May 2023
“Be careful what you wish for”. If I could go back one year, this is what I would tell myself. I’ve been touting the list of the benefits for global investors to relook at Japanese equities for nearly a year. But I certainly didn’t think it would happen this quickly and certainly not in this magnitude. The large-cap Nikkei 225 is up +18.4% in local terms as of May end and already up another +5% MTD. In US$ terms, it is up +11.7% as of May, outpacing the S&P 500. The broader Topix is more subdued but equally impressive at +12.6% and +6.3% respectively. It has been led primarily by large caps and technology, much like the US. And it has been driven entirely by foreigners. As of May end, foreigners net purchased +3.1 trillion yen of stock while individuals net sold -2.2 tln, trust banks (a proxy for pension plans) net sold -3.5 tln, and investment trusts (another retail proxy) net sold -0.6 tln. Additionally, foreigners net bought +2.0 tln of Nikkei 225 futures while every other group were net sellers. It has been particularly acute during April~May with the 2-month rolling net inflow (dark blue line below) at its highest level since the start of Abenomics that started when the LDP retook the Diet in late 2012. That early run in TOPIX from 800 to 1200 was similarly driven by foreigners. It feels like Abenomics all over again.
Like Abenomics Part I, the singular determination of the market feels too hard and too fast. Unlike last time, though, forward fundamentals look worse, not better. Of course, I am talking my own book since we do not invest in large caps and have avoided high beta industrials and technology. But there is a reason for this aversion and it’s not that we are simply being contrarian. We continue to hear macroeconomic risks from companies that we speak to both in and out of our portfolio as well as a multitude of other datapoints, both individual bottom-up and industrial/macroeconomic top-down. Semiconductors are still weak and, outside of production for the new fall model smartphones, there appears little to get excited about. WSTS is looking for a strong rebound in semiconductors for 2024 after bottoming later this year so, perhaps the market is looking out a year in advance? But we’ve already heard one of the major silicon wafer manufacturers push out their recovery forecast. Supply chain bottlenecks in the auto sector appear to have relaxed, leading to inventory rebuild so that’s one positive (albeit a supply-led one). Wage growth and employment appear firm across the world despite the persistent inflation and rising rates. And, in Japan, tourists have returned with a vengeance. In April 2023, 1.9 mln visitors arrived in Japan vs April 2019 at 2.9 mln. While this is still only 65% vs pre-pandemic levels, last April 2022 was just 139,000; the majority of the shortfall is the lack of visitors from China. So, it is a relief that, at least someone is buying our stuff.
But, at the seams, we hear more negativity than positivity. The leading Japanese cardboard maker, for example, had unofficially revised down their annual volume expectations this year, citing weaker consumer demand. Energy prices are falling for similar reasons. Consumers are downgrading their purchases to lower priced goods despite higher nominal wages due to the high levels of inflation. Real wages were, unfortunately, still negative in April at -3%, marking a 13th month decline (it’s been negative for 25 consecutive months in the US). While most of our portfolio companies have raised wages +3~5%, nominal wage growth for the country was only +1%. Industrial production is still down YoY for 6 months in a row and comparisons get more difficult from late summer. Machine tool orders has also been negative every month this year and double-digit negatives during the last three. Similarly, housing starts have turned negative and accelerating during the last 3 months; as such, the construction machinery rental market is in the doldrums. While post-pandemic inventory rebuild continues across many industries, I fear inflation fatigue is sinking in. We had an interesting conversation with a major household goods manufacturer who said, “we’ve never had to ask to raise prices before, so the negotiations are taking longer than we are all used to”. If one thinks about it, the last time price hikes were normal in this country was probably in the 80s, so salespersons from that age have probably retired or at least not involved in the day-to-day operations anymore. We’ve become so used to deflation that, in the words of one manufacturer, “we never realized that price hikes could be a strategic option”. What that also probably means is that inflation will steadily continue for a while as sell-in continues. Whether sell-through will be firm for the rest of the year and the consumer will continue to bear this burden without faster wage hikes is something we cannot predict, neither here in Japan nor, I suspect, any other country including the US. But after the fastest rate hike cycle in history in the US and the fastest rise in inflation since the 80s (for both the US and Japan), I continue to believe that something must give which is why visibility is so poor wherever we look.
As much as our underperformance keeps me up at nights, I certainly won’t deviate from our strategy, nor do I wish to, which is based on bottom-up fundamentals; our choices to date has and will continue to be based on what the fundamentals are telling us (and a little interpolation/forecasting based on that). If I continue to see the consumer unphased by higher prices, we may change our portfolio decision. But, for now, I only hear from companies about hope that the 2nd half (and beyond) will improve without much basis to back such claims. And so, I stay cautious. I hope our partners and prospective future partners will benefit, in the long run, from our caution.
Masaki Gotoh
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“When everything seems to be going against you, remember that the airplane takes off against the wind, not with it.” – Henry Ford, American industrialist.
As you may all know, we Japanese are very particular about the four seasons. It’s probably because, here in Japan, the seasons are so distinct from our humid summer months to the picturesque fall foliage, and the beautiful winters with some of the best skiing in the world to the world-famous spring cherry blossom season. The disparate seasons in this tiny land mass about the size of California (but 3x the population) also bring with them frequent natural disasters such as earthquakes, hurricanes, volcanic activity, blizzards, floodings, mudslides, tsunamis, and even the occasional tornado. As such, we are probably more obsessed with the daily weather than other countries (this is just my personal impression). In fact, I pay 480 yen a month so my family can be aware of, not just daily or weekly weather forecasts by town (which is available freely from a variety of sources), but weather forecasts at sports stadiums, golf courses, ski resorts, firework events, or other specific locations and live events, many with real-time cameras, as well as other forecasts such as pollen density, yellow dust predictions, timing and percentage of bloom of cherry blossoms, when and where fireflies can be seen, estimated height and speed of waves around Japan, ocean water temperatures, heat wave warnings, strength of ultraviolet light, ideal times to dry clothes outdoors, shades of the fall foliage, unexpected torrential rainfall warnings, more accurate natural disaster warnings (of those mentioned above and then some), and even 5-min rainfall forecasts within a radius of a block or two for the next 6 hours.
These diverse seasons provide an abundance of varying food resources. The islands of Japan have one of the richest fishing grounds in the world where warm currents meet cold currents, providing one of the most ideal environments in the world for a large variety of seafood. Out of the 15,000 different varieties of saltwater fish, 3,700 species live around the waters of Japan, of which 1,900 are exclusive to our waters. It is very normal for one to say, “It’s almost the fall. I can’t wait for the [mackerel].” You could swap out [mackerel] with another dozen types of fish. The winter is particularly delectable with the many seasonal crab and shrimp varieties. And some species arrive twice a year such as bonito which tastes different in the spring as they swim north in search of food (so they test less fatty and fresher) compared to their trip back south in the fall to breed (and taste fattier like tuna). Conger pikes, freshwater eels, and grunt are also multi-seasonal with differing tastes. The same can be said about fruits and vegetables. I always get anxious toward late summer as I look forward to the mushrooms and root vegetables that become abundant in the fall. Similar, the spring brings new crops after the cold winter, making them taste particularly sweet.
As such, we are very aware of nature. We are sensitive to the changing of the tides and the flow of the wind and water. This is true in our daily lives as well. There is a term called “nagare” whose direct translation would be “flow”. The communal culture of the Japanese society probably has a strong sense of “Flow”. It’s hard for us to go against the grain and would much prefer to go with the Flow. As I’ve pointed out in the past, that is why we are particularly acute of our surroundings, whether it be nature or other human beings. In fact, there is a commonly used phrase “kuki o yomu” (“KY” in shorthand) whose directly translation would be “read the air” and means to “read between the lines”, or more like, “sense the situation”. Make a minor social mistake and someone might whisper to others, “they aren’t very KY”. So, we are always, instinctively, sensing and reacting to the “Flow”.
As scientifically, fact-based minded that I believe myself to be, I too believe in the “Flow”. That’s probably why I trust Eastern medicine as much as Western medicine. I go to acupuncture and acupressure regularly, take traditional Chinese herbal remedies, and do yoga and pilates (at least I used to when I had more time). I occasionally play Japanese mahjongg with my friends [Just to avoid future confusion, I want to clarify that Japanese mahjongg and traditional Chinese mahjongg rules are VERY different]. Anyone who’s played the game will tell you that there is a “Flow” to the tiles dealt and/or tiles drawn. There is a fixed number of 136 tiles (4 sets of 34 unique tiles) of which 13 tiles are initially distributed to each of the 4 players randomly. Each turn, you draw one tile from the walled pile and discard one. Eventually, you try to make a 13+1 tile hand before your 3 other opponents completes a hand or all but (usually) 14 final tiles are left (which acts like a cut card in blackjack). It is just as random as any other card game. And yet, I truly believe there is a “Flow”. At the beginning, one plays as they normally would but, as the evening continues, you might begin to feel the “Flow” is against you and may choose to play more defensively or, conversely, more aggressively. It’s usually prudent to be more conservative until the “Flow” changes (or just let that evening pass and hope the “Flow” is in your favor next time).
It happens in other areas of life too. I met up with an old Kellogg colleague of mine whom I hadn’t seen in nearly 10 years, entirely out of chance (although this “chance” also came about from another “Flow” which I’ll leave for another time). He came over for drinks and, during our casual conversation, I mentioned to him that my spouse was in the latter stages of chemotherapy to treat breast cancer. It turned out that his partner just found out a few days ago that she discovered a tumor too (and, of course, we offered to help where we could). Coincidentally, right before my wife started her treatment last year, we met with a couple whom we never met in a private setting together and found out during dinner that they had just gone through the identical treatment as we were preparing to do (and thus was very helpful in preparing us for the next few months). It was as if fate brought us together at the exact time that we needed it. This is another type of “Flow”. City highways, supermarket and security lanes, and immigration and customs lines also have “Flow” even though, theoretically, it should be random (as people who travel with me know, I’m ALWAYS behind the person that packed fruits or has a passport problem).
I believe that of public equity markets as well. Of course, I don’t use tarot cards to make investment decisions. But I do believe there is a “Flow” to the markets, and I don’t believe in random walk (although, of course, I believe in models like Black-Scholes that is premised on random walk [with drift]). Because of the infinite variables, the “Flow” is harder to read as compared to mahjongg or poker (both of which I’m not very good at which means that I’m not a good predictor of “Flow”). But there are 2 undisputable outcomes from the “Flow” – volume and price which do not move randomly. There is a human (or at least an algorithm with rules) making infinitesimal buy/sell decisions that cause volume and price to change, creating the “Flow”. Sometimes the wind is on your back and sometimes, like now (for us), you are facing against it. But, like the Japanese seasons, it can turn suddenly and violently. Until it does, I believe we need to be aware of it, but generally must ride it out rather than try to change direction, particularly with a strategy like ours.
In mahjongg, if the tiles are aligned correctly, you can take someone’s discarded tile rather than the walled piles (called “Pon” or “Chi” depending on the type). It might lower your return slightly, but your existing hand moves one step forward and may help improve your odds of winning (or at least make the other 3 players more cautious). But more importantly, the “Flow” has changed because every 4th tile in the walled pile that would’ve been yours has shifted. Some people make this move purposely to change the “Flow” when it has been blowing against you. And I know this sounds crazy, but the “Flow” does change! Ask any Japanese mahjongg player, professional or casual, and they’ll tell you the same. Often times, your opponent’s winning streak (and/or your losing streak) abruptly changes. I know it sounds very anti-science and “Ripley’s Believe It or Not”-esque. I can assure you that I am faithful to science and fact. And yet, I’ve seen the “Flow” change via a single “Pon” too many times in my 35 years playing mahjongg to know it happens.
When your losing streak is long, I think investing might occasionally need a “Pon” too.
