we generally follow this one in public spaces, but, in private spaces, it depends on the “sphere” of your counterparty) and in crowded places like elevators and public transportation (we almost certainly follow this one). But they never enforced any such statute. Now, according to the government, we can choose “freely” from March 13, except for certain locations like hospitals and public transportation during rush hour, where they will continue to “suggest” (not command, mind you). They will continue to “advise” that the elderly, those with pre-existing medical conditions, and expectant mothers to continue wearing masks after March 13.

 
I have no idea what will happen from next week. To “freely” choose is not so easily done in Japan. Even I, being brought up in the land of the (law-abiding) free where individualism and independence are prized above all else, will be watching what others do very closely and in each sphere of influence. Don’t get me wrong; I WANT to remove my mask (taking aside that I have a bad case of hay fever and we are entering heavy pollen season when I usually wore a mask anyway before the pandemic). But I’ll do whatever the Rule of the Community implies to do, which I won’t know until March 13 or later. Like Rita Mae Brown, American novelist, said, “the reward for conformity is that everyone likes you but yourself.” That pretty much sums up how we currently feel about masks. I’m guessing a majority of people will start taking it off from the summer when masks become really unbearable (last summer, I used these little portable fans that I could attach to my mask to help circulate the hot air … which defeats the purpose of wearing a mask but at least I was following the Rules). After that, I suspect most of us will just keep them off, at least until next flu season.
 
The same can be said about corporate governance. There were many initial concerns when the Stewardship Code (SC) and Corporate Governance Code (CGC) were introduced. Neither had any legal standing and, while a Governance Report became mandated by all listed companies, there was no need to comply with the CGC, taking a comply-or-explain stance. The SC also asks its signatories to comply-or-explain but, unlike listed companies, it does not require all managers to become signatories. As such, it was feared that these two Codes would have little impact on corporate governance improvement. But both listed companies and signatories took them seriously from the start. For example, only 11% of listed companies chose to comply with every item in the CGC. It would have been much easier to simply say, even superficially, that they complied with all 73 principles in the CGC rather than going through each principle in detail, especially since it wasn’t (and still isn’t) enforced. Furthermore, they sought to improve their standing in compliance (which is also unnecessary). For example, only 36% of companies (TSE 1+2) complied with Principle 4.11.3 which asked to disclose the results of board evaluation. Now, 77% comply as of last year (92% of Prime listed companies). New departments have been created to focus on completing these reports and making improvements to internal processes for better governance each year, especially as the exchange continued to update and expand the CGC (we are on our third iteration and has expanded to 83 principles). The only one that has a low compliance rate at present (at 50% compliance) is one that they just added in the most recent update of the CGC in Jun 2021 with regards to disclosure of sustainability initiatives (those listed in Prime further require detailed analysis of climate change risks). Prior to this update, only 28% of Prime listed companies were signatories of the TCFD (Task Force on Climate-related Financial Disclosures); the figure is now 75%. Many companies now produce a Sustainability Report in additional to their Annual Report (or an Integrated Report that combines the two). Again, this is not mandatory, but more companies produce these reports each year.
 
I do not have similar quantitative metrics for SC signatories (roughly 50% of asset managers who are members of the Japan Investment Advisers Association are SC signatories, but the figure is 97% on an AUM basis; this figure is roughly the same from when the initial version of the SC was released). And, admittedly, it’s much easier to comply-or-explain with the SC without taking it too seriously, especially as it is fairly vague in what is asked of its signatories; admittedly, we don’t put much resources in updating our status. But this is because I don’t believe we need a “Code” to tell me what a proper steward is; we take being a steward much more seriously than the Code requires of us, though I do commend the intent of the Code. And it, too, is on its third iteration, one of which attempted to target Japanese asset owners (though, so far, it has failed to do so; only 79 pension plans are signatories out of over 1,200 corporate pension plans and only 24 of the 100 insurance companies registered in Japan, though there is a logical reason for this which I won’t elaborate here as it is a separate complex topic in itself). Still, I can say from first-hand experience that the asset managers are taking it seriously. Questions about governance are being raised much more frequently, even by analysts who had historically went into group meetings asking for meticulous figures of the most recent quarter simply to “fill the model”. I’m certain both buy-side and sell-side analysts initially began badgering management regarding governance simply because they became signatories and needed to “check-the-box” that they asked the appropriate SC-like questions. But whether your intent was cursory or serious, if you taunt management enough times, they will respond. For example, only 32% of SC signatories voted against or abstained from director retirement bonuses when the SC initially started; I, for one, can’t think of any reason why anyone would vote for these proposals. That figure has risen to 65% most recently (still too low but a significant improvement). The number of proposals itself has declined from 3,379 directors to 1,781 directors, which shows that many companies have chosen to eliminate the practice, and I’m sure the SC was the trigger.
 
While it may be hard to understand, conformity has its benefits too. That’s why just changing the classification of COVID-19 from Class 2 (which includes infectious diseases like tuberculosis) to Class 5 (same as seasonal influenza) will likely have a strong effect, in addition to the voluntary mask-wearing (-removing (?)) guidelines starting next week. Similarly, having the JPX just suggesting that a sub-book PBR is “bad” will probably produce results at a certain point that may encourage companies to understand the cost of capital. For better or worse, It is rare times like this that I’m actually glad that the Japanese can be lemmings.
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