Odd Lots - Lots More on Why Japanese Stocks Are Surging

Episode Date: March 8, 2024

Japanese stocks are suddenly soaring, with the Nikkei 225 hitting an all-time high this week after decades of languishing. Warren Buffett has been upping his stakes in Japanese companies and activist investors are taking an interest in the market for the first time in decades. And while all these dramatic headlines might seem to be coming out of nowhere, the road to Japan's big corporate comeback has arguably been years in the making. On this episode of Lots More, we speak with Travis Lundy, a Japan markets expert and special situations analyst who publishes on SmartKarma. He walks us through the history of Japan Inc. and how we got to this point. We discuss just how investor-friendly have Japanese companies actually become, what specific examples are we seeing of return-focused strategies, and what seems to be driving the change.See omnystudio.com/listener for privacy information.

Thanks for listening to Oddlots. Follow the show on Amazon Music for more future episodes or just ask Alexa play the podcast, OddLots on Amazon Music. Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk bonds for a minute. Capturing value and fixed income is not easy. Bond markets are massive, murky, and let's be real. Lots of firms throw a couple flashy funds your way and call it a day. But not Vanguard. At Vanguard, institutional quality isn't a tagline. It's a very big. It's a very big. It's a very much. commitment to your clients. We're talking top grade products across the board of over 80 bond funds, actively managed by a 200-person global squad

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Vanguard Marketing Corporation distributor. Berg Audio Studios. Podcasts, Radio, News. How's Hong Kong? It's okay. We're perking along here. It's feeling a little bit better, you know, the last week or two here. Oh, that's good.

Than it did for much of the second half of last year. Have you watched, have you watched the expats? No. I'm debating. I categorically refused to do so. I think I'm going to watch it once all the episodes are out just for nostalgia value. But yeah, I have heard mixed reviews. Yeah, it's it's, it's, I objected to the way they, you know, they did it and I objected to.

I was sure I was going to object to certain portrayals and I bet I'm not going to be surprised. Joe, did you, did you know about that? So this was a huge thing in Hong Kong where during the pandemic, they let Nicole Kidman in, like, without having to go through quarantine in order to film scenes for the show, which is all about expats living in Hong Kong. Oh, I'll watch that. It was like a huge controversy. Everyone was so annoyed about it because it was just such an obvious double standard. I did a deadlift. One, two, three.

Hedgmy. Okay, go. What two. Gemsmy. Uh, barges. This is an after-school special, except... I've decided I'm going to base my entire personality going forward on campaigning for a strategic pork reserve in the U.S. Where's the best with ink pasta?

These are the important questions. Is it robots taking over the world? No, I think that, like, in a couple of years, the AI will do a really good job of making the oddlots podcast. And people will say, I don't really need to listen to Joe and Tracy anymore. We do have... Cha-ching. The perfect guest. Welcome to lots more.

where we catch up with friends about what's going on right now. Because even when odd lots is over, there's always lots more. And we really do have the perfect guest. It seems like it's fun to be an investor in the Japanese market again. But after like 35 years. Yeah, you had to wait a while. I think stocks for the long run, right? The Niki, I think recently on some measure, broke its 1989.

The infamous 1989 peak is back. Yeah, there it is. There's the chart. I just pulled it up on my terminal. Pretty impressive. Travis, is it fun? Has it been enjoyable? Yes and no. Partly, you know, being in Japan, you're constantly, and I'm not in Japan, I'm in Hong Kong, but being, you know, involved in the Japanese market, you're constantly told, well, you know, the Magnificent 7, they were up like, you know, 73% last year. How about you? And then, okay, well, Japan's up 40% and the S&P's up less. Okay, but yeah, but that's in yen. And, you know, the dollar. or strengthened against the end. And so there's always some naysayers here and there. But yeah, it's been okay.

And there's been a lot of changes. And those changes have really been rewarding for those of us who've been watching and waiting for these changes to manifest themselves more publicly. Yeah. So we are speaking to Travis Lundy. He is, of course, repeat all thoughts, guests and a special situations analyst who publishes on smart karma. One of the smartest people I know when it comes to both markets and general trends, I guess in Asia, based out of Hong Kong. But you have a lot of historical experience with the Japanese market, right?

In fact, this is sort of your bread and butter, corporate Japan, special situations, big events in that market. Yes. I've been involved in the Japanese markets for 20 plus years. I lived in Japan for 20 plus years. I moved to Hong Kong for a job, and I'm still here. But I do a lot of my work related to Japan. So this is the thing that you hear. And the thing is you've been hearing it for a while.

So this is why I'm not entirely satisfied. But a thing that you hear is, oh, well, suddenly corporate Japan, management in Japan have become much more focused on returns or become more shareholder friendly, et cetera. I guess there was this perception at one point, you know, that management in Japan for a long time ran the business for management or insiders and now they're running for shareholder. For salary men, for their employees. Is this true? Is this actually a phenomenal? phenomenon that's changed? Yeah, it's changed quite a bit.

It really has. And part of this is if you go back to the history, you know, back in 1642, seriously, the post-war, you know, the occupation administration broke up the Zybotsu, but they were afraid of communism. So they allowed the, you know, they allowed the corporate groupings to reform instead of vertically, they allow them to reform horizontally around banks and financial institutions. And a bunch of the shares in corporate Japan were handed off to individuals, but individuals then sold over the years, and there were no buybacks, but the financial institutions just

accumulated them. So by the mid-80s, financial institutions, that is to say, banks, trust banks, regional banks, life insurance companies, property and casualty insurance companies, and then, of course, corporations, they held two-thirds of the market, which is just nuts, right? Since then, it's gone way, way down. And part of this is, you know, banks support, you know, companies. A company has a need to invest capital, so they go borrow some money from the bank. The bank says, here, I'll buy some warrants too, and the warrants become shares. Okay, now you IPO a subsidiary of a major company.

company. And that subsidiary has, you know, you know, three different insurance companies, three different banks, five different supplier partners, 10 different customers already as shareholders. They sell some off to retail, but it's still 80%, you know, corporate and finance. And this is, it's part of society. You know, crossholdings wasn't some, you know, malicious thing designed to keep out, you know, voting shareholders. It was really, you know, let's go all do this together, support each other, be nice and friendly, and suddenly became rude to sell. You know, why would, I would sell this in order to go make money for myself? You know, I'm part of a society. I'm just going to support this. Now, eventually, you know, they started selling down because they needed to.

There was a, you know, 1980. And then, you know, by 1998, we were, you know, half, half off. And, you know, there was a banking crisis in the late 90s that persisted through the early naughties. A couple of brokers went the bust in the late 90s. A couple of insurance companies went bust in the early naughties, mostly because they held too many shares, which had gone too far down. That and real estate, obviously. And, you know, the shares started going down, and the banks and insurance companies and corporate started seeing this as kind of an existentialist risk.

So they sold shares. And, you know, those shares ended up in the hands of foreigners, retail, and more public shareholders engended more questions about what management was doing. So one of the things I'm curious about is what the proximate trigger is or was for this newfound, I guess, like investor slash return focused idea in Japan, Inc. So, you know, when it comes to Japan, I think I can remember like for decades. Almost everything touching the Japanese market and economy tends to be done. discussed in almost cultural terms. It's kind of weird, but like people were always debating

whether or not the culture of the Japanese economy could change, whether or not it would be more open to things like imported labor, immigration, or whether that was just impossible given attitudes towards foreigners. But also whether or not the, I guess the sort of like internal focus of companies was down to a different type of societal value. So more of a collectivist society versus maybe the rampant individualism that we see in the U.S. So what was the change here? Because people were kind of like dismissive of the idea that this could happen for a long time. I think a couple of things. First was, you know, when the dollar yen went from 150 in 1990 to 79 in 1995, all of Japan Inc., which produced in Japan and sold abroad,

the giant export machine, and they lost huge sums. And so all of the Japanese companies, they set up production bases abroad. So now you have, you know, Toyota making cars in America sold to Americans. And, you know, Japan turned the demographic corner. Japan was much slower to come back after its banking crisis than, you know, the U.S. was after its own banking crisis in the 80s. And, you know, the Japanese business of Toyota didn't make nearly as much money as the U.S. business. So, you know, profits piled up abroad. And, you know, companies became cash rich.

Because companies had found that they were unable to borrow when they needed to invest, simply because the banks were too weak to lend too much money, and they were always afraid of lending to companies who had a plan rather than companies who had assets to back their loans, companies started to hoard cash. They hoarded cash and they hoarded shares. Shares were not marked to market. And so they became a rainy day fund. And as long as they didn't get hit, you know, you were okay. Go down 50%. You have to impair them. But as long as they don't go way, way down, you're generally okay. So they became a rainy day fund just because they needed to hold on to this stuff, to be sure that they had access to money when they needed it. And so we kind of went through the naughtys, Japan, you know, came through the GFC better than, you know, most people, I think. And then there was a push towards increased stewardship and increased corporate governance. Part of this was, you know, based on the Scandinavian experience where some of the pensions decided to go whole hog on better stewardship and better corporate governance pressuring companies back in the late 90s.

The UK did so in the early naughties. The TSE set of a corporate governance code in 2004, which nobody will remember and nobody ever paid attention to. The UK set up more of a stewardship code and more of a corporate governance code as time went on. There were more reports about the effectiveness. Japan copied that and set up a stewardship code and a corporate governance code after much back and forthing in the political arena. And it finally got there just after Mr. Abe was elected in late 2012. It showed up in 2014 and a corporate governance code in 2015, there was pressure. People saw it. It was finally, you know, starting to push. From what it sounds like, you know, I started in the beginning with my cynicism, it's like,

oh, you'll always hear this. It's like Japan is turning the corner on, you know, management styles and corporate governance, et cetera. What it sounds like is actually all that's been true. It's just a very long process. So there's the long process of the sort of diminution of the crossholdings, the long process of the various expectations at the TSC, et cetera. So all of it was always true. It just takes a while for these things to sort of come to fruition. That's, yeah, that's exactly right. And, you know, we, Japan hit bottom in 2012 when the dollar yen was super low. And it's been up since. You know, we've had a four bagger, five bagger in the NICA in 12 years, call it. And that is not bad, you know. It's been in the end

terms, which means it's less in dollar terms, but that's where we started from. And we had to come up the hill through Abenomics, through a bunch of different privatizations, to get some leadership examples out in the public so that the media could point to that company. That company did something good. And the hint that everyone's supposed to take is, I should be more like them. Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk bonds for a minute. Capturing value and fixed income is not easy. Bond markets are massive, murky, and, let's be real.

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Factor, Canada's number one ready-to-eat meal delivery service. I understand that, you know, at a high level, there are examples of shifts in Japan corporate governance. So, you know, there are actions being taken at a sort of like executive slash strategic level. But I kind of wonder how much that filters down. to day-to-day business. Because I remember a lot of my friends from high school in Tokyo, you know, they stayed in the city and they went to work for Japanese companies. And admittedly, the last time I spoke to them, a lot of them, was pre-pandemic. So this would have been like

2019 or 2018. And so many of them were just miserable. Like the working culture was terrible. you know, gender dynamics were terrible. I just wonder, like, how much of that aspect of Japan's corporate culture has actually changed? That's actually changed a lot. And it changed a lot in, you know, post-GFC, in part because, you know, companies weren't making any money. And Japanese companies didn't want to pay overtime. And so one of the things is, you know, you pay overtime and eventually people end up with a little bit more cash in their pocket. The manager, you know, his job is to take out the subordinates. They all go to some bar,

and, you know, that's where they end up at the hostess bar. But they no longer had any money. And Japan really, you know, when I arrived in Japan in 1990, you know, this was Julianas Tokyo. Actually, they went under just before that. But, you know, it was really, you know, Japan's great. Japan's fantastic. Japan's the top of the world. We will conquer the U.S. in five years. And, you know, Hong Kong was much like that when I arrived in 2011. But, you know, it was a Japan, you know, took us, you know, a step back. And they really, you know, 15 years of being beaten down economically speaking, you know, household incomes not going up, asset prices going down, real estate prices going down. People decided that, you know, leisure, hobbies, foreign travel, all of this is much more interesting. If I'm going to have a job which really stinks, well, guess what? I'm going to quit that job and I'm going to go work for a foreign company where I'm treated better. Travis, you mentioned the importance of you need some company to do it, and then everyone wants to emulate them. So some company takes some actions, the stock goes up, people, shareholders get rich, then other shareholders want to get rich.

Which company did that in Japan? Who is that, who is that prime mover? That's a good question. The example, which was perfect here, was when the Tokyo Stock Exchange and the FSA changed the corporate governance code, the first time, you know, after the original, they made. an amendment to it, one of the general principles, which said, if you hold corporate crossholdings, you are obliged to check them every year to see whether you need to hold them in order to do business. And strictly speaking, you should never need to hold crossholdings in order to do business. You should be able to do business with partners all the time anyway. And no company should restrict other companies from, you know, selling their shares. That withholding business as a threat would be a really bad,

thing. So they put that in there. And then they said, okay, we're going to do this as an example. And CSE owned 4.9% of the Singapore Exchange. And they, you know, they made a little presentation and says, well, we've decided we've talked with the Singapore Stock Exchange. We've decided we don't need to do this. But we'll have a continued good relationship with them and partner on products and services. And so we've decided to sell one third of our stake every year for the next three years in order to not disrupt the market and not cause market, you know, consternation. And we will apply the proceeds to, you know, improving shareholder returns. And that was the example just as they changed the corporate governance code.

You know, since then we've also seen activists coming in. Actually, a perfect example, an absolutely perfect example, is Tokyo Electron. In 2013 to 2015, there was a long-running merger negotiation and a approval process between Tokyo Electron and applied materials in the United States. And they ran a similar business. And Tokyo Electron was always kind of stodgy. They held some crossholdings. They held a lot of cash.

And they kind of built their business in a certain way. And they spent, you know, basically the better part of two years talking to Amat. And they walked out of it and the deal broke. The DOJ, you know, blocked it. And it was announced at the end of April, 2015. and they came out and said, all right, we've learned so much in the process of two years. We're going to completely change our business. The stock is going nuts.

I'm just looking at a... Stock is going nuts. It's a 10-bagger, right? They basically said, you know, they said, we're going to concentrate on our customers in a different way. We're going to have a different dialogue with our customers, much the way Amat has a dialogue with their customers. We're going to take all of our extra cash. We're going to buy stock back. We're going to set a minimum payout ratio of 50.

So every quarter or every half, you know, we're going to pay out exactly half of our earnings. So you know what you're going to get as a dividend. And we will strive to produce more shareholder return. It wasn't noticed at the time, but, you know, people noticed it later. And the stock is way up. Other companies, you know, took a less good governance stance at the time. But, you know, there were a bunch of examples and it's slow. and but it's it's kind of you know rolling stone so speaking of people noticing i mean you mentioned

just then there's been more activism we've we've certainly seen a lot of inflows into the market as well and i think the fact that you know stocks the niki is at a record is obviously catching a lot of people's attention but are you seeing that impacting investor behavior like are people responding to the market maybe differently than they once did. And I'm also thinking back to, again, this is kind of a cliche, but the Mrs. Watanabe idea, it used to be that a lot of retail investors in Japan would be focused on currency arbitrage because that was kind of a way of getting returns in a period of slow economic growth and the lost decade and all of that. But I mean, now you can invest in stocks and get a return that way. Yeah, it's an interesting question. Last year,

There were a lot of strategist comments and some of the famous Japan specialist Tuitarati were commenting on how much foreign inflow there was into the market. And indeed, in the first half of 2003, we saw about 4.5 trillion yen come in, which was a really big thing. That was the biggest inflow we had seen in almost 10 years. But, you know, the second half, you know, kind of dampened it and we lost 1.5 trillion. But if you go back 2022, 2021, 2019, 18, you know, that 3 trillion yen didn't cover half of the outflow during the previous five years. So it was nice to come back, but we were at no means, you know, overweight foreign exposure. The other thing is, you know, you've seen this everywhere. The rise of passive has been, you know, dramatic.

And that includes, you know, American pensions investing with American fund managers who manage international portfolios. a lot more of it's now in passive than active. And so we've seen a rise of passive flows and a decrease of active flows. But the activism itself depends on active investors, not passive investors, because the passive investors, you know, they just go with the thing. If it gets taken over, it gets taken over, it doesn't get taken over, it doesn't get taken over. What am I going to do? So one investor, one investor who's out bullish on Japan and even wrote about it in his recent note, Warren Buffett, and he has stakes in five companies, and he says they follow shareholder-friendly policies, some of their Mitsubishi, Mitsui, Sumitomo, or Benny Itochu. I don't know if I'm

pronouncing all those correctly. And he says they also, they don't pay their executives as much as U.S. executives. So what is it about these companies? Are like, what is this opportunity or the sort of the new Buffett and Japan trade? Well, so that was a fantastic trade. And the reason was a fantastic trade was because those companies are really great companies. They are effectively listed private equity funds. They are very competitive. They pay their young people a lot of money. They recruit very, very good personnel. The personnel get trained. They enter a kind of a little pod and go forth and do projects. There's a project leader, you know, that's a flying V goes up in the hierarchy for the next five or ten years. Eventually, you know, you kind of get kicked out, you get sent off

to another project, maybe you spin out and you do an IPO or you take control of a project, which they then invest in. But back when Warren Buffett started investing, they were able to buy the projects at or buy the company at 0.5 times book. That's pretty good. You generally can't buy private equity funds at 0.5 times book. And these guys had had a, you know, a couple of years of bad returns because they were heavily invested in the oil patch, oil and gas. And when, you know, oil and gas was very high in 2014 and got crushed in 2015 and 2016, these guys had to write off a lot of their investments or write down the investments. So they did.

And, you know, it got kind of, it stayed weak for a little while. They started buying back some stock, but they were kind of, you know, under-loved. but they are still very, very good companies for what they do. They are very financially savvy. They are a bit like private equity because most of their investments are non-listed, and they actually have a fair bit more leverage than you can see by looking at their financial statements. But they just manage it well, and they've got long-term funding. They're super professional, and it could be that the top bosses don't get paid, you know, like $50 million a year.

They get paid pretty well. and that's just part of the Japanese way. Really, executives around Japan don't get paid stupid money. Carlos Gone was one of the examples. And he got paid $10 million, I think. And everyone's like, oh, my God, $10 million. Oh, Carlos Gone. Oh, my gosh, that was such a story.

I just remembered, I did a TV ad for Mitsubishi. This was my other high school job was doing, like, ads of various sorts. And it must have been like 2000 or 2001. I think I got paid probably like about the equivalent of $50. I should have asked for stock. Yes, you should have. That'd be not a million. Well, it went down from there from there for 10 years.

Tracy would have held. Tracy would have held the whole buy and hold investor here. I would have actually. There's one other thing I wanted to ask you, which is, you know, we've been very focused on corporate Japan. But how much is this whole conversation we're having about changes? How much of this is a reflection or even a vindication of abenomics? I think it is a vindication of abenomics in part because part of what Mr. Abe wanted to do was he wanted to make Japan conscious of its, shall I call them, positive attributes, where Japan had something to offer the world, he said, you know, go forth and make money. We will support you.

We will, you know, figure out how to get you loan. that you need to do to go, you know, spread the good word. And I think that at the same time, we had the introduction of the Japan stewardship code, which gave, you know, activist investors, basically a stick to beat on companies and then gave the corporate governance code as, you know, part of the, the anvil, if you will. And there were simply a bunch of things which entered into the framework, which helped companies get out of some of the doldrums post March 2000. 11 earthquake and end 2011 Thai floods, which impacted the Japanese economy dramatically. I think that it was all kind of came together to bring Japan out of what had been five-year

doldrums, which had been at the tail end of 20-year doldrums. And I think that he gets a fair bit of credit, but I really think that kind of a societal change which happened with a large number of inputs. And it's just, as you mentioned, Joe, it's going to take time. A perfect example is crossholdings, right? We talked about that before. Japan is effectively the world's largest long short fund. There's something like 70 trillion yen of crossholdings across corporates, banks, property

and casualty insurers, actually 70 trillion was last year's number. I think we're probably up to 100 trillion now. This is a lot of money. But basically, all of those crossholdings are funded by the equity of the holders. That is to say, if a bank sells its crossholdings, it gets money, then it takes the money and it buys back its own shares. Well, if you unpack that, it basically means all of these companies and banks and insurance companies have, they've effectively shorted their own stock in order to own the crossholdings. Now, that's really, really bad governance.

And I don't know that Japanese companies have figured that out yet, but by the idea of saying, I don't need to hold the crossholdings in order to do the business, and then I will take that money and buy back the stocks. You know, that's really great. The thing about this is, you know, the banks hold a thousand different stocks. And every one of these crossholdings is a strategic position. This is a corporate-to-corporate relationship. It's embedded in the DNA of the corporates for the past decades. It's part of their business, you know.

It's a huge number of relationships which need to be unwound. politely. You can't simply go to somebody and say, hey, you know, we've, you know, thanks for all the laughs, but, you know, I'm going to go sell $5 billion of your stock in the market. I hope it doesn't hurt the stock too much. So you have to be polite about getting out of it. You have to consider how it's going to impact the shareholders of that target company. Also, if you've got, you know, some company has like 15 different crossholders, they can try to accommodate, but they can't accommodate their 15 different crossholders unfairly. They have to treat all of them fairly. So if all of them want out, then, you know, they have to figure out how to get out of their own crossholdings to get the cash,

to buy them back. So it's a huge, enormous logistical problem here. And this takes time. It has taken time. For the past 10 years, it's going to take another five or 10 years. Just today, we had the property and casualty companies come out with their business improvement order plans. They had a scandal last year where they had a price fixing and the FSA decided that in part this was due to the overly cozy relationships which were caused by crossholdings. Now, that's kind of garbage, but they said it. And this is actually, you know, it's absolutely perfect for the Japanese insurers because, you know, if you're out there saying, gosh, you know, all my, all of my shareholders are telling me, I got to sell your stock. And, you know, I really don't want to sell your stock.

But, you know, what can I do here? And then the regulator comes in and says, you must sell the stock. Then the insurance company goes to all its partners and said, you know, my regular tells me, I got to sell all my stock. It's the law. So this is, you know, insurance companies are, are, have to be super happy about this because the regulator has now told them crossholdings are bad. Therefore, got to sell. Tracy, my new party trick, by the way, is I'm going to say, you know, Japan is really a long short hedge fund. The world's biggest long short. Masquerading is a country, and then I'm going to scratch my beard and walk away and sound very smart.

I look forward to the tweet, Joe. I'm sure it's coming. So you know how to talk about this otherwise. The Japanese insurers, and they're one of the really big crossholders. You know, they had to come out with their plans and they said, you know, we're going to get rid of our crossholdings as soon as we possibly can. And one of them said, you know, we're definitely going to get rid of all of them. them by fiscal year 2009, which is like six years from now. So, you know, it's going to take time. I don't think there's any, there's no expectation that it's going to, you know, they're all going to be out the door next year. And what the other interesting thing here is that if the, if the insurance companies have been told by the FSA that they can't hold crossholdings because

it's a danger to appropriate business practices, well, what does that say about banks? You know, the FSA regulates the banks too. So if it's bad for insurance companies, it's bad for banks. So we're going to see this sometime later this year, I think, where the FSA is going to go into the banks and say, you too, you've got to do it. And, you know, we're already seeing it here the last few weeks or a few months where companies and banks, et cetera, they're doing huge offerings of stock out in the market. Foreigners are buying them.

They're distributing the shares out to other buyers, et cetera. So there's a lot more flow here. here this year and the very end of last year. So we're going to see more flow, more interest. It's going to all happen. It's all good. It'll be good for years. It sounds good. It makes me long for the go-go years of Tokyo. And when you mentioned this, but when everyone was like, oh, Japan can do anything in the world. Japan's great. Like, it feels like we're maybe not that extreme, but coming round a bit to that again. Yeah, I don't think we're going to back that way, actually. Definitely not. I think that what Japan has done is they've learned to

be earnest and have, you know, a fair bit of humility, but also, you know, this Abe pride in what you can do. May not be able to do everything, may not be Magnificent Seven, but I know I can do the right thing. And that's one thing which I think foreign investors should get out of Japan. And I think, you know, Warren Buffett made a comment about that. There's some high quality businesses in Japan. And, you know, governance is pretty good. I mean, and it's got a tailwind to it. So that's the right thing. And, you know, there may not be a Google or an Apple here, but there's a bunch of really good stuff. Tokyo Electron. Tokyo Electron. I want to take Joe to Tokyo at some point and, like, show you all the places I used to go out in.

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