We’ve entered the all-important first-half earnings season. Around 1/3rd of the Topix 1000 companies had announced as of October end (all 1,000 have by Nov 9). While we haven’t gone through all of these companies, of course, my impression is that it’s leaned negatively, at least versus expectations. I can see this quantitatively by looking at average relative performance of each stock vs the index from the day prior to announcement until a week later (assuming that after a week, other factors begin to affect the stock price). While the average absolute return was +1.8%, the average relative return was -0.6%. On a market cap weighted basis, the average return was +3.6% (+0.9% vs the index) which would suggest that large caps have tended to outperform. Whether this was due to positive earnings or consensus was just low for larger companies where coverage is greater, one cannot say without going through individual names. But I would expect, given the much weaker yen versus initial company guidance, large caps, which tend to include more exporters, would have seen better numbers. In terms of industries, the most significant outperformance came from autos accounting for nearly 60% of the positive relative attribution. Machinery also contributed positively although this was largely due to a single large cap name, Keyence. Among our own names that have announced, there were few surprises in terms of their results or revisions. The post-release returns were mixed but weighted positively. Our average post-release one-week return was +2.0% absolute and +0.5% relative (attribution based on portfolio weight before announcement was +1.0% and +0.4% respectively). While we are still waiting for two more companies to announce, the fundamentals appear to have started to turn around, playing into our contrarian investment thesis. We expect this reversal to play through for the remainder of the fiscal year.

 

On a separate note, I heard an interesting story over dinner the other day with one of our brokers. I suggested that business must be good with all of the renewed interest in Japan and the rising turnover (which should be translating to higher commissions). However, they said “yes, but not so much from a research sales perspective”. When I asked them to elaborate, they said that it feels like most of the additional flow has been via futures or passive flow rather than active managers or hedge funds. Given what we’ve seen on the ground and the continued disconnect that we hear between the economic outlook from companies versus the index price action, this did seem to make some sense. Being biased as a long-time Japanese equities analyst, I do think that “this time is different”. I am hopeful for sustained moderate inflation and wage growth (at least among stronger companies) as well as industry consolidation leading to better pricing power. However, like 2005 with the Koizumi reforms or 2013 with Abenomics or 2023 with the JPX initiatives, it does feel too fast (and too broad). Change in Japan generally occurs gradually, and I fear that the hype might not match reality. And if just following the fundamentals, according to Bloomberg, Topix Q3 EPS (excluding extraordinaries) was up +34% but if one excludes negative earnings, it was up only +7%. The trailing 12M EPS grew only +5% excluding companies with negative earnings, compared to the +23% YTD market return [local currency basis]. Unless we are expecting an acceleration in earnings growth from here, the market run to date is mostly multiple expansion. At a market price-to-book at 1.3x on an ROE of just 8.7%, it does feel like a pause is in order. As such, if we are right and our companies continue to show earnings growth, I remain comfortable with how we are positioned.​

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Masaki Gotoh

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“Brand is just a perception, and perception will match reality over time. Sometimes it will be ahead, other times it will be behind. But brand is simply a collective impression some have about a product.” – Elon Musk, CEO of Tesla, SpaceX, and xAI.

I think the biggest surprise during my years at business school was the discovery of Marketing. Like most other new business school students, we all loved Strategy class. Some liked Finance too (I wasn’t one of them). But I never thought I’d enjoy Marketing the most, despite having taken only 2 classes; my summer internship at Goldman interrupted my education from what I wanted to learn to what I needed to learn. It may have to do with the fact that I’ve always had an interest in psychology and sociology, probably because I was forced to change schools ever 2~3 years or so due to my father’s frequent transfers across the US. But for whatever reason, I was fascinated at how marketing can shape consumer behavior if managed wisely and over time. Of course, one cannot live by marketing and branding alone; the product must satisfy. But it is an incredibly powerful tool and probably does not get enough credit, especially in Japan.
 
And, so, I was highly amused (and satisfied) when I heard about the “Bruno Palessi” brand. This is a shoe brand that came out with a glitzy campaign in an upscale shopping mall in Los Angeles. It started as a private launch party where Palessi shoes were showcased in beautiful glass shelves and gold mannequins. Via Instagram and other social media, they brought in social media influencers and other jet-setters to the champagne-flowing private opening to get their feedback on this new up-and-coming Italian brand. The shoes were priced at hundreds of dollars, some for even $1,800 a pair. “Palessi is just high quality, high fashion, taking your shoe game up to the next level”, “It’s just stunning. Elegant, sophisticated and versatile”, they would say. It was a great success.
 
It was also 100% fake. It was an advertising prank by Payless ShoeSource, a discount shoe retailer. The shoes were real but were actually being sold at Payless at a fraction of the list price at this event. Of course, those who had actually paid hundreds of dollars for these shoes were made aware of the prank later (and were offered to take their elegant shoes home for free).

 “Consumers are not capable of discerning the quality and value of the things they buy”, according to a consumer behavior consultant in the The Washington Post article where I read about this (this marketing campaign was in late 2018 but I just read about it recently). The article goes on to quote the consultant that “the way that we evaluate things is through associations. If you put wine in a nice bottle, people like it more. If you package things up to look more premium, people will like it more.”

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Being a value investor (in investing as well as my personal life), I’d like to think that I am less susceptible to such branding techniques, but I’m sure I am no different from other consumers. “Price” and “Value” are not equivalent. I do understand that what one person believes to be “value” may not be the case for another. Maybe someone rich enough would think there is little difference in paying $30 or $300 for the same pair of shoes. Or perhaps someone has personal gratification for paying up for shoes in a beautiful, comfortable setting. I’m sure there are many people that buy upscale brands to prove their fashion sense, especially if the brand is recognizable, and even better so if the label can be boasted with some subtlety, for example, the red bottom heels of Christian Louboutin pumps.
 
While “Price” and “Value” are not equivalent, I suspect “Price” and “Quality” is (often) perceived to be equivalent. If it’s expensive, there must be a good reason that it is. And this is separate from simple supply and demand. Scarcity value works only if it is perceived to be high quality, i.e. just because there is less of something does not make it more valuable. The benefit to this approach is that it requires less research. If it is expensive, it must be good (or at least better than something that is less expensive). One can be justified for buying something expensive from the simple logic that if other people are paying up for it, other people have done enough work or there is enough history to prove it to be of high quality. I will be the first to admit that I assume so at times during my daily life (although I generally look for a way to buy it, or something similar, cheaper).

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I think financial markets are not that different. There are over 60,000 listed companies to choose from and a lot of analysis done on many of them by professionals. In Japan alone, there are 4,000 companies, 1,300 with at least 1 analyst coverage. I’m guessing that a sell-side analyst covers maybe 10~15 companies and spends all of their time thinking about what the fair value of the stock is. But that fair value will, almost certainly, be dependent on some sort of earnings multiple and, thus, is defined by just 2 variables, future earnings (one, maybe two years) and the multiple. And, more often than not, the earnings (or rather perceived future earnings growth) will dictate the multiple. If it grows fast, it deserves a higher multiple. While we’d argue that there should be a variable regarding visibility of earnings to adjust the multiple (similar to our “fundamental-based beta” calculation to calculate the discount rate), the sell-side answer is often “whatever the (average) multiple was in the past”, which implicitly assumes that past earnings growth will be the same as future earnings growth.

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Now, we would also argue that “earnings growth” and “quality” are not necessarily equivalent. We’d prefer to say “sustainable and visible earnings growth” is one of the leading components of “quality”, but not the only one. But if “earnings growth = quality”, then “expensive” would be “quality”. And, therefore, using this simplistic logic to choose high quality (i.e. high valuation) would make sense.

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But there are two major flaws to this argument, the first from making the assumption that history defines the future (despite all of the caveats that say otherwise). We certainly believe history helps us forecast the future; but to say that a stock was trading 25x on average for the last 5 years means it should be 25x for the next 1~2 years seems overly simplistic, especially since when one says 25x “on average” probably means “22x~28x” which is a pretty wide spread on a multiple of an earnings number that, itself, is a forecast. Conversely, to assume that a stock that used to trade at 20x but has, more recently, fallen to 10x must mean that the quality has fallen, is also an over-simplification. I’m almost certain that something did happen. The question is whether that something is a structural change or a temporary one. And that takes work to dissect.

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The second flaw is that they forget the law of diminishing marginal returns. If a company that made $1 mln made $2 mln the next, they grew earnings by +$1 mln for a 100% return. But the next +$1 mln will be a 50% return and the next 33%. If they can reinvest all of their earnings to continue compounding earnings at the same ROIC as the past, perhaps they can continue doubling earnings. But I’m almost certain it gets more difficult as the numbers get larger. A fixed multiple for future earnings ignores this analysis (unless, of course, the analyst was using a slightly lower multiple every year to account for the diseconomies of scale, something I have never seen done until after the fact).

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While DCF is certainly imperfect, I see it no more or less imperfect than a multiple based on recent history off of just one (or two) years of forward earnings. We do, of course, review our own DCF-based fair values based on traditional multiple metrics too, just to see if our target multiple can make logical market sense. But we would not define quality based on earnings multiples alone. Expensive stocks are often growing fast, and we would certainly not avoid a stock just because of high multiples. But we would need to ascertain the sustainability and visibility of the fast earnings growth to justify the higher multiples, rather than just assuming expensive = quality.

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