Asia

The poisonous Fugu fish and Japanese stocks

The Fugu fish is a puffer fish that’s a highly prized delicacy in Japanese restaurants. It’s also fatal to the consumer if not prepared by an expert chef. That’s because parts of it contain a poison said to be 1,200 times more deadly than cyanide. And so, to Japanese stocks, which are still well down on the peak reached 25 years ago. This is despite recent efforts to puff them up with money printing and currency devaluation. After falling for so long, the Japanese market may not be exactly toxic these days. But I believe there are better places in the world for investors to go fishing.

A quarter of a century ago Japan was nearing the end of a massive speculative bubble. The stock market peaked in December 1989 and is still 62% below that price high. Following a brief spike in late 2012, following the announcement of new policies, the market has been moving sideways since May 2013, and is now heading down again.

There’s an overused cliche that everyone should invest in “stocks for the long run”. In general it’s a good guide. But just how long is the long run? Investors in Japanese stocks have been losing money for nearly 25 years, and aren’t even close to breakeven. It’s like Japanese investment portfolios have been slowly poisoned by incorrectly prepared fugu fish.

Take a look as this chart of the TOPIX index since 1968 (source: Tokyo Stock Exchange). It shows that Japanese stocks are at roughly the same level today as they were in 1986. That’s 28 years without a capital gain, which is equivalent to almost a generation.

TOPIX index since 1968

TOPIX index since 1968

Of course there has been modest dividend income. But Japanese companies have not tended to be big dividend payers, so I’d expect this to have been between 1% to 2% a year. Currently the market yields around 1.9%.

So Japanese stocks have certainly tested the patience of even the most ultra long term investor. “Stocks for the long run” doesn’t appear to always work.

But the key here isn’t the asset class at fault, or even the time involved. It’s the price paid when the stocks are bought. If you buy at elevated valuation ratios you are almost certain to have disappointing future profits.

According to the Tokyo Stock Exchange the P/E ratio of Japanese shares was a staggering 70.6 in December 1989. To put that into perspective, the median (middle value) P/E for the US S&P 500 index is 14.6 since 1871. Clearly Japanese shares were excruciatingly expensive in 1989.

Put simply, if you buy stocks when the P/E ratio is extremely high then you can expect poor returns or even losses, however high the expectations are for future profit growth.

High growth expectations almost always fail to materialise. And even if they do, if you’d paid a fortune to buy that growth then your profits will still be modest.

It’s one of my golden rules of investing: never overpay for growth. High growth expectations almost always fail to materialise. And even if they do, if you’d paid a fortune to buy that growth then your profits will still be modest.

So why take the huge risk that things won’t turn out to be the best of all possible worlds? You’re much better off finding stocks or stock indices of companies with reasonable growth prospects, but also with extremely low prices (low P/E and/or price-to-book ratios.)

Investors in Japanese stocks in the late 1980s were making exactly that mistake. They had seen massive profit growth in recent years and were extrapolating it far into the future. Remember, the investor crowd has a very short memory. Again and again, yesterday’s hard lessons have to be relearnt by the shoal of fickle investor goldfish, as they dart between whatever juicy morsel is the flavour of the month.

(Note: investors in speculative new technology stocks are usually taking an even bigger risk. Those companies often have fast growing sales figures, but most of them are far from reporting any kind of profit. Many never do. The outcome for investors is usually dreadful. Just remember, before you get excited about hot tech stocks: most of the media coverage focuses on the rare successes, not on the vast majority that fail.)

So the Japanese stock bubble has been unwinding ever since 1989. Pity the poor old Japanese investor. As if that wasn’t bad enough, house prices have also been steadily falling as well. According to the Economist they’re down 51% since 1990.

This is a crucial point. Two major Japanese asset classes, both of which are usually profitable investments in most countries at most times, have been a disaster over the past quarter century.

After such a long time it will take a huge amount to convince the Japanese that these are exciting places to park wealth. It could take another generation to convince them. They’ve lost the stock market habit. And low investor interest means low probability of prices taking off, except temporarily.

The Nikkei 225 index, which is the most widely recognised index of Japanese companies, reached an all time bottom on 25th November, 2011. It was down at 8,160, a fall of 79% from its peak on 29th December, 1989.

It bumped around near that bottom for about a year. But then between November 2012 and May 2013 the market rocketed 80% to reach 15,627. Japanese stocks were on fire again! The fire was fuelled by a sudden increase in foreign investor interest in Japan.

Around the time loads of analysts and investment newsletter writers were touting Japan as an excellent place to invest. But I had my doubts. I first wrote about them for OfWealth in March 2013.

The big problem, as I saw it, was that the speculative rally was predicated on an explicit government plan to devalue the local currency, the yen. The government had promised to print “unlimited sums” of yen to get the economy going. This was, and is, a key part of Japanese prime minister Shinzo Abe’s central plan to get things going again in Japan – a plan that has since become known as “Abenomics”.

But if it was that easy to grow an economy, why don’t all governments print money all the time and make us all rich? Something is obviously fishy here.

The answer: because it doesn’t work. You can promise all the paper puffery you like, the end result will still be poisonous. In Japan’s case the long term end result will most likely be massive debt default or hyperinflation, which ultimately amount to the same thing for investors.

But in the shorter term, the theory was, and is, that the weaker yen would boost profits at Japan’s manufacturing companies. This is because lower yen production costs should make companies more competitive in international export markets.

But this ignored a few inconvenient facts. Exports were only around 14% of the Japanese economy, and much of the manufacturing done by Japanese companies happens overseas. Costs for overseas manufacturing wouldn’t fall due to a falling yen.

Also, if the yen was falling then the stock market could rise in yen terms. But foreign investors would only profit if the stock market rose more than the currency fell.

Anyway, it all looked too speculative, although investors bought the story hook, line and sinker. The market wasn’t cheap and was rising on the wing of a weakening currency and the prayer of higher future profits. Here’s what I said at the time:

According to the Financial Times, Japanese stocks have a P/E ratio of 16.7x and a dividend yield of just 1.9%. To me this looks like Japanese stocks are already fully priced, even slightly expensive for a low growth economy. This isn’t bubble territory, but neither is it cheap. Buy-and-hold investors will need a lot of future earnings growth to make a decent return.

The initial “good news” rally has already passed. Japanese stocks could continue to rise in the short term, as momentum traders keep piling in. But long term investors that like to buy things when they are cheap – the kind of sensible investing we encourage at OfWealth – should look outside of Japan for their profits.

So what’s happened since? Well in yen terms the Nikkei 225 index is up nearly 20%, from 12,315 to 14,738. But the yen is down against the US dollar by nearly 12%: the dollar buys 106.79 yen today, versus 94.41 on 24th March, 2013. This means the one dollar buys more yen than before or, put another way, the yen has weakened against the dollar.

Here’s a chart of the US dollar / Japanese yen exchange rate for the past five years (source: oanda.com). A falling line shows dollar weakness and yen strength and vice versa. You can clearly see how the yen has weakened significantly since late 2012 (rising line).

US dollar / Japanese yen

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The net result is that the Nikkei 225 index is up 5.8% in dollar terms since I first wrote about it. That’s a modest rise, but it all happened in the month immediately after that first article. That was when the speculators and momentum traders were still piling in.

Since then the market has gone sideways, as the following chart shows (the line starts on the date of the article, and is in yen).

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A follow up article about Japan was published by OfWealth on 7th April, 2014, just over a year later. Again I expressed my scepticism about the logic of investing in Japanese stocks, mainly because they didn’t look cheap enough to be attractive. Since then the market is flat in yen terms and down almost 4% in US dollar terms. (I suppose that proves, in a way, that market timing is both essential and impossible…)

Something that I admit has surprised me is that Japanese earnings-per-share (EPS) have increased more sharply than I expected. Comparing the changes in price with the changes in P/E ratio I calculate that they’ve jumped 18% over the past year, measured in yen. However, adjusted for the currency weakness, earnings are up a much lower 9% in dollar terms.

That’s a strong performance, although part of it has been achieved with record levels of share buybacks according to recent reports by Bloomberg and the Economist. When a company buys back its shares the profits are split across fewer remaining shares, which is the same as saying that EPS is driven up. This is a short term fix, and not a sign of healthy growth.

With or without the buybacks I don’t like how this EPS growth has been achieved: deliberate debasement of the currency. This is yet more of the increasingly desperate economic intervention and market manipulation that we’re seeing across the highly indebted developed world. Much of that debt will turn out to be toxic waste.

I never like investing where the main rationale is the whim of politicians and bureaucrats.

And like all investments based on uncertain government or central bank policy, they are prone to failure once the policy itself fails or is withdrawn. I never like investing where the main rationale is the whim of politicians and bureaucrats. Share prices in Japan may go up or down in future, but I don’t want to have to rely on uncertain government policies as the main driver.

Plus I’m not sure how long Japan’s trading partners will put up with this aggressive monetary mercantilism. The main countries in question are China, the USA and South Korea. At least two of those already have historically uneasy relationships with Japan (clue: it’s not the USA). How long will it be until they devalue as well? Currency wars are never far away these days…

Japan is a wonderful country to visit, and the food is sensational. Although I admit I’ve never tried to eat the poisonous Fugu fish…and I may never be persuaded. But, food and culture aside, I’m still unconvinced by Japanese stocks, and continue to recommend that you stay away. There are safer places to go fishing for profits.

Stay tuned OfWealthers,

Rob Marstrand
robmarstrand@ofwealth.com

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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.