I’ve been following the Value Investing Congress this week. I like to watch for common themes that multiple intelligent investors are spotting. One such place is Japanese equities on the long side. Another is Japanese Government bonds on the short side
Let’s start with the bonds. Kyle Bass has long been negative on Japan and in particular government bonds. He spoke again this week about it, but consider the following which was from early last year:
Bass is betting against Japanese Government Bonds using interest rate derivatives or CDS. He thinks JGBs are mispriced, unsustainable and susceptible to the "Keynesian endpoint". I'm sure U.S. Treasurieswill be vulnerable at some point in the future. I can see the Government hearings now. Here's a WSJarticle from December 2009:
"Traders are betting against Japan's debt in myriad ways. Some bearish traders are entering into option contracts betting on "forward rates", or the direction of Japanese yields. These options are among the most heavily traded of the commonly used bearish tools, so some beginners to the game are embracing them. The downside is investors can find themselves exposed to big losses if yields fall further.
Others buy credit-default swaps, derivative contracts that serve as insurance to protect against a default of Japan's debt. The cost to insure $10 million of Japanese bonds is about $70,000 a year for five years. That price has climbed from less than $50,000 since October.
Still others are buying more exotic instruments, such as "CMS caps," also called constant-maturity-swap caps, and "swaptions." These interest-rate options reward a buyer if Japanese rates climb over the next few years, but limit downside because there is only a one-time upfront payment.
Mr. Bass has purchased protection on about $12 billion of Japanese bonds, according to a person close to his firm, a move that is costing him about $6 million, a skimpy price because most investors still doubt the trade will succeed. If 10-year yields, currently at 1.3%, rise to 3% or so, Mr. Bass won't make that much; but if they hit 4%, he would make about $125 million on his $6 million investment. He will make at least $125 million for each subsequent percentage-point rise, according to people close to the firm."
Japan clearly has issues. Like the reason it also has cheap stocks. A couple of gurus have noticed.
Pabrai from his annual meeting:
Currently researching companies in Japan. If he ends up buying companies there, he will buy a basket of companies each with small weightings in the portfolio. He said stocks there are very cheap. He thinks there may be value in Coke bottlers in Japan. The Nikkei has done nothing for 27 years.
Spier from the VIC:
Spier actually sees Japan as a compelling potential investment. Screening for stocks in this universe returns a lot of companies with negative enterprise value, many of which are paying dividends and partaking in share buybacks. In particular, the Aquamarine Fund manager singled out Otaki Gas (TYO:9541), a pipeline company that owns assets in Japan. His best idea is slightly morbid in Heian Ceremony Service (JSD:2344), a funeral service business that can benefit from Japan's aging population.
Now if you don’t mind. How about putting the two themes together ? As money rushes out of Japanese bonds at some point, some of it will have to end up in the Japanese stock market. So not only can you be long the stock market and short bonds. You can leverage this by being long Japanese stocks that are long the stock market.
Consider the following from a favorite manager of mine, Orbis Investment Management:
“Japanese stockmarket investors turned more negative this quarter due to the uncertain political and
economic outlook. Ten-year Japanese Government Bond (JGB) yields refl ected this, trading below 1%.
This level has only been breached twice before in 20 years. Against this backdrop, our fi nancial sector
investments, particularly the life insurers, underperformed.
Investors might wonder why we would have any exposure to Japan’s life insurance sector given low to
negative nominal GDP growth, a shrinking and ageing population and high existing penetration rates
for life insurance products. Equity investors and acquisitive life companies have focused instead on
high growth economies like China and India. Yet your Fund has a 10.4% exposure to two Japanese
life insurers. The larger investment is in Dai-ichi Life, Japan’s fi rst mutual life insurer in 1902, and
an insurer in the traditional mould. Smaller T&D Holdings has an attractive niche through its longstanding
relationship with tax accountants that distribute its products.
Life insurers are not easy to value due to the long-term nature of their business. We believe their intrinsic
value should be assessed by embedded value (EV), the sum of the company’s tangible net assets plus the
present value of future profi ts on existing business. As EV captures the underlying economics of the
existing business only and conservatively assigns no value to future business, life insurers have historically
traded at a premium to EV to refl ect the value of future business. Both Dai-ichi and T&D currently trade
at about 0.5 times current EV. This is below what they would be worth in a run-off situation, where no
new business is written, and does not refl ect expected growth in EV of 8-10% per year. By comparison,
European life insurers trade at 0.9 times current EV, while in China they trade at over 2.0 times.
What makes these companies even more attractive, however, is that their EV is geared to any sell-off in
bonds or rally in equities because of their asset/liability mismatch. We believe that low JGB yields of 1%
per annum are not sustainable. With general government gross debt-to-GDP at close to 200%, Japan
makes Greece look thrifty. Government leadership is lacking and the recent campaign for leader of the
Democratic Party of Japan shows that the ruling party remains deeply divided. Bond yields are now
more than 1 percentage point below dividend yields, a situation that has occurred once previously in
the last 20 years, for a six-month period in 2008/2009. This is all the more unusual given that Japanese
companies have traditionally had very low dividend payout ratios. Contrast this with the US, where the
dividend yield on stocks has not exceeded the ten-year Treasury yield since the late 1950s.
Should bond yields rise, the EV of these companies would rise sharply, leaving their current share prices
at even steeper discounts to intrinsic value. We are bottom-up stockpickers, but that does not mean
we ignore the macro picture. Indeed, the risk/reward profi le can be very attractive where we identify a
macro variable at an extreme level and fi nd under-valued stocks that are not priced for any change in this
key variable. Our view is vulnerable to any further decline in bond yields, but with ten-year JGB yields
only 1% per annum we believe that the downside risk is largely discounted in existing share prices.”
