We have finally completed the results of last fiscal year earnings and new guidance for the next year (for the 70% of listed companies whose fiscal year end is in March). And the trend was largely the same as my preliminary assessment from last month’s commentary where guidance tended more conservatively than usual with much of the gains expected in the back half. The reasons for the lack of margin expansion are pretty much the same including higher labor costs, higher distribution costs, higher energy costs, and overall inflationary pressures. The obvious Economics 101 question one might ask is “if there are inflationary pressures, that means everyone is raising prices, so why don’t you?”. And the simple answer is that 1. many of the inflationary cost pressures are coming from outside of Japan (where the weaker yen is hurting) and 2. few companies are raising prices to reflect the impact of cost increases in full. Now, #2 depends on company and industry but after 30 years of disinflation and the first full year of real price hikes due to (external) material price inflation, it’s becoming less easy to do so, especially if the reason is fixed costs. The only firm that seems like they are raising prices carelessly is McDonalds (a hamburger cost JPY 110 before the pandemic [JPY 100 a year before that] and is now JPY 170, up +55%). And with real wages still negative (April logged the 25th consecutive month of negative real wages), price hike negotiations are becoming a little less smooth. While there has been much fanfare about the average 5+% base wage hike (the highest figure since 1991), these are mostly listed companies and even the listed small caps are considered fairly large from a country-wide perspective. The 4,000 listed companies in Japan employ only 3.6 million of the 57.6 million working population who are spread out across 3.7 million companies. This may be partly why country-wide nominal wages actually only rose +2.3% YoY last month. Still, this nominal figure was nearly a 30-year high and it’ll take a few months before the entire impact of the wage hikes filter through such that real wages should sustainably start to rise sometime during the summer (assuming inflation stays where it is). While it won’t affect wages, the one-time tax break in June (thanks to the ever-declining approval rate of the Kishida administration) should add a little boost to households as well.
 
So, if consumption doesn’t falter, I still continue to believe that inflation is here to stay (and I am still confident a decent amount of price hikes will filter through), wage hikes will continue, industry consolidation will progress, and, someday, we’ll see positive real interest rates. But as I’ve said many times, the road will be bumpy, and I suspect 2024 will be the first big bump we encounter.
 
Because earnings guidance from mid-May onward were centered toward listed small caps, their businesses tend to be more domestic-oriented. Perhaps that’s why the guidance wasn’t quite so grim; as an exporter, even with the FX currently at 155+ yen, one certainly can’t forecast such a figure for the full year and most firms used a 145 rate which means exporters have a massive FX hurdle they need to overcome from a guidance perspective (and, conversely, a huge FX buffer at least for the 1st half). But, like many of their larger-cap counterparts, small/mid-caps also announced more buybacks and dividends hikes to counter the less-than-exciting guidance.
 
But what was very notable was the huge magnitude of stock movement, especially when a company issued weak guidance. I frequently saw double-digit stock declines on a -5% EPS or other trivial miss vs “consensus” (since most small caps aren’t covered by the Street, “consensus” is somewhat misleading), especially with stocks who’ve run a lot since the start of the year (e.g. tech, industrials, high-beta names). Additionally, small caps, whose trading tends to be much thinner, would be more susceptible to large changes in volume like that during post-earnings. But even taking such factors into account, I hadn’t ever seen such large movements in the past (and I’ve been watching Japanese markets since the late 90s).
 
Nomura had an interesting report that observed similar price action and hypothesized that this was due to the “new money effect”. Because of the massive inflows from new foreign investors into Japan during 2023 and the 1st quarter of 2024, many were probably unaccustomed to how stocks trade around earnings. They ran the stock because it looked cheap, especially from a US$ perspective, and looked peripherally interesting. But then, as guidance was for flat or single-digit EPS growth, they’d crush the stock. Nomura noted that this post-earnings price action was similar to past periods when foreigners rushed into Japan (I assume this was during Abenomics as that’s the only time in recent memory that they had flocked to Japan; prior to that would’ve been during the Koizumi reform but I don’t remember such price action back then). While I haven’t bothered to check if there is any truth to Nomura’s thesis, it made a lot of sense to me. Japan has many local quirks, particularly as you go down the market cap scale. And because of the (relative) lack of long-term, fundamental-oriented investors to begin, it is difficult to figure out who is driving the stock. I remember back in the mid-2000s, Raj, my old boss from Standard Pacific, would ask me “who’s selling”? And while I may not be able to name a precise institution (nor was he expecting me to), I could get a sense of who was driving the stock and why, mainly because we focused on large(r) caps where sell-side coverage, but there was much less individual participation and quants funds that (I hypothesize) is adding to this volatility. And as one goes down the market cap, both investors and the companies themselves become less financially aware. And in Japan, which is not entirely capitalistic like the US but what might be called “collective capitalism” which is like capitalism with a dash (or two) of socialism, basic Finance 101 principles often do not apply and, therefore, the actions that companies take may seem counterintuitive to first-time (or even experienced) Western investors. It takes communication, understanding, and a little cajoling (or, with some activists, tormenting). But, most of all, it takes patience and experience.
 
Therefore, I would tend to agree with Nomura about what is leading to this increased volatility and, frankly, absurd valuations, both to the upside and downside. It will be interesting to see how this bumpy 2024 will play out within that context, especially with so many geopolitical chess pieces also in play.
 
We are soon entering the rainy season so if any first-time visitors are contemplating a trip to Japan, I HIGHLY suggest you avoid this season or the abominably humid summer and come during the extremely pleasant fall or picturesque winter, especially since I think quite a lot may have changed by then and, if nothing else, we will have much better visibility, for better or for worse.

​

Masaki Gotoh

​​

===

​​​

“We don’t stop playing because we grow old; we grow old because we stop playing.” – George Bernard Shaw, Irish playwright.
 
My wife sometimes says that I am too strict with our boys. I, of course, don’t think so, having been raised as a very typical lower-middle class Gen X household. Now life wasn’t hard back then, but it did take a lot of individual effort without much adult guidance or supervision to get by. We didn’t have the luxury to think about the planet or social unrest and just tried to get through each moment day-by-day, and, therefore, didn’t have the advantages that my children have (and I’m sure each subsequent generation has said and will say the same). And so, I often use the carrot-and-stick approach when disciplining my children. Recently, I had to wield my stick toward my younger son, Louis, and took away his digital games and streaming media for a month. The only times I allow him to watch television is as a family (which generally means documentaries; we recently watched “Fed Up” together which is a 2014 documentary about the evils of sugar, available on Amazon Prime by the way).
 
But I also allow board games. When I was a young child, I LOVED board games (mainly because I didn’t have any digital games until my dad brought home our first MS-DOS PC with a 5 1/4-inch floppy disk drive, the green-on-black CRT monitor, and a dot-matrix printer; we got it for free as it was not being used at his office and it ultimately led me to obtain a degree in Computer Science). Every Christmas, I would look forward to the new board game and usually another volume of “Charlie Brown’s Super Book of Questions and Answers” which was a collection of random trivia on a particular topic like Space or Science. I recently bought the whole series for my own son, so he didn’t have to wait 5 Christmases to read them all as I did; it has since been renamed to “Charlie Brown’s ‘Cyclopedia” and extended to 15 smaller volumes (for marketing purposes I’m sure), in case anyone is looking for a great set of books for their children.
 
Despite all of the games available on your iPhone, iPad, PC, Nintendo Switch, or Playstation 5, you’d be amazed and hopefully delighted to know that new board games are still being developed and sold. I’ve started buying some random games which I can play with my digital-game-grounded son. My older son Leo, who isn’t grounded from playing with his iPhone, still tries to limit his digital play time and plays the board games with us so as not to upset Louis too much (though Leo still quietly comes to hide in my room on occasion to play with his games with his headset on).
 
While many of the new games are great fun, the classics are still wonderful. Louis particularly likes Mastermind where our relative scores have since become on par to each other after he understood the patterns, a feat I am particularly proud of as I’m a pretty good player. We have other classics including, of course, Monopoly. The history of Monopoly is rather interesting. It was originally called “The Landlord’s Game” developed by, ironically, an anti-monopolist named Lizzie Magie. The original game had not one but two sets of rules to choose from. One was called “Prosperity” where every player won money when another gained a property. The goal was for everyone to win which would happen only when the person with the least doubled their resources. It was a game of corroboration and social good to teach the negative effects of land monopolism and the use of land value tax to remedy it. The second set of rules was called “Monopoly” where the goal was to buy property and take rent from those unlucky enough to roll a bad die. The winner was the person who used their wealth to eliminate everyone else. When Parker Brothers bought copyrights to the game, they eliminated the “Prosperity” rules as well as the taxation rules. I don’t know the exact rules but would’ve have liked to try that version too.
 
Louis doesn’t like Monopoly very much, though this isn’t because he doesn’t like to win. If anything, he loves to win, and, conversely, hates losing. But because much is left to chance, he gets upset when he starts to lose (especially since, in the game of Monopoly, once you start losing, you probably lose more and more over time, accentuating your distress).
 
My favorite board games tend to require more skill than luck but has a little of both. As I mentioned in the past (I think), I was very much into war games, several of which I have unopened at home as they are a few years too early for my boys. They require a lot of strategical thinking and experience. When these games involve 3 or more people, there is a further element of human behavior and reading your opponents (who may, at times, become allies too). But these games usually involve the use of dice which means that there is an element of luck too. But I wouldn’t say it’s purely random; one could compute probabilities based on the number of rolls one is allowed which is generally a function of the size and/or strength of one’s army or resources.
 
The equity markets are like one massive multiplayer strategy game but with multiple “winners” and “losers” and an infinite number of players who change frequently, all running differing strategies. We all work with imperfect information, much like board games often do, and try to gather as much information as possible to increase the probability of our decision to buy or sell (or short for those inclined). Some of this information comes rather suddenly and, unlike board games that generally have an unlimited time between turns, may require a decision and/or action. And there is an element of luck, too, like a sudden change in regulations or natural disasters or other disruptions that creates temporary (and sometimes structural) winners or losers. And experience does, I believe, add to your edge, especially, I would argue, for foreign markets or new, complex industries. For such arenas, “the only winning move is not to play” (a quote from the supercomputer W.O.P.R, nickname “Joshua”, in WarGames). This is, of course, entirely my opinion, but this is why we don’t invest outside of Japan nor in “new markets” like genomics or cryptocurrencies or AI as I have no more technological knowledge than the average person on the street (although, of course, I have to think about and be aware of the potential consequences or opportunities that these new technologies will bring to existing industries).
 
Arguably, I would say the gaming aspect is probably closer to trading than investing. The short-term skirmishes don’t really matter to us unless they are, collectively, a concerted effort toward a strategic victory in a specific battle within a certain theater. It is these strategic decisions made by the senior commanders that are of vital importance to investors like us. The short-term oriented traders can make their frequently updated buy-sell calls or trade around earnings and play the trading game; I used to do a little of that back during my hedge fund days. I am sure many are very, very good at it, but I think, luck (or randomness) is a much larger factor, especially in a country like Japan where information is not as readily available and the players (and their actions) are less clear. But the direction and, equally important, the execution of what the generals decide will, I believe, decide the final outcome, and therefore, the time element is less important but the information gathering, analysis, and simulations become vital to the decision-making process.
 
I, like Louis, really dislike losing (even to my children so I don’t hold back when playing our games). Losing ruins my hour, day, week, month, or year. But in the long run, I do believe if we have the information, do the proper analysis, and consider the risks, we will “win” (meaning an acceptable risk-adjusted double-digit return). Despite the short-term misery that these skirmishes sometimes cause, it is the long-term game that I try to focus on, however temporarily painful it may be. A company may have missed a quarter or guided weaker. But the question to be answered was whether that miss was simply a setback that can be overcome in the next battle once reinforcements arrive, or has it changed the course of the war. Are they guiding weaker to keep their peers at bay or do they really think dark days are ahead?
 
During this earnings period in particular, there were strategic mishaps too, notably with regards to weaker-than-expected shareholder return policy or pitiful ROIC/ROE targets. But some of these mistakes were a communication problem, not a structural issue (although some announcements were truly pathetic, thankfully none that we owned). I recently mentioned to one company that,
 
“I’m not upset that you haven’t been clear about your target payout ratio (like other analysts were). But what you should be explaining to us is that your ROIC has been growing due to accretive acquisitions. The nature of the business does require a lot of capital, so we’ve kept WACC low through use of low-cost debt below our ROIC. Therefore, we have and will continue to reinvest your capital in accretive ROIC projects while maintaining a low cost of capital.”
 
They seemed very surprised (and pleased) that there was an investor that wasn’t just shouting “raise dividends!”. At another company that we own, we asked them to clearly define ROIC based on net tangible assets that is actually used in the business. Furthermore, despite what appears to be low accounting-based earnings, free cash flow is very high, implying room for higher payouts (the latter point added by the CEO himself). Furthermore, we will not haphazardly pay down our low cost debt and maintain a healthy balance sheet. The stock was up nearly +20% last month on this statement which helped not just us or other shareholders but the company itself, notably management.
 
Investing isn’t like “Monopoly” where a single player is trying to wipe out all other players (except, in the case of value-destroying companies where the company is destroying value for all of its shareholders; thankfully, we would never invest in such a company, but I applaud the hard-core activists that do and are attempting to change the ways of such bad actors). As long-term shareholders, I think we try to play by the rules of “Prosperity” where our gain is the gain of every other minority shareholder.
 
I hope they bring back both rules of Monopoly so that more people can understand the difference, in the board game, in the equity markets, and in real life.

​​​​