Having spent a week in Japan recently, most people I spoke to were worried about rising inflation. Wages have increased by 5%, food prices, including rice, have doubled, as has the cost of my hotel accommodation. While we could do with food and energy prices easing, the risks of inflation seem evenly balanced – the Bank of Japan is focused on real wages and these need to show a consistent uptick before victory against deflation can be declared.
Monetary policy remains very accommodative, with real interest rates negative and bank lending growing solidly. My colleague David and I have, for some time, felt that the Central bank risks being a little behind the curve and our view has not changed. If anything, the Bank of Japan appears more hawkish, having implemented three rate hikes to date. Most members expect inflation to exceed 2%. With Ms Takaichi’s loose fiscal policy, recent Chinese export restrictions and a weakening yen, inflation risks do remain elevated.
As is often the case, developments in Japan can be precursors to broader-based issues. The rumblings in the Japanese bond market offer a glimpse of what could happen in the US bond market. Repatriation of Japanese capital could easily trigger a sharp rise in the yen. Holdings of US treasuries are $1.2trn, with recent flows driven by foreigners. That worries me.
That said, the year has started strongly for the Japanese market, despite a snap election, Greenland issues, Chinese export restrictions and a surge in long-term bond yields. But beneath the surface, the lack of breadth is a concern. Just 13 of 33 sectors have beaten the market year to date. Whether it's private credit, artificial intelligence or fiscal deficits, there are plenty of worries, but juxtaposed with that is a seemingly Goldilocks US economy. The musical chairs dance goes on. But added to that list of concerns is a loss of Fed independence. This also happened, you will remember, in 1928/9.
With the results season in full flow, the momentum is, so far, with manufacturing companies beating numbers. Autos have been a mixed bag with big misses at Yamaha Motor and Denso. The key development, though, is Toyota Motor’s bid for Toyota Industries – a critical test of corporate governance in Japan. Initially, the bid was derisory, as the value of its investment securities was worth close to the bid price. This valued the core business at next to nothing. The bid has since been lifted by +8-10%. Elliott, a foreign fund, has acquired a 6% stake and believes the fair value is ¥25,000, representing a 28% increase from current levels.
A representative of the Japan Stock Exchange intimated to me that 20% of the Tokyo Stock Exchange First Section [the premier market division for Japan's largest, most established and highly liquid companies] could be delisted over the next 10 years. The “real juice” would be in mid-sized and small-sized companies, where the journey regarding good corporate governance was in the foothills, rather than already discounted. [Multinational conglomerate] Hitachi, for example, now trades at five times book value and 30 times earnings, with a yield of 0.8%. Its corporate governance would score 9 out of 10. Great company though it is, we’re more interested in mid-caps in our two funds, where founding families now have a choice to make.
It’s why we continue to plough a slightly different field by focusing more on small and mid-cap companies, where there’s more room for better corporate governance. I certainly got to see this firsthand, having visited several companies in which we invest.
They include Hochiki, a little-known leader in the highly regulated fire alarm space. Entry into the market by foreigners is tough and Hochiki gives us great exposure to a growing overseas story in the UK, USA, Singapore and Australia. We caught up with M&A Capital Partners, whose jewel in its crown is its cash war chest. Their net cash is ¥44bn, which is nearly 44% of the market cap.
Perhaps my favourite company visit was to Fuji Seal, a shrink wrap label business run by a force of nature, Mrs Okazaki. The company has a strong US presence, with production facilities in Mexico, North Carolina, and Kentucky, and counts Coca-Cola as a key client. We also saw one of the cheapest paint companies in the world, which has net cash of ¥108bn. It is a hugely profitable company, having achieved an operating margin of 12% for over 30 years.
Value stocks have outperformed growth for now but some growth stocks are beginning to look cheap. At the moment, being a contrarian investor is not paying off. However, on the bright side, M&A activity (in value terms) is at an all-time high and balance sheet restructuring will continue. More than a quarter of the Topix 500 has net cash above 20%, while the market's return on equity is 8%-9%, versus 11% for Europe. If Japan can move towards European levels, there is significant upside over the next two years, but I sense the journey will be bumpy.
James Salter is founder of Zennor Asset Management. The views above should not be taken as investment advice.