Still avoiding Japan

Avoid the fashion for Japan

Just over a year ago I explained why I was unconvinced about the long term case for investing in Japanese stocks and shares. Nothing has changed my mind since then. There are just as many reasons why Japan is likely to be a poor investment as there are reasons to expect a profit. Not least, Japanese shares are not cheap.

At the end of 2012 and during early 2013 the investment world was full of Japan bulls. There are still plenty around. Just last week I read some analysis that made the case for why Japanese stocks are a good bet for foreign investors.

Japanese share prices peaked in December 1989, and thus have been in a 24 year bear market. In fact, at its current level of 14,809, the Nikkei 225 index hasn’t gained since 1986. If nothing else, this proves that it can take a very long time for buy and hold investing to work out, if you buy into the wrong place or at the wrong (high) price.

In a nutshell, the bullish case for Japan goes something like this. The government of Japanese Prime Minister Shinzo Abe has an aggressive economic policy to devalue the local currency, the Japanese yen, using quantitative easing (money printing). Since Japan is an export economy, a lower yen will make Japanese export goods more competitively priced in global markets. In turn this should lead to higher Japanese corporate profits and so share prices will rise.

Certainly the yen has fallen against other major currencies. The US dollar bought 78 yen at the end of September 2012 and now buys 103 yen. That means the yen is down 24% against the dollar in a year and a half.

But to make the case that a weaker yen will boost Japanese exports we need to look at the export destinations for Japanese goods. Japan’s main export markets are China (18%), the USA (18%), South Korea (8%), Thailand (6%), and Hong Kong (5%), between them making up 55% of Japan’s total exports.

Apart from the US dollar, the yen has fallen 26% against the Chinese renminbi yuan, 28% against the South Korean won, 20% against the Thai baht and 24% against the Hong Kong dollar (which is effectively pegged against the US dollar). Weighted for the amount of Japanese exports that these countries buy, the yen has fallen 25% against their currencies.

So far so good. Except we now get to the first problem. Japan’s economy is not as dependent on exports as most assume. According to Reuters, goods exports were 13.5% of GDP last year, which compares to a similar weighting in the euro zone and 10% in the USA. Japan isn’t that special.

That said, for companies that make up the MSCI Japan index of shares around 35% of sales come from outside Japan. However, a lot of Japan’s big “exporters” actually produce a huge amount of their goods in overseas factories, and not in Japan itself.

For example, Honda Motor Co. opened a new factory in Celaya, Mexico in February. This brings the company’s North American manufacturing capacity to 1.92 million cars a year, with 33,000 employees. That’s huge. And it means around 95% of Honda’s North American sales will now be produced within the region.

Clearly a weakening yen will not result in lower product prices if the goods are actually produced outside Japan, with costs incurred in non-yen currencies. And if exports are not such a big part of the Japanese economy as most people think then the benefits to Japanese corporate profits as a whole are likely to be marginal at best.

…it’s only a matter of time before the governments of other countries get fed up with Japan’s deliberate policy of devaluing its currency. There is plenty of political tension…

Plus it’s only a matter of time before the governments of other countries get fed up with Japan’s deliberate policy of devaluing its currency. There is plenty of political tension between Japan and both South Korea and China at the best of times.

Those countries are big manufacturing centres. So if they see a threat to their own industries from increased Japanese imports, or extra competition in export markets, then they may also try to weaken their currencies. If that happens then any supposed benefit to Japan’s exports, real or imagined, would be diluted even further.

Next there’s the small matter of locally generated profits and local assets within Japan. If you’re investing into a foreign country’s companies, and that country has a weakening currency relative to your own, then their local earnings and assets will be losing value over time in terms of your own currency.

Let’s say you think in US dollars when you invest and you buy shares in a Japanese company that has earnings-per-share (EPS) of 100 yen. And let’s say the yen then loses 24% against the dollar, as it’s done since September 2012. So the yen is worth 76% as much as before, in dollar terms.

That means that, after the devaluation, 100 yen of EPS is worth only 76% as much in dollar terms. Put another way, yen EPS has to grow 32% to be worth the same number of dollars as before (100% divided by 76% equals 132%).

Now you start to see the problems with the idea that a weaker yen makes Japanese shares attractive. You need a big leap in yen earnings to make up for the currency weakness. Only around a third of Japanese corporate sales are made overseas and even less are from goods produced inside Japan and exported.

Plus the flip side is that two thirds of corporate sales are made within Japan, in a fast depreciating currency. Even if export profits get a boost at some companies due to Abe’s policies, it’s hard for me to see a strong case, looking at the whole of Japan Inc., why earnings will grow enough to make up for the weak currency.

Then you have the issue of assets. A lot of Japanese companies are sitting on piles of cash. I’ll give you one example.

Fast Retailing Co. Ltd. is a clothing company that alone is around 10% of the Japanese Nikkei 225 index. Most of its stores are in Japan and France (another low growth country with big problems). I calculate that 51% of Fast Retailing’s net assets are cash (net of debt), and most of that is devaluing yen.

Yet despite its high exposure to low growth countries and devaluing assets this stock has a very high P/E of 41 and a dividend yield of just 0.8%. (And with all that cash, why doesn’t management just increase the dividend payments? It doesn’t exactly inspire confidence in the management team’s opinion of shareholders…)

(If you haven’t seen it yet, you can find out more about the P/E ratio and dividend yield in our free report Wealth Workout Just see Step 3: Stock investing made easy.)

Incidentally, Fast Retailing doesn’t have the biggest weighting to the Nikkei 225 index because it’s the most valuable company in Japan. This index is price weighted, which is the incredibly stupid system of calculating index weights based solely on the price of a single share.

You should never, ever make an investment decision based on the nominal price of a single share… What matters is the relationship between the share price and earnings or assets per share, plus the prospects for the company.

You should never, ever make an investment decision based on the nominal price of a single share. It’s 100% irrelevant whether the price of and individual company share is 1 cent or $1,000,000. What matters is the relationship between the share price and earnings or assets per share, plus the prospects for the company.

For this reason alone you should never invest in a fund that tracks the Nikkei 225 index, or any other price weighted index (the Dow Jones Industrial Average in the USA is another example). Most indices, such as the MSCI Japan or S&P 500, are weighted using the market capitalisation of the companies. That system isn’t perfect either. But it’s far, far better than price weighting.

So back to that Japanese cash pile. The argument goes that this corporate cash could be invested in growth, when corporate management teams see the new opportunities as a result of the weaker yen. Well, yes, anything’s possible.

But my experience of working in Japan in the past is that Japanese management teams are extremely cautious. Who wouldn’t be after a 24 year bear market, and regular bouts of deflation? So I don’t see this cascade of investment happening quickly.

In the meantime, a large amount of the net assets of Japanese companies are held in yen cash, the very thing that the government is doing its best to devalue fast. Call me old fashioned, but buying an asset that everyone wants and expects to lose value has never struck me as a good investment tactic!

In fact in every other country in the world the risk of a big currency devaluation would usually be given as a great reason to sell. Many people were claiming exactly this logic for selling emerging market stocks earlier this year.

…analysts are so desperate for new ideas that they make the case that a weak currency is a reason to buy the index. They’ve got it all backwards.

It’s only in the case of Japan that analysts are so desperate for new ideas that they make the case that a weak currency is a reason to buy the index. They’ve got it all backwards. Needless to say I’m not convinced.

As you can tell I think the arguments that Japanese profits are about to take off are relatively weak. And even if I’m completely wrong and profits do go up, then any gains measured in yen could be offset by the falls in the yen itself, due to the large amount of domestic profits. But, in any case, the profit outlook is only part of the equation. What about valuations?

At the end of February the MSCI Japan index had a P/E ratio of 15 and dividend yield of just 1.85%. There is nothing about either of those figures that says this market is cheap.

Combining this unattractive valuation with the unconvincing case for yen profit growth and the policy to devalue the yen itself, I continue to recommend that you avoid Japanese stocks. There are more convincing opportunities elsewhere.

Stay tuned OfWealthers,

Rob Marstrand


Photo originally posted by Istolethetv on Flickr.

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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.