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Written by: Sean Peche | Ranmore Fund Management
"There are a lot of good things to say about the Japanese stock market right now."
Some canny investors are in there – Warren Buffett’s Berkshire Hathaway has been buying into Japanese trading companies – while the CEO of the Tokyo Stock Exchange has made positive moves to encourage Japanese corporates to unlock value.
And the market is on fire, up 33% over the past year, albeit just 15% better in dollar terms after the yen’s steady decline.
The question now is whether it’s still a great place to invest.
The short answer, in our opinion, is selectively, yes.”
“Let’s look at some valuation metrics to see how the market stacks up against US stocks – and indeed whether it still offers good value against other parts of the world.
We’ll start with the conventional price/earnings (PE) ratio. My Bloomberg screen tells me that on this basis, the S&P 500 trades at 24x earnings which is 41% more expensive than Japan’s Topix 500, where the ratio comes in at 17.
A PE ratio tells you how many years of stable earnings it would take to recoup your purchase price – if you paid £500 for a business that earns £100 a year, you’d recoup your investment in five years, assuming earnings are all distributed as dividends.
But if earnings are growing then it would take a shorter time – and that’s why investors pay higher PE ratios for growing companies.”
“However, this method ignores the relative balance sheet strength, an important parameter after a long period of low interest rates when so many companies have loaded up with debt.
Say that same business has £300 of debt. Although you’re paying £500 in cash, you’re also assuming £300 of debt meaning you’re effectively paying £800 – so it would take eight years to recoup your investment.
Conversely, if the business has £300 of cash in the bank, you’re effectively paying £200 – just two years of earnings.”
“Another measure – Enterprise Value (EV) – brings this balance sheet strength into play, being simply the market value plus net debt or minus net cash.
So why don’t we use an EV/earnings ratio rather than PE? You could, but since net earnings are after the interest expense we’d be double-counting the impact of the debt, adding it to the numerator and deducting the cost of debt in the denominator.
Similarly with interest income and cash. At Ranmore we don’t mind double penalising companies with lots of debt but the conventional approach is to use earnings before interest.”
“Unfortunately, the main users of EV – think corporate bankers and private equity folk – took this useful measure further, thinking, ‘We could make the valuation seem lower if we also excluded tax, depreciation and amortisation’.
This gave us Ebitda, or as Warren Buffett put it: ‘earnings before lots of expenses’.
And since heavily indebted companies can be profitable before interest expense but loss-making after, we should be very careful about how we use EV/Ebitda.
But it’s a thing, so let’s revisit the Japan-US axis. Now the gap is much wider than the P/E ratio would have us believe. On this basis, the S&P 500 stands at 14, 133% more than the Topix 500’s ratio of 6.”
“So what does this mean?
It means that US companies have more debt than their Japanese counterparts because many took advantage of low interest rates, bingeing on debt to finance acquisitions and repurchase shares. In contrast, many Japanese companies hoarded cash and invested in other domestic equities for a rainy day.
And since the conventional EV calculation doesn’t treat marketable securities and long-term investments in the same way as cash, some Japanese companies are even cheaper than the conventional EV calculation suggests – especially smaller and mid-sized ones with large investment portfolios.”
“Take, for example, Nippon Television, a company with a market cap of Y560bn and net cash of Y130bn, giving it an EV of Y430bn.
However, this calculation ignores the Y541bn worth of long-term investments held in other Japanese-listed companies. That means that investors are buying the company for less than the value of their net cash and investments, while also having a stake in a stable business generating Y40bn a year of net income.
Of course, you need to think management will unlock this value, but signs are encouraging that a new team there is moving in the right direction.”
“Before going all in on Japan for cheap large caps, it’s worth looking at what Europe has to offer. The short answer is plenty, and again, relative valuations tell the story.
The increased investor interest in Japan means that many of the large companies have risen so far that they are now trading at substantial valuation premiums to their European counterparts.
That could be justifiable if they have greater growth prospects or earn higher returns on equity (ROE).
In banking, the giant Sumitomo Mitsui Financial Group generates ROE of 6.5% and is priced at 0.9x tangible book value and 13x earnings.
Compare that to Barclays which generates a higher ROE (9%) but trades at almost half the valuation and at 0.6x tangible book value and 7.5x earnings
In the car world, Toyota generates a 15% ROE and trades at 1.6x tangible book value and 11x earnings. BMW’s ROE is almost as high (13%) yet the valuation is substantially lower: 0.9x tangible book value and 6x earnings.
As ever in investing, beware of the sweeping statement, whether it’s ‘This time it’s different’ or in this case ‘Japanese equities are cheap’.
It may be true for some segments of the market – especially small and mid-caps – but it’s certainly not true for all parts.”
Related: Is Investing in Asia About More Than Just China?