May was another brutal month for us, following our large March underperformance. And, like March, it was primarily due to a single name, this time, our #1 holding portfolio Macromill. However, unlike March where the reason was clear, Macromill’s stock action cannot be as easily explained. The stock, like it has from the start of the year, remained bumpy and volatile, trading similar to the TSE Mothers index (where retail tends to be active and has a high concentration of Internet-related growth constituents). Up until May 12, the stock had fallen -11.5% MTD compared to the Mothers index at -10.6% and our benchmark SMID index at -2.3%. While that, in itself, is disappointing, considering that the stock had been up +8.5% YTD as of month start vs our total return benchmark at -4.2% and Mothers at -29.7%, it is understandable that some reversion would result, especially as margin calls were undoubtedly occurring within the weak Mothers index.

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After the close on May 12, the company announced strong Q3 results of +12.0% YoY growth (vs our estimate of +8.4%) and margins of 17.8% vs our estimate of 15.5%. While this represented a margin contraction vs last Q3, this was expected due to rising labor costs (which the company had been very clearly explaining from many quarters before and easily deduced from Q1 and Q2 results). Furthermore, they announced a tie-up with Amazon Ads toward tagless digital advertising measurements. Macromill had announced in previous quarters that they were speaking with several global platform providers toward cookie-less solutions as information privacy is being tightened (Apple and Firefox have already blocked third-party cookies used in digital advertising and Google is expected to do so by 2023). This was the first concrete step toward further tie-ups that we expect to be announced. Finally, they also revised up their full year estimate by +3.4% topline and +9.8% EBIT to 5.6 bln. While the new estimate was still slightly below our estimates, the company has been continually conservative throughout the pandemic and always lowballed their expectations. We raised our own estimates from 5.7 bln to 6.3 bln, taking into account the Q3 overshoot. As there are only 2 analysts that cover the stock, there isn’t a real “consensus”, but they were actually slightly ahead of our estimate at 6.0 bln (which they have since reduced to 5.8 bln). The commentary from those two analysts have been positive.

 

And, yet, the next day, the stock fell as low as -17.2% before closing -11.5%. We could not understand the reason for this decline, and it also took the company by surprise as well. The only possible negative that one might be able to read through at that time was rising unit labor costs and increased labor market competition, which is the largest cost to their business. While important, the stock action seems excessive if for this reason alone. It might have been a precursor to SNAP’s surprise announcement of a weakening macro environment, leading other US advertising stocks down in the weeks to follow. However, it should be noted that the major Japanese advertising agencies are not seeing any slowdown in the Japanese digital advertising market. In fact, Hakuhodo, the second largest advertiser in Japan, coincidentally held an investor meeting on the day of SNAP’s announcement and was asked if they have observed any weakness in demand due to inflation and a possible global slowdown. They commented that, if anything, the reverse is true and that their Japanese clients have held back advertising spending for 2 years and are anxiously looking to deploy more as Japan slowly reopens. We’ve heard similar statements echoed by our daily goods manufacturer in our portfolio where they explicitly stated that, despite rising costs, the one area that they will continue to spend aggressively is advertising and, in particular, digital advertising. We have heard this anecdotally from other manufacturers as well.

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It should be noted that Japan has reopened much slower than the US and, therefore, has more short-term upside toward the post-pandemic recovery. It was only 2 months ago that they declared an end to the national state-of-emergency. The country only began allowing tourists back into the country a week ago (at an excessively measured pace). We’ve had to stand in line to get into restaurants for lunch like we used to before the pandemic. And I’ve already had 3 work-related dinners in the 2 weeks since I returned from my overseas business trip; it’s been so long that I even forgot how to fill out our T&E request forms. A simple read-through of a slowing US advertising environment does not necessarily mean that it should be extrapolated in the Japanese domestic advertising market.

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While we use DCF estimates to calculate margin-of-safety vs intrinsic value, we do look at price multiples as a reference. In that respect, the stock currently trades at 13x “consensus” June 2022 earnings (which are currently lower than ours) and 12.5x June 2023. This compares to 15~16x at other domestic comps. Using our estimates, they are currently trading at 11.5x June 2023 earnings, even after taking into account rising labor costs, for a company that we expect to see double-digit bottom-line growth for the next several years.  As such, we have used the opportunity to add to our position in the portfolio. We believe the market has provided an incredible opportunity to invest in a franchise whose growth is driven not just by industry expansion as digital advertising continues to develop, but also by Macromill’s superior position in digital advertising research with a unique resource that will allow them to further their #1 stronghold in the digital advertising research space as the world moves toward a cookie-less society.

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While we are deeply disappointed with our year-to-date returns, we believe that our portfolio, with companies like Macromill, is well positioned for a domestic recovery which has been much slower than our Western counterparts but now starting to gain pace.

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Also, I’d also like to add a voice of thanks to those who met us face-to-face during our 2+ week global trip. I have to say, it is MOST CERTAINLY 100% better to see you all face-to-face. I’m sure Zoom and video conferences have their purposes, especially for first time meetings, but they will NEVER replace true one-on-one meetings. It was wonderful to see all of you and I’m already excited to for our next trip (whenever that may be). If I could add a little color from this trip (with, obviously, biased datapoints), I think, broadly speaking, interest level toward Japan has, on the margin, risen. Perhaps that has to do with the new interest rate paradigm (and Japan’s “value” proposition within such an environment). Also, I did receive one or two concerns that corporate governance (or, rather progress thereof) feels like it may have receded. That is definitely not the case. I think it has to do with the gamma, where Abenomics altered Japan’s necessity for better corporate governance from zero to one (or negative to positive) and, as such, gamma is high. But it has continued to progress. As one datapoint, for example, the total amount of buybacks announced year-to-date is around 8 tln yen, already above the value for most full years prior to the pandemic, and on pace for an all-time high. Governance improvement has, in my view, become more “normalized” in terms of progression. The initial stage was indifference to concern (driven, in large part, due to regulation and/or top-down pressure). It has moved on to acceptance to, perhaps (optimistically), understanding and perhaps even, with some firms, differentiation. I also think the E&S of ESG is moving to where “G” was 10 years ago. I suppose one has to be a little Japanese to “feel” this change. But I’d be happy to keep reporting such changes (as I see it) to our readers!

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Masaki Gotoh

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PS: One administrative item I thought to highlight is with respect to our addition in Macromill. We had discussed with our current fund investors to change the maximum allowable position size in the fund from 15% to 20% (the limit only represents the point where we can no longer add; we can continue to hold above 15%). While this discussion was triggered by the stock action of Macromill, there is also another logical reason. Prior to launching the fund, we had expected an average of 20 active investments in the portfolio with room for another 5 for those slowly on their way out. As such, an average position size would be 5%. I expected a high conviction position to be, at most, 3x of an average size, leading to our 15% limit. After 2 years, the portfolio has become more concentrated and has tightened to 15 positions or so; our current portfolio has 17 positions, of which one is on its way out and another will likely be out in the next 3~6 months. As such, an average position is now closer to 7~8% and, therefore, it would make sense to increase the maximum position size.

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“♪ The need to express; To communicate; To going against the grain; Going insane; Going mad ♫” – lyrics from La Vie Bohème from the Broadway musical Rent.

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I’ve always had a strong love of fine arts including concerts (of all musical genres including classical, jazz, pop, and rock), plays, operas, and musicals. Within musicals, by far, my #1 absolute favorite musical is Rent (and, yes, I’ve seen La Bohème too and it’s probably my #1 or #2 favorite opera). I’ve actually never seen the musical in New York, though. The Broadway cast comes to Tokyo every few years to perform for a week or two and I’ve never missed an opportunity to watch them perform. So, when they came again this year (delayed by 2 years due to the pandemic), I decided to take my sons to see their first musical (it was my fifth time out of the eight total times they’ve performed in Japan).

 

As all young boys probably do, my kids love to sing and dance. Initially, though, and not surprisingly, they had trouble understanding Rent (and too many “bad words” which upset my older son Leo a little … I forgot about that before taking them with me). But a few days later, my younger son Louis, who tends to be the more artistic one, began humming some of the songs from the musical. I immediately pulled out my copy of the Rent movie adaptation and he, of course, wanted to watch. Afterwards I asked him which song he liked the most. Rather surprisingly, he said his favorite is La Vie Bohème. Of course, he doesn’t understand a single word, and he probably likes it because the actors all seem very happy during the song and dance. When he does ask about the lyrics, I have quite a bit of trouble explaining it. If you haven’t seen the musical, the song is very … well, bohemian; I have to look up some of the references in the tongue-twisting lyrics, myself (here’s a good link that explains many, by the way: https://genius.com/Original-broadway-cast-of-rent-la-vie-boheme-a-lyrics). Most of it is way too early for a six-year-old to understand anyway.

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La Vie Bohème is also my favorite song in the musical/movie, not least due to its raw language. I wouldn’t say that I embrace bohemianism in full, but I certainly empathize. While I don’t have extreme political views, as I’ve alluded in the past, I probably lean more left than right in the political spectrum, which, I suspect, is somewhat unusual for someone in the buyside. Most of my former bosses and work colleagues in the past leaned distinctly to the right, leading to fun after-dinner conversations over drinks. And, no, that certainly does not mean I don’t care about returns … that is my primary objective, of course, not to mention my duty as a fiduciary. And, no, I don’t like high taxes (though I tolerate them) and I don’t like excessive regulation. So, perhaps it’s more accurate to say I’m a liberal with regards to many social policies but lean conservative on economic policies. Besides, I believe it is definitively wrong to bucket someone on to one side of the aisle or the other, despite the world becoming more polarized.

 

But, then again, maybe it’s a value thing? I mean we definitely have “to go against the grain” by seeking value where others do not, and it is insanely maddening at times (like this month).

 

“To more than one dimension” … oh absolutely! If a concentrated portfolio had only one dimension, we’d definitely be adding zero (or negative) value.

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“Hating convention; Hating pretension” … maybe hate is too strong a word but if we embraced convention, it’d hard to be contrarian. And I certainly dislike pretentious comments.

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“To no absolutes” … a concept I practically live by.

 

“To being an us, for once; Instead of a them” … yes, definitely, since 2008 when growth started its meteoric rise (and maybe we can now be an “us”?).

 

And … well, ok, some of the other parts of the song my not apply to all value investors (although anyone who’s eaten breakfast with me knows that I absolutely love huevos rancheros!).

 

So, to my fellow value investors, if you haven’t seen the musical or the movie adaptation, both are available on DVD/Blu-ray so I hope you have the opportunity to enjoy it. And if you have, it’s worth watching again over a glass of wine or beer and maybe you’ll find that you can relate to some of the lyrics too.

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La Vie Bohème!

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