While the broader TOPIX index (total return including dividends) was down -1.5%, the markets continued to gyrate heavily based on macroeconomic and geopolitical news. As such, volatility remains at elevated levels whether it be the historical 22-day volatility (which would not include any effect from the double-digit index moves on Aug 5 and 6) or forecast volatility (which, by definition, does but less so over time). I’m sure we can all hazard a guess as to what is causing the current bout of volatility clustering. But it only started with the surprise BOJ rate hike into positive territory; there have been many other macro events since that is further fueling the volatility. Furthermore, what was, arguably, the last bastion of (somewhat) political stability in the developed world had been upended by another surprise when Ishiba-san was unexpectedly elected to lead the LDP.
 
Given all of this commotion, there was little to change the general stock trends from post earnings in August, outside of those with FX sensitivity or industry exposures that is particularly sensitive to macro factors. Within our portfolio, the 2 names that had been outperforming during the first 2 months of the quarter accounted for the bulk of underperformance for September with no specific news to cause this reversion (with the remainder being the difference in dividend yield vs the benchmark due to differing fiscal year ends, another unusual quirk of our portfolio that I mentioned in a past monthly). As mentioned last month, fundamentally, our companies are doing very well, and we are expecting double-digit bottom-line growth rates for the next coming years for the majority of our investments as Japan finally starts to normalize, although some are expected to start slower than others. Moreover, most have company-specific drivers that we expect to reap rewards in the coming year or two that can partially shield us from further external commotions. As for those where high earnings growth is less certain, we have begun to slowly unwind those names and replace with those where earnings momentum is clearer.
 
For better or for worse, our top 5 names have little to no currency exposure; I suppose I should say “for the worse”, at least in the short run, as the consensus seems to be that US interest rates will remain high and BOJ rate hikes will be slow, a view opposite of what the world seemed to believe just a month or two ago. As I have no idea, we do not construct the portfolio based on currency views. Still, for over a year, I have wanted to move the portfolio more balanced from its highly domestic bias. However, the fundamentals did not support such a rebalance at the time and, therefore, we had been waiting patiently for those fundamentals to potentially shift (or at least its probabilities in our favor) rather than forcing such factors in the portfolio. Therefore, some of our newer (but still low-weight) names have more global exposure (as do 2 additional names waiting to be added) as forward visibility has begun to improve and/or idiosyncratic drivers can help overcome any market-driven uncertainties, not to mention that they are significantly cheaper than they were 12 months ago.
 
Still, the short-term volatility is expected to create significant gyrations to our relative and absolute returns. From late October and through early November, the majority of companies will begin to update their second half fiscal year guidance. As you may recall, many companies had kept their first half guidance conservative while expecting a recovery in the second half. Overall, I suspect such optimism will likely be tempered or pushed out at least one quarter. The most recent reversal of the yen will probably provide a sigh of relief, especially for the exporters. However, this also has the side effect of continued inflationary pressures which will inevitably lead to further dispersion between the haves and the have-nots. Personally, I welcome it, but I suspect that view may be unique to long-term (quality-oriented) stock-pickers. Still, I do expect that the unabated beta-led, market-wide stock rally which began from early 2023 to the first calendar quarter of 2024 has come to an end.
 
In either case, I look forward to the days when we can simply invest in good businesses without having to obsess about politics or monetary policy.
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Masaki Gotoh​​

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“In my view, the biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. Not only is the mere drop in stock prices not risk, but it is an opportunity. Where else do you look for cheap stocks?” – Li Lu, Founder and Chairman of Himalaya Capital

 

It’s been four and a half years since the pandemic shook the world. And despite what, in retrospect, was an amazing feat of medical wizardry that helped us overcome the disease so quickly, we are still living with the after shocks on many different levels, some temporary and some possibly permanent. Of course, the most notable is the demand-side shock as the world (ex-Japan) reopened so quickly while simultaneously experiencing a supply-side shock as the fragile global supply chain could not fulfill that sudden demand at that speed. But Japan didn’t react the same at first. Just as a reminder, much of Japan was still in a quasi-state of emergency until Mar 2023 and had nationwide mask “mandates” until May 2023. So, our (domestic) demand side shock was a little delayed and not as sharp, especially as the weakening yen made imports much more expensive. Still, we were affected on the supply chain disruptions especially from outside Japan with abnormal order levels continuing throughout 2022. Inventories were so low that I had heard stories of overseas customers coming to the warehouses in Japan of their parts suppliers, even while Japan was still partially locked down, because they believed that the Japanese supplier was hoarding the precious inventory (and was proven wrong when they saw the barren warehouse). While orders declined rapidly in 2023, companies were able to work through their high backlogs from 2022 and, with the help of a cheaper yen, export their way out of 2023. We are still feeling some of the aftereffects of that channel inventory being worked down but, overall, at least looking from Japan, we seem to be at or near a balance in most sectors. Unfortunately, we are entering a period where global demand may be wavering (or at least being put on hold until after the elections). But at least inventories appear to be near normal levels.
 
Additionally (or perhaps consequently), the massive global inflationary environment and equally strong monetary response had incredible repercussions across the globe. This, too, is being corrected for most of the world. Japan, again, was unique in that inflation was more subdued as the Japanese supply chain absorbed some of those external price shocks. But they were strong enough to cause price hikes across almost all industries as well as wage hikes at speeds unseen since the early 90s. Despite all of the fiscal, monetary, and governance-related initiatives and experiments over the last three decades, it took a global pandemic to finally escape our disinflationary spiral.
 
Separately, the political landscape has also changed drastically. I suppose one could argue that the pandemic may have accentuated this polarization, but I suspect it had been brewing all along and perhaps the pandemic (or rather its inflationary fallout) took us over the tipping point. As mentioned above, even the politically boring Japan had its shock recently with the election of a maverick, which may ultimately lead to similar political disarray. After saying he wouldn’t, the new PM Ishiba-san chose to dissolve parliament (which seems like a political death wish to me, but we’ll see). Our elections will be on October 27, just a week before the nail-biting US presidential election. While the latter will most certainly have serious consequences that will change the world, our elections are similarly important for Japan to see if we can revert back to the status quo, or we move toward a more radical path.
 
And, of course, let’s not forget the many conflicts across the globe, wreaking additional havoc on commodity prices from oil to wheat to metals. While, like everything else, I suspect it will eventually normalize, but the conflicts may escalate before they do. The outcome and speed at which we get there will probably depend on who the next leaders of the democratic nations will be.
 
Other side effects from the pandemic include possible permanent changes to our livelihoods such as the way we work, the way we value time, and the way we use technology. And the value difference between generations, both qualitatively and quantitatively, seems wider than ever.
 
So, what does this all mean in the context of Japanese stocks? As I’ve hypothesized over the many monthlies, the major fundamental shift from disinflation to inflation will, in my view, have profound effects. I gave an example at a conference recently where I mentioned that my first job out of Cornell was as a semiconductor engineer at Hitachi in 1992. My first salary was around 220,000 yen per month before deductions which, at current rates, is under $1500 (in addition, most large firms pay 2 bonuses a year worth 2~3 months of salary each, depending on labor negotiations and, more recently, performance). Fast forward to April 2021 and, 20 years later, a 1st year undergrad would earn only 200,000 yen per month at the same firm. But for the new grads who started in April 2024, Hitachi raised 1st year monthly salaries to 250,000 yen or a 25% increase in just 3 years. I saw that average summer bonuses, which has been largely flat since 1992, had exceeded an all-time high this past summer, at least at large corporations. Also, back in 1992, I earned 5% in my corporate savings account (a perk that large companies offered to employees that allowed us to save a portion of our salary at, roughly, the 10-year rate). That same perk, for the few companies that still provide it, earns 0.5%. And incredibly, Japan CPI is currently higher than that of the US. While it’s probably due to the currency, it’s still an anomaly not seen, except for a few months in 2014, since the oil shock of the 70s (though ex-food and energy, Japan inflation is still lower than the US).
 
Unless senior management of a Japanese company is currently in their mid-60s or above, they’ve never experienced inflation or positive interest rates. And even if they are that age, they went through it as lower-to-middle management at a time of an unprecedented asset bubble which hardly has any relevance now. Nor have they ever felt the huge change in corporate governance and, consequently, what is expected from your shareholders whom, back in the 80s, where group companies and strategic cross-shareholders. Furthermore, unlike during the deflationary era where cash is king, the change in purchasing power should lead to increased debt and not just because of shareholder activism. This may surprise many, but Japan wasn’t always cash rich – that’s just a function of deflation. In fact, Japan loved debt in the 80s when there actually was a thing called inflation. Conversely, if you already are indebted like many of the unlisted small enterprises that account for 85% of companies in Japan and whose debt-to-asset ratio is at 60% vs the national average of 32%, the debt servicing cost will rise in addition to your other costs. In fact, all costs including goods, services, labor, and capital will rise, something you’ve probably never had to deal with, at least not as senior management.
 
Similarly, in our industry, unless you were a portfolio manager in the 80s, the competitive environment of the companies you invest in will change drastically. Japan will no longer just be a trendless trading market based on factors but one where stocks follow corporate fundamentals (in addition to the factors that drive them). Governance has changed dramatically in just the last 2 years which will also change the way you need to look at companies and management. The stock exchange has also found religion and are not just promoting the understanding of cost of capital and the unwind of strategic shareholdings, but also a reduction in the number of listed companies. MBOs are more frequent as the cost of staying publicly listed is rising. I had postulated that consolidation and bankruptcies will rise. So far in 2024, M&A activity is expected to mark an all-time high while, if the current rate is maintained, the number of corporate bankruptcies is expected to exceed 10,000 cases from a low of 6,030 in 2021.This would be the highest level in 11 years (though still nearly half that of post IT-bubble years). “Past performance is not an indicator of future returns” is, in my view, more relevant than ever in the field of Japanese equities due to these many fundamental changes.
 
And, so, volatility will likely remain fairly high as these many cross currents, both short-term and long-term, unfold. But while I’m sure it’s unnerving to both companies and investors, this as also when, as Mr. Lu points out, the opportunities increase. It is exciting to be living through this once-in-a-generation shift. I can’t wait to see how Japan will look 10 years from now!

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