I’ve mentioned several times in the past year or so that as Japan hopefully begins to normalize after 3 decades of disinflation into a country with positive real interest rates, there will be many challenges, and the markets will not act as straightforward as the beta-led Japan rally of 2023 would indicate. I think I said, “the road will be bumpy”. That was clearly an understatement.​​

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I wanted to discuss how the start of Apr~Jun earnings season saw a very similar pattern to the Jan~Mar earnings season where earnings results were met with extreme single-stock volatility, both up and down. I wanted to mention how we again saw stocks that reacted oddly when they were slated to announce intraday but, for whatever reason, was delayed until after the close, suggesting an increase in short-term trading activity whether it be human or otherwise. I wanted to show how the 10-yen move in the yen last month and the contraction of the interest rate differential will likely cause even further dispersion. I wanted to provide examples of how the stocks of some cyclicals and tech companies, who had loaded their guidance toward the back half, wildly reacted after Q1 earnings results which, in normal years, is the most uninteresting, least important, and often ignored quarter.

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Well, there doesn’t seem to be much point now. All of what I mentioned above is true and relevant. Even today (Aug 9), we are seeing names in our wish list that are up +15% and down -9% (and, in our portfolio, up +10% and down -2%, and that’s with just 14 names). Furthermore, as we watch the reaction post-earnings, it’s not quite as simple as one would expect fundamentally. Just because a company beat consensus doesn’t mean the stock went up and vice versa. I realize that “whisper numbers” are important (and obtainable) on Wall Street, but Kabutocho (where the Japan Stock Exchange is located) isn’t quite as sophisticated and not nearly as well covered except for a handful of Nikkei 225 names. So, both on the beta and alpha front, it has been “interesting” to say the least.

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I read an article last night (Aug 8) in the Financial Times titled, “The great sell-off and why the Japanese market trades like a penny stock”, a great, eye-catching title. The author drew three conclusions: 1. The true face of Japan was exposed with its cosmetic changes revealed, wage increases and sustained inflation questioned, and mismanagement and misallocation of capital too ingrained in an economy with a shrinking, aging population. Or, 2. Because of the view of #1, the movement helped flush out the fast money that Japan didn’t need, and the long money that have waited on the side lines for so long can now do their proper work without distraction. The opportunity is huge but buying the whole market is risky. In his words, “Caveat emptor: this place is for stockpickers only.” Or 3. Something extraordinary is happening in Japan. “Normalisation, in one form or another, is going to be extraordinarily painful and … will make Japan look a lot like an emerging market. Get used to it.”

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I believe it is both #2 and #3. As I’ve said all along (and admittedly self-serving), this market will be for stock pickers from here on out. The extreme dispersion we are witnessing in the very short term is proof of that. In fact, I think we can use another sell off as it’s still probably not been cleared of the fast money; the market reverted too quickly. And the yen has only gotten back to where it was 6 months ago. The indices are still up for the year and flat on a US$ basis. Let’s get the yen back to 130 (which is where it was at the start of 2023). Or let’s clean out the carry trade altogether and bring it to 120, which is still cheaper than pre-pandemic. And, in the meantime, let’s flush out the Japanese companies that can’t make it in the new norm where wages rise every year and inflation sticks. We finally got our first month of real positive wages in June after 23 consecutive months of negative real wage growth. While I’m no policy expert so I can’t say where inflation will be in a year, I can tell you that all the companies that we own or follow, all who are leaders in niche fields, will continue to raise wages next year too. The shrinking population is positive for our businesses as they can hire and grow their business while others wither and die (or are acquired). Thanks to the pandemic, our companies can accelerate their leadership position. As I’ve explained regarding our selection process, Quality companies show their worth in difficult times, not when everyone is growing. This is when they take share, grow faster, and come out of the cycle stronger than they were going into it.

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So, I welcome these massive, confused, irrational stock movements even if it means more pain to come because the Value component is even wider now. Volatility = Opportunity.

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Masaki Gotoh

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“Yesterday, we were an army with no country. Tomorrow, we have to decide which country we want to buy!” – Jeremy Irons playing the antagonist Simon Gruber from Die Hard with a Vengeance.

 

Recently, I’ve started rewatching the "Law & Order: Special Victims Unit" on Hulu during my “turn off” periods late at night after everyone is asleep. For those following my unnecessarily long monthlies, I wrote (in the Jan 2023 monthly) about how watching this program had become part of my nightly routine during the long twice-a-year, two-week trip to the US and Europe, but since we hadn’t been able to take a trip for over a year, my urge to watch it returned. And, no, it’s not to satisfy some morbid desire to watch a program about human depravity. I like it because it’s short, it’s not continuous (you can watch any episode in any series in any order), it’s predictable, and yet, the endings can range from very gratifying (you see the bad person get what they deserve with a satisfying judgement handed down in court) or mildly pleasing (the bad person will get what’s coming to them but it’s implied and not explicitly shown) to disturbing (the bad person gets off due to a technicality or gets a mild sentence) or outright unacceptable (the bad person is found innocent and/or they don’t find the right criminal). The progression of the program can be anticipated so I don’t have to watch too intently and can multitask with my phone or, more recently, the Paris Olympics in the background, but I have to refocus toward the end as it is unpredictable. I guess it’s like the recent stock markets that way. You know what should happen (fundamentally) and it might actually progress that way. But when the company announces earnings, whether it was a surprise or otherwise, I have to stare at the immediate stock action closely, comb through the financials, listen to the call, and read the sell-side 1st impressions because I can’t be certain how the stock will react in the coming days (and consequently what actions we should take during the coming weeks, including any dialogue or engagements that might be required with management).
 
But in the past few days, the abovementioned quote kept coming to my mind. I hadn’t watched the Die Hard series in quite some time (I’m sure I’m not the norm when I say that I actually liked all of them except for the fifth installment which was okay). In fact, I hadn’t seen any Bruce Willis movie in a while, although I loved him in the Fifth Element, the Red series, and, of course, Pulp Fiction (and was very saddened to hear that he had retired). But I do plan on watching the series this coming 3-day weekend, simply because I can’t get this quote out of my head. It’s not even the best part of the film (the continuous witty dialogue between Samuel L. Jackson and Bruce Willis is). But I do know why.
 
I’ve been having a difficult week … and that’s because I don’t know which company I want to buy. The irony is that, a year ago, the markets were going ballistic for no good fundamental reason and valuations kept getting ridiculous. It felt like the IT bubble and its irrational exuberance, but doubly so in Japan this time as it was also driven by the sub-book PBR hype driven by the acceleration in governance reform as well as the Great Rotation out of China into Japan/India. But I couldn’t chase those high-beta stocks because the fundamentals were not supporting the stock movement. We also screened for sub-book companies in order to possibly gain a little exposure to that optionality … but after meeting several such companies, we realized that they were low or sub-standard quality businesses and had been trading at sub-book for a good fundamental reason, in addition to the poor balance sheet management. Any move to improve their capital efficiency would be temporary and unsustainable. A poor business remains a poor business even if the balance sheet is optimal.
 
And so, I reluctantly kept our very domestically-focused portfolio largely untouched throughout the year (which, of course, led to our underperformance against the +25% move of the market during 2023). In the meantime, we would search far and wide to find companies that would be beneficiaries when the machinery/tech cycle turned AND that had not gone up at unreasonable valuations AND fit our quality hurdle. We did find a few but there were usually fundamental and idiosyncratic reason why they weren’t following the market at that time.
 
In the meantime, we would maintain this list, follow them, and wait for the opportunity, expecting that, 1. the (non-structural) idiosyncratic issue would be addressed and the fundamentals would follow in the next year (i.e. a turnaround story), or 2. the cycle had bottomed and would begin to see a sustainable upturn (i.e. a cyclical recovery), or 3. the business will be a beneficiary of the new norm (i.e. a structural change), or 4. a mix of the three. But, whatever category, the stock would have to be trading at reasonable, preferably cheap, valuations and market expectations not excessively optimistic. Unfortunately, the latter was still very true during the Jan~Mar 2024 quarter and, while it abated a little during the Apr~Jun 2024 quarter, expectations were still fairly high, especially while we still had the cheap yen (even though the gains are largely translation, not transaction based).
 
Now, all of a sudden, the markets are talking about a recession and the cheap yen buffer is looking more like a liability, especially as we look toward the back half (Oct 2024~Mar 2025) when most companies are expecting an economic turnaround while now facing a tough currency hurdle. In the meantime, the 2,100+ constituent TOPIX index fell nearly -10% during the first 2 days of August, fell another -12% last Monday, rose +9% last Tuesday and has since risen a little more, closing today -11% MTD (whipsawing between -1% ~ +2% intraday today; and yes, this is the index I’m talking about, not individual stocks). The markets seem incredibly confused.

Throughout this volatility, we looked at our list and saw some stocks easily fall -10% in a single day. We observed others that weren’t in our immediate radar since they were much too rich to even consider near term but are now looking, at least, approachable. There are some names in our wish list that are down -20%~-30% in the last 7 trading days alone. Like Simon Gruber, we have to decide which company we want to buy!

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But unlike Simon, we are also handicapped by the fact that we are fully invested. So, I also have to decide which company we need to sell to make room for these opportunities. I still like my names in the portfolio, and they are not at our fair values (and most are even further from them due to the market volatility in the last week). But we also have to consider which ones will provide the best IRR going forward so I will have to make the difficult choice to sell a high-quality business well below it’s fair value because there are better opportunities elsewhere.

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This is a dilemma I had not had to face in recent times. But it certainly beats the alternative which was what we were going through throughout 2023. I suspect this conundrum will continue for a while.

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I very much look forward to how the coming months unfold (not to mention what the US presidential election will bring). In the meantime, I’ll relax by watching some more SVU.

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PS: (as per my many monthlies where I honor supporting actors) Jeremy Irons is another supporting actor I think is highly memorable. His performance in Margin Call, which was about the 2008 Financial Crisis, was particularly awesome. He played the character John Tuld, a not-so-subtle reference to then-Lehman Brothers CEO Richard Fuld and Merrill Lynch CEO John Thain.

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