At the recent value investing conference we learned that both Monish Pabrai and his pal Guy Spier are finding undervalued opportunities in Japan. Monish referred to the fact that he was putting together a basket of undervalued companies which reminds me of Buffett sitting down with an S&P manual in 1998 and doing the same with a basket of South Korean companies during the Asian Flu.
Japan is a little outside my comfort zone, especially considering potential currency issues with a heavily indebted country. But I am aware of a world class investment manager called Orbis Investment Management who has decades of global experience.
Here are two very compelling ideas that Orbis has identified in Japan which is a play both on the undervalued stock market and overvalued Government debt:
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 financial 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 greater than 10% 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 long-standing 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 tradeat 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.