Net-Nets from Japan are not a new discovery. When Western markets, and especially U.S. markets, have risen continually in recent years, the number of net-net stocks has decreased steadily. So the devotees of this investing strategy have had to turn their attention elsewhere.
When you are looking for investing abroad probably first you ask, is the market or company safe? Can you trust the numbers and accounting? Are company management and owners honest and sincere? In this case Japan – although business and other culture are different – is quite close to Western standards.
Already James Montier mentioned in his great book, “Value Investing: Tools and Techniques for Intelligent Investing” from 2009, that over half of globally found net-nets were in Japan. This clearly suggests that Japanese stocks are one of the best sources of bottom-up value ideas available. Montier also published a study of net-nets on a global basis. Testing the strategy from 1985-2007, buying an equally weighted global basket of net-nets would have generated a return of over 35% per year versus overall market return of 17%.
Maybe the best time to invest in Japan was during 2011 or early 2012 after the earthquake disaster. At the time already cheap the Japanese market got even cheaper. There were lots of net-nets, and the quality was much better than perhaps anywhere else. Japanese stocks were a once-in-a-lifetime bargain just like many U.S. stocks after the financial crisis in early 2009.
Are Japanese net-nets actual anymore? If you do a screen for net-nets globally today, the Japanese stock market still boasts the greatest number of net-nets, followed by Hong Kong. As a whole Japan's market is still very cheap. And what is the most interesting thing is you are able to find cheap and quality together.
Japan markets and economy overall
Japan is the world’s third-largest single economy, and the Tokyo Stock Exchange is the fourth-largest stock exchange in the world. However, after the economic bubble and the Tokyo Stock Exchange crash in 1990–92, growth in Japan throughout the following two decades was slower than growth in other major developed economies – the “lost decade” has followed another. Japan has pumped vast amounts of money into its struggling economy in recent years to try to spur growth and combat falling prices. But the efforts are failing to produce their desired results.
Japan is a country where democracy prevails and where the rule of law is in place. The country’s business culture is admittedly different and in many ways unpleasant. It’s difficult to find particularly shareholder-friendly management. They have business relationships based more on tradition than profit. Companies are not so efficient. Japanese companies were not always run for profit only. And Japanese stocks deserve to trade at lower price-book (P/B) and many other ratios than the rest of the world. However, in recent times they are working to make a change. The government is pressuring companies to manifest at least a 5%, and maybe an 8%, return on equity and doing something with the surplus cash. After that many companies are actually setting return on equity targets.
So, the business situation in Japan – over the last two decades – has been much worse than it ever was in the U.S. (except the Great Depression) or many other Western countries. It’s difficult to find developed markets that experienced a long-term slowdown as bad as Japan has experienced these last 20 years. It's worth noting that an intelligent investor has always been contrary to popular investing opinion. As Sir John Templeton once said, "Successful investing is not an easy job. It requires an open mind, continuous study and critical judgment."
Some hurdles to invest in Japan
There are some challenges to invest in Japan – at least if you are not Japanese or live there and speak the language. One of the biggest reasons foreign investors avoid Japan is the seemingly insurmountable language barrier. There’s a lack of English language financial information. Not very many Japanese companies report in English – at least not to the same extent as in Japanese. This is especially true for small Japanese companies where the best opportunities are. If you’re intent on doing in-depth research on interesting small or microcap stocks, you’re faced trying to navigate a mountain of Japanese language financial reports. You will get the financials, but that's all.
Maybe you can turn the language barrier to your advantage. Without qualitative analysis you have to rely 100 % on hard numbers data. You are not so biased to your own analysis. In short, not relying upon qualitative analysis and strictly using quantitative analysis will take a significant amount of emotions out of the playing field.
Then you should find the right broker to invest in Japan. The right choice will depend on where you live. You have to survey the situation in your home country. I have used Interactive Brokers. International trades are cheap, and they offer a good platform to work. I can highly recommend it. I have heard that other possibilities could be Fidelity, PennTrade or Schwab. But everyone should check out their domestic options.
Then there’s a minimum lot size. Many Japanese stocks have had minimum lots of 1,000 shares. It can be a big problem for small investors. Japanese stocks often have share prices exceeding 1,000 yen ($8.85), meaning the least you can spend is 1 million yen or almost 8,000 euros or $9,000. That's far too large for many small investors – especially if you are considering purchasing a wide basket of Japanese net-nets. The good news is that many companies are moving to reduce minimum lots to 100 shares and doing stock splits. It is a very welcome and shareholder-friendly move.
Obviously there is also currency risk. You will need to convert your home currency – such as dollars, euros or what ever is your home currency – into Japanese yen to buy these stocks. Almost all of these stocks are only available for purchase in Japan using Japanese yen. Someone may want to hedge currency, but personally I don’t have a view one way or another on currencies. I invest for several different foreign markets, and changes in the value of currencies offset each other over the long term. I do not want to speculate on currencies.
Last minor point is Japan’s stock market trading hours which are different from U.S. or European trading hours. If you want to use real-time international quotes of Tokyo’s equity market to make an exact limit order to trade during the trading hours of the local Japan equity market you have to make a little shift of your day and night in your local time zone.
Special features of Japanese net-nets
Because of the different business and investing culture of Japan there are some special features investing in Japanese net-nets. Many net-nets in Japan are high quality, their earnings quality is pretty good, and balance sheets are strong without interest bearing debt. Because many Japanese net-nets are profitable they also seem to pay appropriate dividends. Also current asset composition is often very favorable, a lot of cash plus short-term investments and accounts receivables combined with little inventory. Having much cash you’re going to eliminate all risks of insolvency.
After all the positive things there is also the other side of the coin. It’s typical for Japanese net-nets to take a long time to get to appropriate valuation levels. Some of those companies deserve to remain net-nets forever. You can find lot of companies without growth or business dynamic. Japanese net-nets are extremely unlikely to be made profitable investments through activism. Forget about shareholder activism in Japan. You can encounter also corporate governance issues like poison pill or not so shareholder-friendly dominant shareholder.
So what is the secret of successful investing in Japanese net-nets?
You should consider following points:
1. Market cap
From Japan you can find big companies trading below net current asset value. Try to avoid them. Back tests of net-net strategies around the world generally show that smaller net-nets outperform larger ones. Same apply in Japan. Ideal range in size of a market cap could be from 30 million euros to about 150 million euros.
2. Growth
Japanese companies usually have much lower sales growth than U.S. companies generally. It is usually better to buy a growing company because profitable growth is the best catalyst you can get. Look at =stable and strong profit margins. They tell you something about a company’s pricing power.
3. Earnings and profitability
Several years of positive net income and profitability provide a reliable business base. Yes, from Japan you can find this kind of net-net. Secondly, try to get net-nets with relatively stable cash flow and in areas of business that are inherently stable. Then look at increasing earnings, current assets and dividends. Share buybacks are very positive signs. Honestly, it’s uncommon to get all these merits at once. You have to always compare quality and price.
4. Valuation
We are looking for companies trading below their net current asset value. To buy stocks trading at two-thirds of NCAV can give us an appropriate margin of safety. Always just better if you can find stocks priced under their net-net working capital.
Because many Japanese net-nets are profitable you can also value them earnings based. Use EV/EBIT before price-earnings (P/E) because many Japanese companies have large amounts of surplus cash on their balance sheets. Enterprise value adjusts it better. You should have a good chance to find many companies under 5.0 EV/EBIT valuation.
Look at high earnings yield, high dividend yields and increasing retained earnings in cash. Still many companies have too much cash and their capital allocation is not the most efficient, but enough cash is good cushion against the downturn.
5. Debt
From Japan you can find many net-nets without debt. So eliminating firms with a debt-equity ratio of over 25% should not be overwhelming but instead very wise and safe.
6. Selling
If you purchase a wide basket of Japanese net-nets and keep them a couple of years you can be pretty sure that you will experience several takeovers. Of course it is not your own decision, but it can be very lucrative in a short time period.
There is no single right answer when you should sell your net-net. I have always advised investors to be patient and not to sell too early. It’s always advisable to re-evaluate your holdings after the rise of the share price. Regarding Japanese net-nets my best advice is sell once the stock has reached its NCAV. When you get the price catalyst take advantage of it. In Japan valuation levels are much lower and nothing unusual is that after the rise of the price it will stay less than book value or even remain at the NCAV level.
Proposals for net-net investing
In this market situation Japan is still great place to look at net-nets. Because of large selection and the exceptional combination of good quality and cheapness it could be the best country for your net-net discovery.
Following some net-net candidates (these analyses were made Nov. 9):
OTEC Corp. (TSE:1736, Financial)
OTEC is an electrical engineering company. The company designs, constructs, and maintains automatic air-conditioning control systems in office buildings.
- Market cap: 4.69 billion yen.
- Price: 911 yen (net cash -684, net-net working capital -195, net current asset 1323).
- Price/NCAV: 68%.
- Growing revenue, earnings and dividends.
- Debt to equity: 0.14 (has been higher!)
- EV/EBIT: 0.2.
- Traiding lot: 100.
- Website: http://www.o-tec.co.jp/.
Charle Co. Ltd. sells cosmetics, clothing and mainly the ladies' innerwear.
- Market cap: 8.78 billion yen.
- Price: 458 yen (NC 552, NNWC 660, NCAV 789).
- Price/NCAV: 58%.
- No growth in revenue, stable earnings and dividends.
- Debt to equity: No debt.
- EV/EBIT: -3.5.
- Traiding lot: 100.
- Website: http://www.charle.co.jp/.
Original Engineering Consultants (TSE:4642, Financial)
Original Engineering Consultants Co. Ltd. is engaged in advanced design-assistance and data-processing technologies.
- Market cap: 2.52 billion yen.
- Price: 377 yen (NC 474, NNWC 529, NCAV 574).
- Price/NCAV: 65%.
- Growing revenue, earnings and dividends.
- Debt to equity: 0.01.
- EV/EBIT: -3.6.
- Traiding lot: 100.
- Website: http://www.oec-solution.co.jp/ (also in English).
Tiemco Ltd. (TSE:7501, Financial)
Tiemco plans, develops, imports, exports, manufactures and sells fishing tackle and outdoor products.
- Market cap: 1.22 billion yen.
- Price: 492 yen (NC 455, NNWC 771, NCAV 1339).
- Price/NCAV: 36%.
- Slow growth, some (temporary?) earnings problems and stable dividends.
- Debt to equity: No debt.
- EV/EBIT: 0.6.
- Traiding lot: 100.
- Website: http://www.tiemco.co.jp/ (also in English).
Yotai Refractories Co. Ltd. (TSE:5357, Financial)
Yotai Refractories manufactures and sells fire bricks, monolithic refractories and ceramics in Japan. The company is also engaged in the engineering and construction of various furnaces.
- Market cap: 6.82 billion yen.
- Price: 310 yen (NC -110, NNWC -12, NCAV 541).
- Price/NCAV: 57%.
- No growth in revenue, very stable earnings and dividends.
- Debt to equity: No debt.
- EV/EBIT: 2.4.
- Traiding lot: 1,000.
- Website: http://www.yotai.co.jp/ (also in English).
Daiken Co. Ltd. (TSE:5900)
Daiken manufactures and sells metal and material parts for building construction and exterior products.
- Market cap: 3.58 billion yen.
- Price: 609 yen (NC 200, NNWC 512, NCAV 1027).
- Price/NCAV: 59%.
- Slow growth, stable earnings and dividends.
- Debt to equity: 0.02.
- EV/EBIT: 0.1.
- Traiding lot: 100.
- Website: http://www.daiken.ne.jp/ (also shortly in English).
Nansin Co. Ltd. (TSE:7399)
Nansin along with its subsidiaries manufactures and sells casters and related products. Its products include logistic equipment, caster screws and wheels.
- Market cap: 3.21 billion yen.
- Price: 419 yen (NC -87, NNWC 45, NCAV 550).
- Price/NCAV: 76%.
- Slow growth, stable earnings and dividends.
- Debt to equity: 0.05.
- EV/EBIT: 0.8.
- Traiding lot: 1,000.
- Website: http://www.nansin.co.jp/.
Taiyo Kisokogyo Co. Ltd. (TSE:1758)
Taiyo Kisokogyo is engaged in civil engineering work, stonecutter construction, pavement construction and steel structures construction.
- Market cap: 2.42 billion yen.
- Price: 689 yen (NC 309, NNWC 637, NCAV 978).
- Price/NCAV: 70%.
- No growth in revenue, stable earnings and dividends. Also stock buybacks.
- Debt to equity: -0.5.
- EV/EBIT: 0.11.
- Traiding lot: 1,000.
- Website: http://www.taiyoukiso.co.jp/.
Terasaki Electric Co. Ltd. (TSE:6637)
Terasaki Electric is engaged in the manufacturing and sale of marine and industrial systems as well as circuit breakers.
- Market cap: 9.77 billion yen.
- Price: 750 yen (NC -562, NNWC -283, NCAV 1013).
- Price/NCAV: 74%.
- Growing revenue, earnings and dividends.
- Debt to equity: 0.18.
- EV/EBIT: 1.6.
- Traiding lot: 100.
- Website: http://www.terasaki.co.jp/ (also in English).
Kawaden Corp. (TSE:6648)
Kawaden designs, manufactures and markets industrial power control equipment. Its products include switchboards, load centers, distribution panels, control panels and monitoring systems.
- Market cap: 6.55 billion yen.
- Price: 2,045 yen (NC 600, NNWC 846, NCAV 2374).
- Price/NCAV: 86%.
- Growing revenue, earnings and dividends. Company’s ROE is 15 %.
- Debt to equity: 0.08.
- EV/EBIT: 0.1.
- Traiding lot: 100.
- Website: http://www.kawaden.co.jp/.
Nadex Co. Ltd. (TSE:7435)
Nadex is engaged in manufacturing, sale and marketing of bonding material and installation work.
- Market cap: 4.58 billion yen.
- Price: 492 yen (NC -833, NNWC -680, NCAV 695).
- Price/NCAV: 70%.
- Growing revenue, stable earnings and dividends.
- Debt to equity: 0.08.
- EV/EBIT: 1.7.
- Traiding lot: 100.
- Website: http://www.nadex.co.jp/ (also in English).
Toba Inc. (TSE:7472)
Toba imports, exports and sells control machinery, industrial robots, measuring and instrumentation devices, electronic machinery and chemicals, among others.
- Market cap: 8.83 billion yen.
- Price: 2,048 yen (NC 447, NNWC 458, NCAV 2468).
- Price/NCAV: 82%.
- Growing revenue, earnings and dividends. Also stock buybacks.
- Debt to equity: No debt.
- EV/EBIT: 1.1.
- Traiding lot: 100.
- Website: http://www.toba.co.jp/ (also shortly in English).
Yonkyu Co. Ltd. (TSE:9955)
Yonkyu is engaged in the selling of fresh fish, bait and feed sales, production and sale of fry for aquaculture.
- Market cap: 12.91 billion yen.
- Price: 1,120 yen (NC 574, NNWC 670, NCAV 1427).
- Price/NCAV: 78%.
- Slow growth, stable earnings and growing dividends.
- Debt to Equity: 0.08.
- EV/EBIT: 1.3.
- Traiding lot: 100.
- Website: http://www.yonkyu.co.jp/ (also shortly in English).
Disclosure: The author has a position in Original Engineering Consultants.
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