Third Avenue Management Comments on Daiwa Securities
The Value Fund took a position in Daiwa Securities in (TSE:8601) the third quarter of 2012. Daiwa is the second largest Japanese brokerage company. It has been a terrific investment for our shareholders. As detailed in the Shareholder Letter that quarter, Daiwa was well capitalized with a 27.4% capital adequacy ratio, but traded at a 27% discount to tangible book value. Investors were worried about the investment environment in Japan, as well as the fact that Daiwa pursued a restructuring program that focused the company on its domestic constituency.
Investors were right to have worried about Daiwa's move towards a Japan-centric strategy as financial market conditions were bleak. Risk aversion was rampant in Japan as households had over 50% of their assets invested in cash products and only 10% in equity products. Trading volumes and IPO activity had plummeted, which is very important to Daiwa as its revenues are strongly correlated with financial market activity. Daiwa's management seemed determined to steer the company towards Japan's troubled economy, rather than away from it, a direction that some investors were not willing to pursue.
Investors usually have reasons for their behavior and, in this case, the Daiwa bearishness certainly seemed to have rational foundations. But we looked at Daiwa differently. Daiwa's strong balance sheet gave it time to re-focus the business, even if results were not immediately positive. Daiwa felt its competitive position was strongest in Japan so it was better to compete there than in other markets. At a 30%discount to book value, the company was priced as if it would continue to destroy value over time. Once the cost cutting was completed, we didn't think that scenario was likely.
Good things happen to cheap stocks. That's a perfect summary of what has happened to Daiwa over the past six months. The Abe government was installed in late 2012 and has taken highly aggressive measures to combat the deflation which has plagued Japan for the past 20+ years. So far, it has created a tidal wave in activity in Japan and Daiwa is benefitting greatly. Retail investors who have been on the sidelines are re-entering the markets. A recent study illustrated that retail volumes now account for 30% of activity vs. 20% in late 2012. With Japanese households having greater than $8.9 trillion in cash and deposits,there could be a lot more run-way for Daiwa to sell their services.
Admittedly, it's early and we are constantly assessing the risks and are continuously managing our position size. On the other hand, the financial results thus far have been eye popping. Daiwa released its most recent quarterly report in May; revenues grew 24% while SG&A declined 7% versus the previous year results. Book value per share grew15% year over year and the annualized return on equity was 22%. Most importantly, the capital adequacy ratio—a commonly used measure of balance sheet strength—remains at the same levels as when we initially made the investment.
From Third Avenue Management's semi-annual 2013 investor letter.