Despite the steepest drawdown for global equities since the pandemic, our portfolio performed relatively well, outperforming our benchmark by over +5%, the best outperformance since inception. There was little growth/value factor tilt and, while small caps fell slightly less, the magnitude of the carnage was similar. The market decline was broad although defensives such as Telcos, Utilities, Health Care, and Consumer Staples fared better. Given the sharp decline in the US (S&P 500 down -9.7% vs Topix down -6.5%), Japanese exporters and other globally sensitive stocks fell particularly deep despite the continued JPY weakness.

 

Our outperformance was not driven by any particular stock and all but one name outperformed the market. On a top-down level, we had specifically reduced exposure to the more macro-sensitive industries during the first half of this year so I can understand from a portfolio-perspective why our portfolio should (and did) outperform. However, some of our names are still directly exposed to the macro economy like Macromill (up +1.7% for the month) and our chemical producer (+2.2%) which are currently our top two positions. I must admit, I can’t cite a specific idiosyncratic reason why they should have outperformed while their peers underperformed the market (Macromill comp Intage fell -5.6% while a specialty chemical producer similar to ours fell -9.7%). If they were down less than the market, I could explain that away with supply/demand or other technical reasons. But 6 of our 13 names were up in absolute terms this month and they had very little factor similarity (two were stocks that are direct beneficiaries to a reopening of the Japanese borders and an influx of international tourism, but so is the one name that had underperformed the market; the other four positive performers have nothing to do with domestic foot traffic). I must admit, I fear that it was a temporary phenomenon, and we should expect some reversion.

 

Still, the performance does confirm that the exposures we had intended to take worked as they should in this environment. As of this writing, there has been a sharp risk-on reversal across the global markets from the start of October and, as we would expect, the portfolio is up but underperforming. While multiples may have contracted, we continue to brace for a global slowdown that should affect forward global earnings, masking the fact that valuations are still too high, regardless of the pace of interest rate hikes. In either case, we do not adjust our discount rates based on global interest rates (our risk-free rate has always been 2% and the equity risk premium set at 6%) so our discounts to fair value and/or valuations do not change based on what the Fed might or might not do. And so, while the first week of October has been somewhat painful, we continue to maintain our portfolio positions and plan to do so for, at least, the remainder of this year. Until then, we look forward to many of you, your colleagues and families visiting Japan when we finally fully reopen this week. As of September end, there are only 11 currencies that have underperformed the yen this year (in case you are curious, they are the Pakistani Rupee, New Sudanese Pound, Hungarian Forint, Ukrainian Hryvnia, Suriname Dollar, Sierra Leone Leone, Turkish Lira, Argentine Peso, Laotian Kip, Ghana Cedi, and the Sri Lankan Rupee). So unless you are visiting from one of these countries, you’ll find Japan incredibly cheap!

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Masaki Gotoh

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“OPTIMISM, n. The doctrine, or belief, that everything is beautiful, including what is ugly, everything good, especially the bad, and everything right that is wrong. …It is hereditary, but fortunately, not contagious.” – Ambrose Bierce from The Devil’s Dictionary.

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Outside of the NHK public broadcaster, Japanese television tends to lack serious content on global current events. On weekdays, the 4 major broadcasters run “news” from early morning to early evening and then again at night. It is repetitive with virtually the identical content running amongst them throughout the entire day and night, and mostly about trivial domestic matters. Worse yet, when it is somewhat thought-provoking, Japanese news programs can’t simply report the news but feel compelled to make subjective comments on them. Like other countries, some of the comments lean slightly left and some lean slightly right. But they are not as pronounced as CNN or Fox News and the magnitude of the rhetoric depends on the individual commentator. But they tend to lean in the same general, dissenting direction. As such, not only are they monotonous, they are uninformative, dangerously suggestive, and even outright misleading. And this continues 5 days a week from morning to night, and even during the weekends. It is probably because of this monotony as well as the communal, uniform, and relatively closed Japanese society that, I believe, the Japanese populace is easily susceptible to influence by the media who can sway public opinion. I’ve always disliked Japanese television news, mainly due to these biases as well as the fact that a significant amount of time is spent on unnewsworthy, even silly content. In fact, I’ve come to rely on global channels to get less-biased content. I know that must sound perverse given the strong distrust of global news sources, but at least with global content, you can hear both sides and extrapolate between them whereas, in Japan, it usually leans in a single direction. In either case, when I do watch Japanese news, it is for its entertainment value, not for its informative content, and, for real news, I stick to the global cable channels, NHK, and the newspapers (digital versions, of course).

 

However, some of the Sunday morning news programs are a little more serious. Although they are still biased, perhaps even more so than the weekday news, it is at least a little less silly (some of them, anyway). One recent Sunday, I was watching one of those typical, highly opinionated, but serious programs. They showed the results of a survey conducted from a sample of 25,000 people that showed that 72% of the population is now in favor of possession of a nuclear deterrent. There was no mention of the margin of error or how the survey was conducted, as is generally the case with the news here (another reason why one can’t fully trust such surveys). As this program was running on a slightly right-leaning network, I checked other sources and found that, while not quite that high, most polls see it above 50%. While I can’t recall what the figure was in the past, I’m certain that it was very low since the majority of Japan wanted less militarization until recently. It is a shocking about-face. As far non-consensus that I am when it comes to Japanese domestic policy (I have always supported both nuclear power and military expansion, both of which used to be extremely unpopular views), I’m generally against nuclear armament, although ever since former President Trump legitimized the North Korean regime, I’ve been more open to the suggestion. Similarly, I have seen other surveys that show more willingness to restart our nuclear power plants (due to higher oil prices), strengthen our military (due to the invasion of Ukraine), and even change our constitution to allow premature defensive capabilities. It is surprising how quickly the hearts of our nation had turned. If Abe-san kept his position for just another 2 years, he may have seen many of his goals come true. Arguably, it is because of his assassination that, perhaps, this change was set in motion. The irony is, if these come to pass, it would have strengthened the very legacy that the majority in our country had wanted to destroy.

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History has shown that sudden change in public opinion is not unusual, but it is usually driven by an underlying belief that had boiled up to the surface, triggered by an event or series of events. World wars do not occur overnight. Populism did not suddenly appear due to a single man. These conflicts ran deep within society but remained hidden, only whispered behind closed doors, until events allowed those frustrations to be exposed into the mainstream. However, in the case of the change in sentiment in Japan regarding the topics above, I believe it is simply because public opinion was not very deep in the first place and was implanted by the media. Of course, I’m certain that Okinawans are truly against an increase in military presence, that the citizens of Hiroshima, Nagasaki, and Fukushima are anti-nuclear from the heart, and the elderly who still remember World War 2 would fight to maintain our pacifist constitution. But I think the rest of us were simply swayed by the media wherever there was some strong negativity that the media could take advantage of. Bad news is, after all, good business for media and with the lack of much to report, any controversial topic is quickly reported and the unrest accentuated. But the conviction of such opinions were not that deep; they can be turned.

 

The market is even more fickle and feels particularly so this year. A very intelligent investor recently said to me very eloquently that the direction of the market can be summed up in three words, “I don’t know”. Like Japanese domestic policy, there is probably little conviction in the economy. Presumably, that is why one weak macroeconomic datapoint can suddenly change forward interest rate forecasts and cause equity markets to go up. I remember when a weak economy usually meant stocks go down, but I guess I’m too old school. But I wonder how many current market participants remember the Asian Crisis, the LTCM collapse, the IT bubble burst, or even the Global Financial Crisis, all of which I’ve lived through in my finance career. I suspect many have not, or maybe they’ve forgotten after the longest bull market run in history. So I thought I’d offer a few statistics, at least from the last 2 major corrections.

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<Statistics regarding IT bubble and GFC regarding peak-to-trough EBITDA, valuations, and index levels for the S&P500, Topix 500, and SOX (please contact me if you would like to see this data)>

 

In terms of the fundamentals, trailing EBITDA for all of the indices above (the S&P 500, the Topix 500, and the Philadelphia Semiconductor index) fell for 2 years after the IT bubble crash and the global financial crisis. It took anywhere from 3 to 14 years for EBITDAs to recover its previous peak. Current estimates have EBITDA rising this year, next year, and the following year so while the market may have corrected, forward estimates are not assuming a slowdown. In terms of valuations, it is less consistent across the markets and cycles but they still fell for about 3 years. While off their peaks, current valuations are still well above previous troughs. Finally, the indices themselves fell 50% or more during previous corrections and took about 2 years before settling down. It then took over 7 years to get back to previous levels. And yet, current stock prices are still well above pre-pandemic levels.

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Now, admittedly, the drivers of this cycle are different from the pre-IT bubble’s irrational exuberance or the pre-GFC financial excesses, although I’d argue that we seem to have a little flavor of both in the current markets. As neither were the predominant view at the time, they could only be confirmed after the fact, so it remains to be seen if this cycle is any different. The balance sheet of the financial sector is in much better shape and liquidity is still abundant compared to past peaks. So there is a chance that the trough will not be so deep or that the recovery so long. Personally, I do not believe that to be the case but I’m certainly willing to entertain the possibility that this time may be different. Comparatively, Japan seems to be in slightly better shape. While forward estimates are similarly high, valuations are closer to previous troughs and the index level is closer to pre-pandemic levels. Still, I think it safe to say that the market seems excessively optimistic, even in Japan.
 

The market’s optimism may not be hereditary. We’ve easily moved from extreme optimism to extreme pessimism in past cycles. But it probably is contagious. I must be too old to catch it, which is why we will continue to invest based on what the economy is telling us. And right now, it is telling us that it feels sick. While we don’t need to wait until it heals, we will maintain our current exposures until the sickness starts to abate. The symptoms might last for some time, but I’m confident that it will heal itself eventually as it always does. And when it does, I believe that, like last cycles, our competitively advantaged businesses will come out stronger.​​