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Clayton Young
Clayton Young
Articles (6)  | Author's Website |

Put Corporate Japan's Cash in Your Wallet

With Japan's corporate governance reforms, patient investors might find its cash in their wallets

August 02, 2017 | About:

There are plenty of reasons to keep your money away from Japan, including the declining and aging population, corporate governance and poor capital allocation, just to name a few. Bad news seems to travel quickly, however, and there is still plenty to like about Japan, which is often overlooked. Here, I will shed some light on Japan’s often overlooked good news.

Corporate Japan’s balance sheet

Japan’s “lost decades” are common knowledge. Any time the words “Japan” and “investment” are used in the same sentence, the conversation tends to include a point about Japan’s bubble burst and subsequent stagnation. It is not all bad though, and some investors may be surprised to learn Japanese businesses have some of the strongest balance sheets on the planet today.

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Source: International Monetary Fund (IMF) study

To be sure, the high cash position is not a function of debt:

asfiPW1BWgnb772mKS_BRJ2nmTUfvcmTn759IUA0

Source: IMF study

Operating businesses are performing well

The good news extracted from the two charts above is the cash position steadily increased, and it was not because of debt. It is safe to say, on average, corporate Japan has been profitable. Meanwhile, the country has become well known for bad capital allocation. Frankly, stacking a mountain of cash on the balance sheet is a good way to lower return on equity (ROE) performance. Joel Greenblatt (Trades, Portfolio)’s return on capital (ROC) calculation, however, would probably be a better metric to gauging the true operating business performance in Japan as it would remove unnecessary cash from the calculation. Greenblatt’s famed "The Little Book That Beats the Market" describes the rationale behind his own version of the ROC calculation.

Here is how the GuruFocus platform calculates it:

EBIT / (Net Fixed Assets + Net Working Capital)

See how it removes the excess cash?

At any rate, aside from providing corporate managers with comfort, a large, static cash position does not do shareholders much good. That said, investing in something because you have too much cash is a fine way to get yourself into trouble. Since no one has really demanded corporate managers deploy or distribute excess cash (until recently), they have sat comfortably on top of the cash mountain. This does not mean the operating businesses are terrible or even remotely bad. In fact, the Nikkei 225 index points at the increasing profitability of Japanese large caps:

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Source: Nikkei 225 Fact Sheet

Playing with the numbers in the chart above gives us a closer look at Japan’s recent operating performance (though it is not the Greenblatt ROC view I would prefer):

 

2012

2016

Earnings Yield

5.9%

6.2%

Dividend Payout Ratio

31%

26%

ROE

6.5%

8.2%

Source: Author calculation of data from Nikkei 225 Index fact sheet

The cash and debt data from the IMF study ends at 2013. Regardless, it is clear corporate Japan has been profitable as a whole.

Catalysts for corporate cash distribution

Oftentimes, identifying catalysts is nonsensical in value investing because value is its own catalyst. In some cases, however, corporate managers need that little “umph” to make a decision - and that is an important and sensible catalyst.

Over the past decade or so, corporate Japan’s large cash position has become a synonym for poor capital allocation. However, things are changing. With Prime Minister Abe’s “three arrows” and the corporate governance code improvement initiatives, Japanese companies are starting to find more reasons to either deploy or distribute cash.

One such example is Fanuc Corp. (TSE: 6954). In 2015, Fanuc had racked up over 1 trillion yen in cash and equivalents with no debt. In the same year, revenues reached an all-time high of 730 billion yen. At the time, the company had a dividend payout ratio of 30%. The company had far more cash than it could possibly ever need. Third Point's Daniel Loeb (TradesPortfolioaddressed this, taking aim at the company’s balance sheet and pointing out its “illogical capital structure."

Not long after Third Point announced its stake in Fanuc (February 2015) and urged management to buyback shares, the company announced a shareholder return plan. The company doubled its dividend payout ratio to 60%. Although the timing of the announcement was impeccable, in a Toyo Keizai interview, CEO Yoshiharu Inaba mentioned there had been ongoing internal discussions about what to do with the ever-increasing cash war chest. The dividend policy remains unchanged today.

While the macro pressures from the government did not appear to affect management's thinking, they are hard to ignore. In the same Toyo Keizai interview, Inaba mentioned that while internal discussions about the cash problem happened without outside pressure, adding outside directors to the board was an issue the company spent more time thinking about, partially due to corporate governance reforms in Japan.

Wrapping it up

The problem with Japan’s corporate governance reform is it does not look like it is working yet. It is no secret that Japan has a cash problem. It is also no secret that Japanese companies are feeling the pressure to share the wealth with shareholders. Investors ought to take comfort in the fact Japan’s ROE problem has more to do with the “E” side of the equation rather than the “R”. The cash that was considered a problem yesterday spells opportunity for tomorrow.

Disclosure: I do not own shares of any of the companies mentioned in this article.

About the author:

Clayton Young
I grew up in Japan and completed an MBA in the U.S., but learned more from reading Howard Marks. I apply an American value investing approach to Japanese companies that are often inscrutable to outsiders who lack fluency in the unique cultural context.

Visit Clayton Young's Website


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