The Japanese emperor’s not so new clothes

Nobody would confess that he couldn’t see anything, for that would prove him either unfit for his position or a fool. No costume the emperor had worn before was ever such a complete success.

“But he doesn’t have anything on!” said a small child.

The Emperor’s New Clothes”, Hans Christian Andersen, 1837

It’s easy to forget that Japan still has an “emperor”, even if he has no empire to rule over and no actual power to rule it. What’s left of his domain of divine right has the dubious honour of being the world’s most indebted nation, against some stiff competition from those paragons of virtue Zimbabwe and Greece. Emperor Akihito’s crown is hollow, and along with Japan’s other leaders he continues to march nakedly into the future. And Japanese companies aren’t very profitable either.

Another week and another bit of bad news for Japan. Exports were down 12.9% in January compared with a year earlier. Japanese stocks rose a couple of percent on the bad news.

Pavlov’s dogs heard the bell ringing and salivated at the prospect of yet MORE stimulus and money printing. Paul Krugman, Keynesian extraordinaire, rubbed his hands with glee. Japan has had a quarter of a century of government stimulus and money printing. According to Krugman’s ilk it just hasn’t had enough of it!

Japan’s stock market has been shooting up and down like a yo-yo this year, albeit mainly downwards. The Nikkei 225 index is down over 20% since 2016 began, and 24% since peaking in August 2015 (both measured in Japanese yen).

Measured in US dollars Japanese stocks have been the second worst performers out of the developed markets. The MSCI Japan index is down 12.8% year-to-date, surpassed in its slide only by Italy’s 17.2% fall (another indebted dog of an economy – with some major bank problems).

This isn’t how things were supposed to be. Money printing and “Abenomics” were supposed to save the day. Yen devaluation would boost exports. Wages would go up. Inflation would rise and spur Japanese savers to become spenders again. The economy would return to growth. Prime minister Shinzo Abe would become a modern day hero – the man who fixed Japan.

The Japanese yen has lost a third of its value against the US dollar and the currencies of other major trading partners and export competitors (such as China and South Korea).

That plan was launched around three years ago. The Japanese yen has lost a third of its value against the US dollar and the currencies of other major trading partners and export competitors (such as China and South Korea).

Since then real GDP has barely budged. In the fourth quarter of 2015 it fell at a 1.5% annualised rate, and was up just 0.5% for the year. Private consumption was down 0.8%.

Japan’s leaders are getting desperate.  On 29th January they announced a negative interest rate policy, or “NIRP”, will be applied to excess bank reserves. Those are basically cash deposits that commercial banks park at the Bank of Japan, the central bank. Some portion of them will attract a 0.1% charge, instead of earning interest income.

At the same time the Bank of Japan continues to buy up government bonds and other financial assets in a continuing flurry of quantitative easing (QE). It’s buying 80 trillion yen (US$650 billion a year, and is projected to own around 43% of Japanese government bonds by the end of 2016 according to estimates by both BNP Paribas and Bank of America, both investment banks.

QE is the process where money is printed by the central bank and injected directly into the banking system as deposits, via the purchase of bonds and other securities. It’s a substitute for the normal credit creation – and hence money creation – of commercial banks.

Resorting to QE means the financial system is broken. It’s monetary smoke and mirrors. You may as well just hand the cash straight to the government, and cut out the middlemen. Japan’s been at it for decades without success (which isn’t stopping others from following them over the cliff).

Japanese government debt is at astronomical levels – around 250% of GDP.

Japanese government debt is at astronomical levels – around 250% of GDP. Japan apologists argue that this doesn’t matter, because the government has also got huge assets of around 120% of GDP, bringing the net figure down to “just” 130%.

But most of those assets are committed (e.g pension funds) or can’t be sold in a hurry or at all (roads, infrastructure). Not to mention Japan’s US$1.1 trillion holding of US treasury bonds.

Try to sell that lot in a hurry and the US bond market would crash, taking the economy with it as the US’s own public and private debt mountain experienced serious landslides (defaults). Japan would rapidly lose a lot of sympathy from its main ally.

And so we come to the Japanese stock market. Many have tipped it in recent years, as the devaluation led export boom was supposed to take off. Many continue to tip it. I’ve long been sceptical, and have recommended staying away (see here, here, here and here).

Often the argument goes something like this: Japanese stocks have a low price-to-book ratio (P/B) and are therefore a bargain. What’s more they’re sitting on lots of cash, so if you strip that cash out of both the price (market capitalisation) and the book value (net assets, shareholders’ equity) the P/B is even lower and therefore an even bigger bargain.

But there are a couple of flaws in this argument. The most obvious one is that when you buy the stocks you buy their spare cash as well, which is in Japanese yen, which the government has deliberately been trying to devalue. So a large part of your investment is likely to go down if all goes to plan.

The second one is a little harder to work out, but even more important. Japanese companies aren’t very profitable, even after more than two decades of economic funk and supposed “restructuring”.

Japanese companies have a return on equity of around 8%. Return on equity measures how much profit they squeeze from their net assets. The equivalent number in the US is 13%, or 63% more.

(Note: you can easily calculate the return on equity of company or index of companies by dividing the P/B ratio by the P/E ratio, expressed as a percentage. The result is E/B, earnings divided by book value, or return on equity.)

Perhaps that this excess cash issue again. Perhaps if we take out the cash from the net assets then we’ll boost the Japanese return on equity to US levels. Perhaps, at least part of the way. But not nearly enough.

In any case there’s another measure of profitability that tells a similar story – and cash balances can’t be used as the excuse. That’s net profit margin after tax. That’s what’s left for the shareholders after management and employees have been “compensated”, suppliers have been paid, and the government has seized its share.

In the case of Japan the net profit after tax is 4.7%, using data from Star Capital. In the US it’s more like 8.9%, which is to say 89% higher.

(Another note: you can easily work out net profit margin after tax by dividing the price-to-sales ratio, or P/S, by the P/E – expressed as a percentage. P/S is market capitalisation divided by top line revenue. P/S divided by P/E is E/S, or net earnings divided by sales, ie net profit margin after tax.)

Japanese corporations have low profitability and their stocks deserve low valuation multiples. What’s more the country is bankrupt but still digging a bigger hole for itself. The population is old and shrinking too.

The Japanese emperor has no clothes, despite years of proof that it was time for a change of attire. As in Hans Christian Andersen’s classic short story, even a child should be able to see that. The facts of Japan’s distress and doom are in plain view.

My opinion? Continue to stay away from Japanese stocks.

Stay tuned OfWealthers,

Rob Marstrand

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.