March continued the large-cap, growth bias that has been playing out throughout the entire quarter for most of the world. While Japan temporarily deviated from this trend from mid-February, Japan reverted back to continue this course during the month of March, although the magnitude of directional conviction seems to have begun to wane each subsequent month. Average daily volumes were down -7% YoY (excluding futures SQ) for each month in the quarter, slightly worsening each progressive month. In fact, it was the most illiquid first quarter in terms of daily volume of shares traded in the last 20 years, despite the fact that there are 42% more companies in TOPIX. Also, I’d note that the first quarter is usually the most liquid quarter of the year due to over 60% of listed Japanese firms, both financial and non-financial, ending their fiscal year in March. While not quite as extreme, a similar trend was seen in the US where daily volume of the S&P 500 constituents were down -4% YoY for the quarter as well (excluding futures SQ); however, if you include all US exchanges (and not just the 500 names in the S&P) and OTC stocks, US average daily trading volumes were down -24% YoY during the 1st quarter, despite some reports saying that retail investors made record dollar inflows into US equities during the past quarter (and seeing that markets are still down vs a year ago, volumes must have been even higher YoY). If those reports are true, this would imply that institutional trading had fallen dramatically last quarter.
 
Furthermore, industry dispersion felt high as well. Using standard deviation of monthly MSCI Japan industry returns as a crude calculation of dispersion, it was the 6th highest month in the last 3 years since the pandemic and kurtosis was the 4th highest with excess kurtosis of +3.2 (meaning it had very fat tails). For the quarter, Materials were up +19%, Technology up +15%, and Consumer Discretionary up +10% while Financials were down -4% and Real Estate -3% (MSCI Japan was up +6% for the quarter). I understand this divergence was similar in the US. I read in a Bloomberg article that the difference between the best and worst S&P 500 sectors was above 20 points last month, twice the average of the past two decades, and the top 5 stocks of the index accounted for 161% of the month’s returns, well above the 41% average of the last five years. In a nutshell, this quarter was a massive reversal of 2022 but with lower volumes.
 
Whether these softer volumes equate to weak conviction of a strong market, I cannot confidently say. There certainly have been periods where a strong-but-low-volume quarter had been succeeded by continued QoQ market strength. But it is not uncommon to see a shift in volume patterns, up or down, signaling a reversal. Add to this the fact that we have seen little fundamental change in the last 3 months nor better visibility, from our perspective, forward earnings continue to look murky at best. As such, we have not made any major changes to our portfolio, particularly those higher weighted where we have fairly high visibility of QoQ earnings improvement. We have begun scaling back some smaller positions whose catalysts are too far ahead and have begun replacing them with stocks whose near-term QoQ earnings improvements are more definitive. One is a domestic B2B software company, a leader in its field, who is only now in the process of moving their customers from a packaged software solution to a cloud-based one, similar to what companies like Microsoft or Adobe had done several years ago. While lifetime ASPs are the same or higher as new features are more easily added, this company recognized revenue of package software sales immediately for the old 6-year license while the cloud version is monthly subscription based. This causes a sharp hit to short-term revenue and earnings at the start of this conversion cycle. But it only gets better with each subsequent quarter as the stock of monthly subscriptions rises. The other company is a market leading producer of a commodity product who has been consistently raising prices ahead of their peers throughout 2022. They will see the full effect of those price hikes in 2023 while input costs begin to decline during 2023. For example, while oil prices may be down significantly from a year ago, they were still slightly up during the quarter on a Yen basis. So, for Japanese importers of commodities, Yen-based costs will decline even with the OPEC+ shock unless the Yen rapidly weakens from here. We actually have a another household product manufacturer in our portfolio that will see a similar pattern as the year progresses. While both of these new positions are relatively small at present, we are slowly attempting to make more room for them. The key to both is that our macroeconomic outlook is not the main driver to forward earnings visibility and in an environment where visibility is low, we feel more confident owning such businesses.
 
[...]
 
I hope everyone has a good start to the second quarter and look forward to seeing and/or speaking to as many as you as possible this year now that the borders are finally fully open.​​

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Masaki Gotoh

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“Economists are people who take care of their own personal economies by forever mouthing doom and gloom.” – Inspector Francis Xavier Flynn, a fictional character from the Fletch & Flynn series by Gregory McDonald.

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During one of my business trips flights, I had a chance to watch the movie “Confess, Fletch”. The original movie adaptation in 1985, “Fletch” (and its sequel “Fletch Lives”) starred Chevy Chase as Irwin Maurice Fletcher, a slick and talented investigative reporter. The movies are based on the Fletch and Flynn series of books written by Gregory McDonald which I first read as a young teenager. Admittedly, I think Chevy Chase (at least in the first of the two movies) did a better job than Jon Hamm from the 2022 release, but the remake was still entertaining. However, they really got Flynn wrong, who, in the books was a brilliant and similarly witty, Irish homicide detective with a James Bond-like past. In the 2022 remake, he was played by comedian Roy Wood Jr. (he was one of the correspondents on “The Daily Show w/ Trevor Noah”) who played the part more seriously than the jocular yet intelligent Flynn in the books. But whether it be the old Fletch movies or the new one, both characters were MUCH more interesting in the books.
 
So, of course, I had to reread it. I dug in my basement and found my worn-out copy of all of my Fletch and Flynn books, including “The Buck Passes Flynn” which is where the quote above comes from. And, as it was 35 years ago, it was still highly entertaining. If you want to read the series, I suggest you start with “Fletch” first, then “Confess, Fletch” where Inspector Flynn first appears, before starting on the Flynn series. In case some of you do, I won’t spoil the ending, but “The Buck Passes Flynn”, the second of the Flynn series, is about a series of mysterious events across America where every man, woman, and child in a rural town in Texas, in a seaside resort in Massachusetts, and at the Pentagon each receive a bag with $100,000. Throughout Flynn’s journey to find the culprit, there’s a lot of humorous dialogue which, essentially, is about inflation and the perception of what “money” is. My paperback itself is a great example of what inflation is. I suspect I bought it around 1988 and the price tag that’s still on it says $2.95. 35 years later, I look up the same book online and it lists for a retail price of $15.99 on Amazon or about 4.9% annual inflation. Interestingly, the US CPI (ex-food & energy) only was above 5% between Jul 1990~Jun 1991 and Dec 2021~now and has been otherwise been around 1~3% from early 1995 to the spring of 2021. So, I guess book prices rise faster than other products or services.
 
Anyway, while the novel is entirely fiction, there were many aspects that felt relevant to today. The side characters in the book are constantly complaining about the rising cost of everything. The victims of the sudden income of $100,000 of “cash money” ultimately ruin their lives. The townspeople in Texas all abandon their homes and mostly lose themselves in Las Vegas. It shuts down the summer tourist town that now charges $200 to buy a sandwich. The ultra-rich character believes money to simply be an illusion and doesn’t even care about it except to the extent that the rest of the world does. He says “I make money because other people believe in it. I collect garbage because pigs want to eat it. Money is a convenient medium of exchange”. One of the possible suspects is a counterfeiter who had emigrated to a small, quaint town in rural Russia to run a printing press for books on communism, using a highly warped view of the consequences of the American Civil War as an example of a malfunctioning economy. Throughout the book, it explains inflation very simply and eloquently. Here is a short excerpt between Flynn’s daughter and her mother:
 
“What causes inflation?” Jenny asked her father.
“Ask your mother.”
“Too much money,” Elizabeth said.
“Then why don’t they stop making money?”
“Because it keeps people employed.”
“Then what’s wrong with inflation?”
“Because the more money there is the less value it has and even the employed people become poorer and poorer.”
 
It doesn’t get much simpler than that. That’s how I’m going to explain it to my children when the time comes. They are just only now learning the value of money but, next, they must learn inflation. The funny thing is that the children of Japan for the last 3 decades hadn’t the need to learn inflation because it didn’t exist. And because we were so wealthy (or so we thought) back in the 80s when books like “The Japan that can say no” and “Rising Sun” were international bestsellers (the movie adaptation of “Rising Sun” was terrible, by the way, despite a star-studded cast including Sean Connery, Wesley Snipes, and Harvey Keitel), Japan could live with disinflation for a few decades, feeling relatively assured that things weren’t all that bad, until we woke up in 2023 to find out how poor we are versus the rest of the developed world (and even against some of the so-called emerging ones).
 
So, I keep thinking to myself how the next few years will unfold for Japan should inflation stick. The doom-and-gloom argument for Japan hasn’t changed, of course. Birth rates are falling and the working population falling faster with the rising burden of a rapidly aging economy in a country that tends to be slightly xenophobic. But the same can now be said of many other developed countries and even China, with an accent on the xenophobia in the West. And, as I’ve continued to say, the biggest surprise in the last 12 months is not only that prices began to rise, but so have wages. Every August, the Ministry of Health, Labour and Welfare (the “MHLW”) announces the results of the annual spring base salary negotiations that begin in early March until around late May. This survey is just for listed, unionized companies with over 1,000 employees which is roughly the top 300 listed companies in Japan. This figure does not include bonuses, overtime pay, position-based income or other benefits, although many such benefits are often some multipliers of the base salary. The results of the negotiations have generally trended at about +2% per year since the late 90s. Unlisted companies and non-unionized companies are not included in this survey, although a separate, broader survey by the MHLW of companies with 100+ employees shows that the figure to be roughly in line with that of the top 300 companies but about -0.3% lower, although this figure includes about 25% of companies (in 2022) that did not offer any wage hikes. 25% might sound like a lot but it was near 40% pre-Abenomics. Furthermore, it is weighted by number of employees, i.e. smaller companies tend to have lower base salary increases than larger companies, although the spread between them have shrunk in recent years. As such, while the results of the main MHLW survey only represents a small (large-cap) sample, it does tend to set the tone for the country (in the past, the announcement by Toyota would be the anchor but this was not the case this year).
 
Base salary increases are generally divided into three parts, 1. a formulaic portion predetermined by each company based on age and/or years employed, 2. individual performance, and 3. what is called “be-a”, shorthand for “base-up”. The latter is an all-encompassing figure that is activated to every employee in the company (generally below a certain rank) due to top-down factors such as inflation, industry practice, and macroeconomic conditions. The “base-up” has been close to 0% for most companies from 2001~2013 for obvious reasons, although it was as high as +2~4% in the 80s and +1~3% in the 90s. Base-up levels had started to rise slowly post-Abenomics as inflation started to stick above 0% (except in 2016 and, of course, 2020-2021) but the fact that final base salaries continued to hover around +2% throughout the period would imply that #1 and/or #2 had begun to decline, although this may also be due to demographics (i.e. the rate of growth for #1 falls over time as does #2 due to the base effect as well as the fact that older employees move to more senior roles where these negotiations do not apply).
 
We had begun to hear the term “base-up” more frequently in meetings with companies and in the media. Most companies with whom we’ve had this conversation had told us that they didn’t have a “base-up” for decades. This does not mean salaries were flat; there simply wasn’t an automatic, across-the-board increase in wages. But coverage of such news began from the start of the year, starting with the now famous announcement by Fast Retailing (Uniqlo) that they would raise wages by a maximum of 40% (of course, this figure is for lower salaried employees and the average is much lower). Many others began to follow including JGC who announced that they would raise an average of +10%, Rohto Pharmaceuticals at +7%, and Canon at +4% (with varying degrees of fine-print caveats). The hikes were particularly high for incoming new employees with double-digit increases versus last year were becoming more common. While the official figures from the MHLW survey will not be released until August, the Japanese Trade Union Confederation (“JTUC”) provides nearly weekly updates of these negotiations with over 4,000 unions in the JTUC which account for about 7 million salaried workers. As of the first week of April (where the bulk of negotiations have been completed), average wages were negotiated at +3.7% (+3.4% for SMEs with less than 300 employees), the highest level since 1993 (unions demanded an average of +4.5% which was the highest level since 1998). Of this, roughly +1.5% is from the “base-up”. Of course, the +1.5% figure is still a far cry from the +3.0% inflation that Japan is experiencing now. But we would expect this is just the start of annual progress in wage negotiations. Many of our portfolio companies have said that they will continue the “base-up” as they expect inflation will eventually stay above +1%. Separately, the JTUC survey showed that part-time or non-salaried workers saw average hourly pay rise +5.55% so far.
 
However, before we start getting excited that we are exiting the deflationary spiral and can look forward to wage hikes, inflation, and possibly even positive real interest rates, it should be noted that only 1.5% of all companies in Japan have more than 100 employees and accounts for under 60% of the working population. There are only 4,000 companies (or less than 1% of the total) that have over 1,000 employees accounting for about 30% of the total working population, and the August MHLW report only surveys 300 of them as the others are either non-unionized or unlisted. Furthermore, all of the surveys above are generally about the parent company and their answers often do not include the smaller subsidiaries nor part-time and non-salaried staff (although Fast Retailing had announced that they had already raised wages of part-time staff by +10% from late last year). While it is near impossible to precisely analyze what the remaining 98.5% companies with 40% of the working population will do, some surveys focused on SMEs such as that from the Japan Chamber of Commerce and Industry found that 42% of their sample SMEs do not plan on raising salaries (although this is still a huge improvement from last year’s survey of 54% who didn’t raise). Also, last October, minimum wages were hiked by an average of +31 yen across all prefectures and 39% of survey respondents said they raised wages because of this regulatory change (most notably in the hospitality industry and retailers). And even this survey is skewed toward “larger” SMEs; over 90% of companies in Japan have less than 20 employees while this survey only had 30% in that size group.
 
So, there will clearly be a bifurcation between the haves and the have-nots. The labor tightness only gets worse from here as the working population declines and young workers more scarce. In the same SME survey, 65% of respondents said that they are short-staffed, despite the fact that foot traffic is still at 80%~90% of pre-pandemic levels in the busiest areas of Tokyo. The tightness is particularly acute in construction, technology, trucking, nursing care, and hospitality. While advancement in IT, productivity improvement, and process changes will help alleviate some of this tightness, over 80% of respondents said that they simply must hire more people, even if it hurts profitability. In fact, among the 58% of respondents that said they would raise wages, only 22% are raising due to revenue improvement or higher profitability while the remaining 36% are doing so because they must secure people despite the fact that their businesses have not improved.
 
What must happen next is an acceleration of acquisitions and consolidation or simply see further small and/or uncompetitive companies leave the industry. Higher quality companies with fatter margins have the luxury to raise wages due to higher margins, just like Uniqlo, one of less than 10 listed retailers in Japan that averaged double-digit operating margins during the last 3 years. The same can be said of our companies, all of whom have industry high margins. This is precisely why they do not fear wage hikes but embrace them, seeing it not as an expense but as an investment. This is what quality means to us.
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