The market that has always been attractive to value investors is Japan. Japanese equity markets have, for the past two decades, been rich and fertile hunting grounds for value investors with many stocks trading below tangible book value.
But the problem is Japanese equities have gone nowhere for the past two decades. Indeed since 1996 the MSCI Japan index is down by 15% and over the past 10 years the index is down 10%. Over the past five years the MSCI Japan has chalked up a positive performance of 28%, but, in comparison to the Standard & Poor's 500’s return of 69%, this return seems insignificant.
Still, Japanese companies generally offer value, and it is this value that some investors may find hard to pass up.
There's value hidden away
If you start digging below the surface, finding Japanese equities trading at a discount to book value is easy but even from the top down Japanese stocks appear cheap compared to the international peers.
For example, the Japanese market is trading at a cyclically adjusted price-earnings (CAPE) ratio of 24.9 compared to the U.S. CAPE ratio of 26.4 and developed world ratio of 21.9. The market is trading at a trailing 12-month price-earnings (P/E) ratio of 19.4 compared to the U.S. ratio of 21.8 and developed world ratio of 21.8. These ratios might look unappealing at first glance, but they don’t take into account the enormous cash piles on which Japanese corporations are sitting. According to the IMF, between 2004 and 2012 cash as a percentage of market capitalization totaled 45% of market capitalization at Japanese corporates. Corporate cash as a percentage of gross domestic product (GDP) at the end of 2013 was 60% compared to just over 10% for the U.S. There is no evidence these figures have changed since. If you strip cash out from market values, then Japan could be one of the cheapest markets in the world.
Starting to change
The good news is that Japanese corporates are finally starting to return this cash. Slowly but surely cash is being returned to investors. Last year dividends rose to 11.6 trillion yen ($102.87 billion), not much higher than the pre-2007 total of 8.4 trillion yen, and are still moving in the right direction. Share repurchases have risen to 6 trillion yen from a pre-crisis level of 4.7 trillion yen. What’s interesting is that while capital returns are slowly ticking higher, cash balances have nearly doubled since the crisis. Another piece of good news is that, according to the Financial Times, corporate Japan is finally becoming more profitable. Profits rose to 3.5% of GDP last year, the highest level for more than two decades. A drive to increase profitability and expand into new markets, coupled with corporate Japan’s strong cash balance, will likely drive acquisitions going forward, reducing capacity and limiting purchases.
The cheapest companies are likely to be the best targets, and this is good news for value investors buying the market’s unwanted stocks.
Even though the main Japanese indices have struggled over the past two decades, value has been the one area of the market that has actually produced outstanding returns. Specifically, according to the Financial Times which presents data from Nicholas Smith, strategist for CLSA in Tokyo, small-cap value stocks have outperformed Japan’s Topix by 300% since 1985. Even megacap value stocks have outperformed the Topix during this period, racking up a gain of 150%.
Looking for value
Analysts at SocGen have picked out some value equities in Japan they like based on Benjamin Graham and James Rea’s original value investing criteria. Their approach considers items such as earnings to price yield being at least at least twice the AAA bond rate and a P/E ratio less than 40% of the highest P/E ratio the stock had over the past five years. Also required is a dividend yield of at least two-thirds the AAA bond yield, stock price below two-thirds of tangible book value per share, total debt less than book value among other restrictive measures. Japanese companies that qualify include Fuji Heavy Industries (TSE:7270, Financial), NEC (TSE:6701, Financial), Nippon Electric Glass (TSE:5214, Financial) and Kaken Pharmaceutical (TSE:4521, Financial).
Disclosure: The author owns no stock mentioned.
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