In September 2013, I visited the 150-year-old sake brewer Fujii Shuzo, in Takehara city, an old town in Hiroshima prefecture. Ryusei, Fujii’s premium sake, is carefully hand-brewed without the use of chemicals and is known as one of the best sakes in Japan. A couple of months later my family ended up buying Fujii but at the time of my first visit, I had no idea it was even for sale.
There are about 1,600 sake brewers in Japan. Usually buying a sake company is virtually impossible. Most are owned by wealthy and respected families in the region. Fujii’s 150- year history sounds long by most standards but it is still quite young for the sake industry. Nakashima Shuzo, a sake company in the Gifu prefecture, has an over 300 year history. It is continuously run by Mr. Kozaemon Nakashima, a 14th generation member of the founding family. Selling a sake business means ending a family tradition and would be considered quite embarrassing in Japan. In Fujii’s case, it ran into financial trouble about 10 years ago and was rescued by another sake company. We were able to buy Fujii because the owner wanted to sell and we promised that the family tradition would continue.
There are 5,586 companies in the world which have over 200 years of operating history. Not surprisingly, 56% of them are Japanese companies. Also, there are more than 26,000 companies in Japan with over 100 years of history. In contrast, the average life span of a company listed in the S&P 500 index is just 15 years.
Longevity of business instantly receives great respect in Japan. Watahan Holdings, a conglomerate in Nagano prefecture, recently went public after 416 years as a private company. This must be some kind of record, I guess. I’m not sure where our preference for longevity comes from. However, there are many astonishing examples of this in Japan. The current Japanese emperor 125th represents a continuing succession for over 2,700 years. Ise Jingu, the most important Shinto shrine in Japan, has been rebuilding facilities every 20 years continuing a tradition for over 1,300 years.
My family was in the brokerage business for about 80 years. We sold most of the business in 2007 and exited it completely a few years later. I was supposed to be the fourth CEO after my father retired. Succession plans were well prepared, even before I was born. However, after spending 10 years in New York, mostly working for First Eagle Investment Management, LLC (formerly known as Arnhold and S. Bleichroeder, Inc.), I was more interested in starting my own firm to pursue value investing. I did not consider the brokerage business an attractive business given shrinking commission rates and increasing compliance-related costs. While it wasn’t the easiest decision, today my father and I think that shutting down our brokerage operation was one of best decisions we have ever made. However, our case is unusual. There are still many small, family-controlled brokerage firms in Japan continuing their business despite facing difficulties.
Cash is Not Always King
When we talk with CEOs of cash-rich Japanese companies and ask them why they accumulate so much cash, the reasons are often the same: to make sure their company survives no matter what happens in the world. They believe the more cash they have, the better prospects for their future. They don’t want to be remembered as the CEO who ended deep-rooted traditions, just like the sake owners who didn’t want to sell their brewers.
Since cash yields close to zero, accumulated cash automatically lowers return on equity (ROE) for these companies. Low ROE also depresses the company’s valuation. Today in Japan it is common to find companies whose net cash is higher than their market cap.
Felissimo, a Kobe-based mail-order company, has a market capitalization of about $90 million and net cash of $130 million. Although it has negative enterprise value of $40 million, its EV/EBIT multiple is positive since the company has been losing money for the last few years. What an irony!
I recently had a meeting with Felissimo and asked about future plans for the business and the cash. The PR executive told me they now believe a large cash pile was the right decision since they don’t need to worry about the continuation of the company — despite its operational losses. However, it is obvious to me that the cash pile allows them to postpone necessary downsizing and cost-cutting.
Another example is Iwatsuka Confectionery, a rice cracker company in Niigata prefecture. It is valued at about $340 million in the Jasdaq market. The company has a 5% stake in Want Want Holdings, a Chinese food company with a $17 billion market capitalization. So, the 5% stake is worth about $800 million with a potential tax liability of $190 million in case Iwatsuka decides to sell the stake. Since Iwatsuka’s main business does not make much money, its profit is predominantly dependent on the dividend from Want Want. After paying corporate tax on the dividend, its ROE is just 2%. We tried to convince management to sell the stake. They see the relationship with Want Want as priceless. Therefore, they say they will never sell the stake.
Lastly, another interesting company is Japan Digital Laboratory. It is a software company for tax accountants in Japan. The operating margin of the software business is quite high, over 25%. However, its ROE is just 4-6%. Why? It is because the company has over $500 million of net cash and also operates a commercial airline business with an operating margin of merely 2-3%. Maybe some of their tax accounting clients take business trips on this airline? We are having a tough time coming up with any other potential synergies between these two businesses (if you can, please email us).
The most common reason for the undervaluation of Japanese companies is poor capital allocation. Maybe the three examples cited above were extreme but we see similar problems with many companies: too much cash, large cross shareholdings, and poorly performing non-core businesses. We tend to invest in companies that have highly profitable businesses which produce tons of cash. But if the cash that is generated just keeps growing on their balance sheets, ROE will continue to decline and share prices will remain undervalued.
Our engagement with portfolio companies focuses on letting the CEO know the intrinsic value of the company and guiding him or her to implement proper capital allocation policies which will grow intrinsic value per share over time. Computing and understanding the true value of the company is a very important first step. We meet with many Japanese CEOs who do not even try to understand it. If that is the case, we may conclude the probability is quite low that the company will implement the right capital allocation policy.
Abe Administration – The Times Really Are A-Changin’
Mr. Shinzo Abe became prime minister in December 2012. To revive the economy, he has been working on a set of economic policies known as Three Arrows: 1) large quantitative easing by the Bank of Japan; 2) public spending; 3) business reforms. The government is currently mired in debt, but Abe has promised to balance the budget before interest payments by 2020. That means public spending is limited. So Abe has set his sights on the $2 trillion of cash sitting on corporate balance sheets. If the $2 trillion of cash started moving around the economy, it would have a major impact on the $4 trillion Japanese economy. Also, if excess cash is paid out, companies’ ROE will improve. That should result in a multiple expansion for Japanese companies and a positive wealth effect for investors, which is also positive for the economy.
To put pressure on companies to do something with their stockpiles of cash, the government has implemented a series of policies such as the corporate governance codes (which include a push for more outside directors), a stewardship code, Government Pension Investment Fund (GPIF) reforms, etc. One of the policies we believe will have the biggest impact on Japanese companies is the recent launch of the JPX 400 Index, which consists of 400 large cap companies. To gain entry to this index, companies need to have a high ROE. The Tokyo Stock Exchange started computing this index at the beginning of 2014. GPIF and many other Japanese pension funds now use the index as a benchmark and many products have been created around this index. Suddenly the index has become the new elite club and every Japanese company wants to gain entry!
Reactions have been swift. Institutional Shareholder Services Inc. (ISS) announced a new guideline. ISS will advise clients to vote against a CEO if his or her company’s ROE is lower than 5% for the past five years. Nomura Securities formed a team to advise companies on how to get into the index. Companies such as Amano Corporation, Sangetsu Co., Ltd., and Aoki Trading Co. Ltd. announced they will return more than 100% of annual cash flow to investors to reduce net assets and improve ROE. Also, large corporations such as Hitachi, Mitsubishi Heavy, and TDK announced ROE targets of 10% or higher. Buy-backs in Japan are expected to increase to $25 billion for the fiscal year ending March, 31st. That’s an increase from last year of $16 billion (although the total amount is still smaller than Apple’s $30 billion buy-back).
When I had meetings recently with some US-based investors to promote our Japanese activist fund, some said they’d heard exactly the same story a decade ago about activism in Japan and were quite skeptical. The biggest difference between 10 years ago and today is that the Japanese (who always tend to follow the crowd) now want higher ROEs. Ten years ago, only some aggressive activists wanted higher ROEs. Now the government wants higher ROEs. I believe the government is quite serious and if companies don’t change even after the policy implementation I believe there will be additional policies and incentives instituted.
When Following the Crowd Makes You Different
Most teachers in Japan tell kids don’t do anything other kids wouldn’t do. In other words, do something because everybody else is doing it. It seems many well-educated Japanese CEOs are still following this rule. For instance, if you ask about dividend policies for Japanese companies most executives will say their payout ratio is 25-35%. A growing company which has large investment plans will still pay 30% of net income as a dividend. A mature software company which has no plans to make investments will pay 30% as well. This makes no sense in terms of the basics of corporate finance. But, it makes sense to Japanese CEOs because everybody else is doing it!
On a more positive note, I suspect a similar thing may happen to ROE. If 10% is the magic number for ROE, many lower ROE companies will start targeting 10% ROE. It may not be appropriate for highly profitable cash rich companies to target 10%, but we think overall it still makes a better environment for corporate governance.
We believe Japanese CEOs’ preference for longevity will not change and many of them will keep their large net cash balance sheet. However, we believe it is possible to reach an optimal point which maximizes ROE while keeping a strong balance sheet. Due to the various policies the Abe administration has been implementing, many Japanese CEOs are now searching for this optimal point.
If you visit the offices of Keyence, one of the most profitable companies in Japan, you will see many fossils throughout the building. It is a reminder to employees that you too will be become a fossil if you don’t innovate or create new products. Japanese companies are very good at improving products when others see very little to change.
Mitsubishi Pencil, one of the best performing stocks in our portfolio last year, has been introducing impressive new products to the market such as Jet Stream pens which use low friction ink to give an ultra-smooth writing feel (especially writing complicated Chinese/Japanese characters), a Propus highlighter which has a window on the nub so the user can see exactly where they are highlighting, and a set of pencils with 300 colors. Jet Stream is already a 5 year-old product but the company keeps expanding the product line of the brand.
In Japan, there are companies like Keyence and Mitsubishi Pencil that continue with never-ending improvement of products and successfully attracting customers. Such companies tend to maintain above-average operating margins for years. We believe this is what Japanese companies are uniquely good at and customers around the world respect the quality of these products. Can we implement proper capital allocation into such companies? I think so, and I believe they will be quite attractive investment opportunities for us with such a history of longevity.Jiro Yasu, CFA is founder of Tokyo-based VARECS Partners, Ltd. He has served as a portfolio manager for the VPL-I Trust since 2006. Over that time he has conducted extensive fundamental research on Japanese small-cap companies while developing a network of deep relationships with public company executives. Previously, he worked at First Eagle Investment Management, LLC and its Asian equity investment team.