Yet Another Value Podcast - Value Punks' Daye Deng on why Warren Buffett $BRK invested in Japanese Trading Companies

Episode Date: October 12, 2023

Daye Deng, Co-Founder and Editor of the Value Punks newsletter on Substack, joins the podcast to discuss his articles that are deep dives on Japanese Trading Companies and why Warren Buffett invested in Japan. Value Punks article on Japanese Trading Companies: https://valuepunks.substack.com/p/deep-dive-japanese-trading-companies Chapters: [0:00] Introduction + Episode sponsor: Alphasense [1:26] History of the Japanese trading companies and Warren Buffett [6:59] Why trading so important in Japanese economy [12:37] Why Buffett made his first investment in Japan [22:23] Breaking down of Sogo Shosha (Japanese Trading Companies) [26:38] Why Buffett holding his investment despite run-up [28:21] Examples of corporate governance and capital allocation changes that Japanese trading companies specifically made to improve them [37:54] Overview of the basket of 7 Japanese Trading Companies, and what Daye thinks is the most interesting/exciting; difference between tier one, tier two and tier three players, and how would Daye label the 5 companies Buffett invested in (Tier 1-3) [43:16] Geopolitical reasons folks interested in Japan [47:13] ESG in Japan Today's episode is sponsored by: Alphasense This episode is brought to you by AlphaSense, the AI platform behind the world's biggest investment decisions. The right financial intelligence platform can make or break your quarter. AlphaSense is the #1 rated financial research solution by G2. With AI search technology and a library of premium content, you can stay ahead of key macroeconomic trends and accelerate your investment research efforts. AI capabilities, like Smart Synonyms and Sentiment Analysis, provide even deeper industry and company analysis. AlphaSense gives you the tools you need to provide better analysis for you and your clients. As a Yet Another Value Podcast listener, visit alpha-sense.com/fs today to beat FOMO and move faster than the market.

This episode is brought to you by AlphaSense, the AI platform behind the world's biggest investment decisions. The right financial intelligence platform can make or break your quarter. AlphaSense is the number one rated financial research solution by G2. With AI search technology and a library of premium content, you can stay ahead of key macroeconomic trends and accelerate your investment research efforts. AI capabilities like smart synonyms and sentiment analysis provide even deeper industry and company analysis. Alphasense gives you the tools you need, to provide better analysis for you and your clients. As yet another value podcast listener,

visit alpha-sense.com slash FS today to beat FOMO and move faster than the market. That's alpha-dash-sense.com slash FS. All right, hello, and welcome to yet another value podcast. I'm your host, Andrew Walker. If you like this podcast, would mean a lot, if you could follow, rate, subscribe, especially review it wherever you're watching or listening to it. With me today, I'm happy to have for the first time,

day dang from ValuePunks. Hey, how's it going? Hi, good. How are you, Andrew? Doing good. Hey, really appreciate you coming on. As we'll talk about, this is a podcast I've wanted to for a while, but we'll get there in a second.

Just first, a quick disclaimer to remind everyone, nothing on this podcast is investing advice. Always true. Maybe particularly true today, because I think we're going to be talking about for my domestic listeners, foreign stocks, a few different ones. Though, you know, they do kind of have the Warren Buffett seal of approval. So with that, I have wanted to do a podcast on Buffett. its investment into Japanese trading companies for a long time. I'll let you go through the history and everything, but I've been fascinated in them,

and I had done basically no work on them. So I just kind of wanted to see what he was seeing and why he did. And you had, I'll include a link in the show notes, you had a fantastic, quite long deep dive into the Japanese trading companies that included a ton of history. I didn't realize the pre-World War II histories of these things and everything. But I'll pause there. Day, talk to me about just the history of the Japanese trading companies. Buffett, we're going to go through all of it. So let's start wherever you want to.

Sure, sure. Yeah. So like, um, personally, I've been covering the Japanese market for 10 years on the Bicai. And I'll admit, like these companies are not the easiest to understand. They are, especially for people who aren't used to looking at Japan and, you know, they're very new ones. They got a long history, you know, they're involved in all sorts of businesses, very diverse portfolios. And ever since Warren Buffett got involved, you know, the interest level, other research on these companies. But at the same time, when I look at the Western media coverage,

you know, most investors discussing these names, I find that most of the time the coverage is kind of a lot lacking. People don't really go beneath the surface these names. So I hope I can add something to the discussion for the listeners today, just give listeners more, you know, and understanding of these businesses. And so, yeah, yeah.

Oh, I just, maybe we can go with some. some history because I thought one of the most interesting lines, like the history will help inform why Buffett like guidance to them say, but I thought one of the most interesting lines from your piece was it's Shoshas. Shoshes today are not the same as Shoshes 20 years ago. And I would argue that investors' understanding of them have lagged. So maybe we can just kind of start the history of these. Okay, very, very good. So let me give a 101 basically. And the transformation you mentioned is actually the most important piece. So maybe we'll we'll start with the very basic. system will end there. And so, so, you know, Shoshas have a very long history, 150 years.

And, you know, back then there were like 30, 40, maybe even 50 Shoshas, and eventually over time it's consolidated. And then today, we got seven of them, seven large tests. When people say Japanese trading companies for Sogo Shoshats, in Japanese, they're referring to these seven companies. And Bobbitt bought the five largest. And from there, I would probably even for the, especially for the casual business, right? Like, you probably can't remember all seven or even five. So I'll just narrow it down to the three largest that you should remember are Ito Chu, Mitsubishi, and Nutsui. These are the three largest and the most influential. And all these shows just combined, seven of them collectively, they account for about $250 billion in market cap, U.S.S. B market cap, and $30 billion in

that profit. So just to give you a sense of the scale there. And, you know, so let's let's talk about what they do specifically then. So here's the first confusion, right? People here are trading companies and they immediately think, okay, trading, you know, they do trading. But actually, trading is not their main business anymore. So pure trading only accounts for like 10% to 20% of profit.

And, you know, it kind of reminds me of an old friend I have who kind of asked me, you know, if you're not in the finance industry, you asked me like, what do you hedge? It's hedging their main business. And I'm like, you know, it's a bit more nuanced that and kind of like that with trading companies so today when you look at them they resemble something much more similar to virtual household in the sense that they

invest and operate a wide range of businesses in all sorts of industries and a lot of people you know when they hear trading companies they think okay you know they must do a lot of commodities trading like metals mining energy and so on but in fact like they do everything so if you know anything about japan you'll know that Convenience stores are a huge thing in Japan, right? Two out of three of Japan's largest convenience stores are owned by the trading companies. And they also own a lot of franchises, like the KFC, Kentucky Fried Chicken in Japan, is actually owned by one of the trading companies and so on.

So they're very diverse. Now just very, very quickly on the trading part before we move on. So the trading part, you know, I think most listeners are familiar with, you know, global commodities trading houses. Like the, you might have heard of like a Trujira or like Blancourt, right? The difference between the Shoshas and those trading companies is that. Those ones, they organize themselves around a vertical. So for example, like a mining expertise, energy, right?

Some of them specialize in agriculture, et cetera. The Japanese trading companies, on the other hand, they organized themselves around the region, so Japan. And they basically handle like everything, you know, that, you know they evolved to basically serve the needs of japan so you got you know one of their biggest business is importing resources because japan had no resources of stone so like iron ore and you know coal from australia you know they import salmon from norway and sell it to the japanese supermarkets and it's not just the imports but they also deal with export so taking

japanese industrial products chemicals automobiles etc and selling abroad so that's just trading in a nutshell. Can I just pause it? So, let me just pause on trading. So and you listed nicely. You said, hey, these guys, you actually went in reverse order of your piece, but you know, you said, hey, these guys do three things, trading, investing, operating. But just the trading, I did have a question on that because that's kind of the first thing I heard of them when I, I heard about that. Why is the trading necessary? Like, obviously, is it because Japan is, you know, it's basically an island nation? So that's the series. I just think of like the United States. Obviously, you can work with an expert.

importer, but there aren't, you know, it's not like Goldman Sachs is the largest export importer in the entire nation. And if you want to, you mentioned Norwegian salmon. Like I can kind of understand coal or something huge, but salmon, like, no, I wouldn't be going to Goldman Sacks to get salmon imported. Like, why are they, why is the trading so important here? Is this just legacy? Is this something specific to Japan being an island nation? Yeah, I think it's a large has to be with legacy. If you look at their first business, one of the first, you know, in the 1980, in some times in the 80 countries, Japan opened their port for trading. And one of the first industries in Japan to develop was the textile industry. That was the genesis of these trading

companies. And what they did back then was they basically imported cotton from developing, like from countries like India that have natural resources. And then they took machinery from advanced countries like Germany and UK and then they took both of those things together raw material machinery and then nurtured the Japanese textile industry then they took the textile and then you know in product and then they exported that abroad and so they were super successful in that they made a lot of money and eventually what happened is that they just conglomerate and by that I mean you know when you make such a huge amount of profit in one industry you keep investing that in another and you keep dominating more and more industries so they they brought

that to chemical, industrial products, everything. And they even entered the financial industry. They created a bank. They dominated insurance. It just became like, just like crazy, crazy big thing that dominated every part of the Japanese economy. And then they got super close with the government. Eventually they got, you know, they started funding Japan's war.

And that kind of actually spilled the demise of these conglomerate. Back then, it was post-di-bososur. But, you know, after the Second World War, you know Japan law and then US came in and one of the first things they did but they decided to dismantle this you know monopoly because partly because they were so linked to you know Japan's imperial the militaristic government that they decide to you know disband this thing so what we see today is actually only like a fraction you know as big as they seem they don't seem today they're actually

just a fraction of like how big they use but a bit of a historical kind of perspective And now a quick break to remind you that this episode is brought to you exclusively by AlphaSense, the AI platform behind the world's biggest investment decisions. AlphaSense gives you the tools you need to provide better analysis for you and your clients. As a yet another value podcast listener, visit Alpha-dashcense.com slash FS today to beat FOMO and move faster than the market. That's alpha-dash-sense.com slash FS. That is great. So let's turn to, you know, I just want to mention one more thing before we get there.

So one interesting thing you had your piece that I had no idea, right? You said, hey, these guys, you think you might hear as domestickers or whatever, you might hear trading houses, right? And they, oh, whatever. You said, these guys have a brand. You mentioned of the top 10, I think it's like of the top 10 companies to work for in Japan. Five or six of them are these trading houses, right? So, again, just as a complete foreigner, is it kind of like a McKinsey Goldman thing, right, where everybody knows McKinsey and Goldman, you go to one of these guys, you're basically, you know, everybody kind of knows, oh, this guy wouldn't work for the sharpest finance place in Japan, or is there something else there? Thanks for mentioning. That is a super, like, so important in this, because, you know, I often get asked by people, like, what, what the, like, are there western equivalents to these businesses, right? And of course, I can say, you know,

has a way in these conglomerates. But in fact, from a brand kind of perspective, they are actually a lot more similar to, as you said, like a Manzanibura, or Golden Sachs, in that they, you know, every year they hire hundreds of like this best talent from the top universities, right? Like they just got a super strong talent pool, number one place to work for in Japan.

They frequently come up, you know, ahead of even Sony and Toyota, and it will be top tier, like, Jewish, Japanese foolish ships, that everyone wants to work there. they pay three to four times higher than the national average salary. So, so, so that's very, and in addition to that, not only they hire the top talent, but, you know, they're just like Goldman Sachs in the sense that they're super connected

to the public sector as well, right? Not just the private sector, like, you'll find a lot of politicians who came from the trading houses or, like, they have, you know, so it, it's almost like systemic in the, like, it's not just another sort of private corporation, they are so important. I mean, the way after reading you right up and thinking about them a little bit, the way I was kind of thinking of them, it's literally if Goldman Sachs had a merchant bank, right? It's the Goldman Sachs, and obviously Goldman Sachs has a little private equity firm, but, you know, it would be if Goldman Sachs had KKR attached to it.

Pretty much, yeah. Okay, so let's turn to, let's turn to why Buffett makes the investment, right? So tell me when Buffett makes the investment, what you kind of think he's seen. And I mean, I think the returns, the old man still got it, right? Like, the returns have been pretty outstanding since he made the investment. But let's talk about, you know, there is something to the brand. It's not, it's probably not a coincidence. He invested in Goldman Sachs in 2008.

He invested in these in 2008. But why does he make the investment? What do you think he's seen at the time he's making the investment? And he's obviously continued hold. So what do you think he continues to say? Yep. Yeah. So, so the, so in terms of, like you said, I think what he saw at the beginning is this

was 2020 when he first made an investment, what he saw back then, and the reason why he continues to hold these today, in my opinion, are two different things. So let me go through that, right? So I think, you know, the initial investment was made more on the back of just, you know, purely quantitative reasons. So inflation, protection, cheapness, those were the main thing. And today, the reason why he continues to hold on to these companies is for the qualitative means, the management. Let's pause and talk about the qualitative reasons, or sorry, the quantitative reasons, right? So you say 2020, he makes these, correct me if I'm wrong, he makes them like in mid-2020.

So we're talking like pretty, pretty depths of COVID-esque, you know, obviously things that bounced off the March bottoms, but it's a very scary time. People don't know how long lockdowns are going to go. People don't know winning back. Like, this is a very uncertain time. And Buffett, who I specifically remember the Birxham, meeting in April 2020, where he seemed pretty shut out. You know, he was an old man who was, this was very scary for old.

So this is like the kind of the only investment he makes during the COVID era, if I'm not misremembering. So what is he seen on the quantitative side that makes him make this initial investment? Yeah, yeah, yeah. Keep in mind, this was like you said, it was like at that time, right? There wasn't even that inflation. It was when the Fed was saying they're fearing like deflation. They want inflation to be higher.

That's the environment we were in at that time. Buffett made this. It was highly highly contrary, right? And I might actually surprise many people by saying this, but at the time, Buffett actually did not meet the management of this company. So, and this was actually confirmed by the management. So for them.

Well, he said, I mean, it's not out of character for him. I want to talk a lot about Buffett here, but it's not out of care for him not to meet the management team. Oh, it is actually in 2020. Like, how is he going to meet the management team? the management team, but I'm sure he's not flying to Japan in mid-2020. Japan wasn't even taking people in mid-2020. Right, right, right, no, totally.

And I guess I made that point kind of like, when I kind of thought about, for example, his oil investments, right, his approach wasn't, because with trading companies, he bought five of them, right? He took like a basket approach to this. Whereas with his oil investment, he didn't just say, I'm going to buy like five oil companies and get exposure to oil. He bought oxy with conviction, right? like what like 30% of a company 50% or whatever right so that so it's kind of a pretty different

approach compared to the ones he took oil I guess that was maybe my point there um but let's go back to the quantitative side of this so so uh at that time right also was expressing his concerns for inflation um these trading companies have some of the best inflation and protected assets in the world, in mining, energy, agriculture, and these were trading as below both values. And the interesting, the important thing here is that wealth is actually borrowed yen as a very cheap rate, thanks to Japan's low interest rate and the fact that, you know, first year has the best credit.

So he got the funding at close to like 0%, and then he invested in the company which were offering three to five percent dividends and so the carry was fairly attractive at the time but i think he also bought himself a pretty you know valuable optionality for the massive gains that would materialize if commodity crisis was in the three and and it did so let me there's a couple different areas something i had wanted it and some that just came to me but let's start with the yen right so i hear lots of people say oh look how smart buff it is he made this great currency carry trade, right? Exactly what you said.

He borrowed yen at effectively zero and he bought these dividend paying companies that, you know, they yield 5% they're trading below book value. And I say, okay, okay, I'm not saying you're wrong. Like, I guess one thing I would point to is you can go back. Buffett has always had a fascination with borrowing and yen. You know, I look back to, I think it was in the early 2000s. He took out long term bonds and like he had no investments in Japan and he took out long term bonds to borrow then.

So obviously you set a fascination with just how low of rates you can borrow in Japan. So I'm not trying to, but at the same time, if I was like, hey, mid-2020, Buffett could have just borrowed at, you know, Berkshire's long-term borrowing rate at that point was one or two percent because interest rates were basically zero. Buffett could have borrowed and bought, I pulled up chart, J.P. Morgan, JPMorgan for all of 2020 has a three to four percent dividend yield and is trading. pretty, I think for most of it, they're trading below book value, right? So why I just hear a lot of people saying, oh, he did this great currency trade. And I don't know, like, you know, you and I

right now, we could go on our interactive brokers account. And everyone should remember nothing on this podcast investing advice. I'm not suggesting to go out and take margin. But we could go take margin out at interactive brokers. I think their rate is like 6%. And we could go find a dividend paying stock and buy it at 9%. Like this currency trade is always there. I understand Berkshire has better because they're an investment grade borrow. But I, I always just wanted, like, he couldn't have done it with anything. I just kind of dismissed that he was like, yes, I'm ready to like, Yolo, currency trade, dividend carry.

No, I hear you. I think that's a relevant pushback on this. On this one, I would say maybe where it's a bit different this time is just, if you listen to Buffet, you know, he's telling people he is participating in his exact words, participating in the future of Japan. Like, this is what you said. And I think this is pretty different from, like, have you ever heard both say something like, I'm participating in the future of China or India or Brazil, right?

I haven't heard him say that, but I think I haven't heard Munger say that he's participating in the future. China, maybe. But I'm, like, I think this time there's something unique about it. I'm interpreting, as a Japan investor, I'm kind of interpreting this as a pretty strong signal for Japan. And trading companies are often set to be like the gateway to Japan because of how much business relationship they have across like both of private and public markets there with the government. I think through this, it's highly possible Buffett, you know, Birchard gets introduced to more investment opportunities down the line. So we'll probably, I'm expecting to hear more from them over time in terms of their activities there. No, I love that point.

I was not, I had not heard the Buffett quote that he was investing in the future of Japan through these. So I think you're right. Like, you know, he looks at these and he, a lot of people have been bullish Japan, right? A lot of people have said over time, hey, you know, we think we're hitting the end of the deflationary cycle. I mean, I think he looks at these and he sees great businesses that he very much understand, you know, as you said, they're kind of Berkshire-esque. He invested in Goldman, so he understands the brand. He gets access to the Japanese. He's bullish Japan.

He gets them. And he gets the carry trade. Andy gets in below book value. So I see that. Once go back to one point, you mentioned, hey, these guys own some of the best inflation protected assets in the world, right? And one thing I didn't, we didn't pull on when you were going through the background is, hey, we mentioned trading, we mentioned operating, we mentioned investing.

We didn't say how much of the business is coming from them. So could you just, we don't have to get too grand, but could you just break down like how much of the value here or how much of the earnings is coming from, you know, just the import export trading versus how much is coming from the investing versus how much is coming from the operating business. Yeah, yeah. So sometimes it's a bit hard to separate these, but I'll give you an example, right? So in trading, let's say they're distributing the iron ore from Australia. Well, it's just so happens that these trading companies also have investments, equity states in those iron ore mine. So the way you could look at this business is it's sometimes hard to like separate that part

when you're like equity owner and you're doing the distribution, but basically if you look, just look at the trading commissions that they earn, it's probably, you know, 10 to 20% of total profit. And 40% to 50% might, I think it depends on the company, but kind of the rough image, would be the investment profit. So, you know, through the equity methods, through dividends received from their investment, you know, capital gains on their portfolio, investment portfolio. And then you've got the rest of the 40 to 50% just being operating earnings from companies that they've told them to consolidate on their balance sheet. So they're essentially operating companies there, just like Berkshire operating, they're reclaiming and so on. Actually, so maybe I'll go back to that point about the transformation, right?

I think from trading to being an investment company. Perfect. That's actually like a super, super, I think in fact, that is the most important thing to understand about these trading companies. So I talked about the trading earlier, and basically sometime, you know, around the 1980s, the trading company basically said, you know, screw these trading businesses. We don't want to be a middleman anymore. And the reason that happened was because the trading business, the pure commission-based trading, was under pressure, and they were facing a risk of disintermediation.

because if you recall at that time, the Japanese economy was shifting from, you know, the basic industry to consumer electronics, to automobile. And then with that, you got huge companies like, you know, Sony and Toyota come into the Knicks. And these companies started dominating, and, you know, they were very different because they were big, they have the resources. They said, you know, they said, we want to control our distribution network. We don't want to evolve towards that. And even if they were to outsource that, they'd, you know, pressure the mission, right? So the trading company basically said,

okay, like, you know, our business is under attack, what do we do? And the solution they came up with was, okay, we got all these, we made money from the trading, you know, let's reinvest all this back into owning assets in the world that we can distribute. Because if we own the bad thing, like, no one can disintermediate them. So that was kind of their solution. And so this goes back to, like, the example I gave you about the iron ore, right? They distribute the iron ore, but then, you know, you'll find that many top mining assets in Australia are, in fact, co-owned by the Japanese trading company.

And same with all these things, you know, these assets around the world. Let's just ask a silly question, not knowing tons about the background here, obviously, but, you know, I do hear you on, it does make sense. Hey, we're starting to get this intermediate. Let's go buy the assets, right? But the other side of that would be like every time I've heard something like that, this isn't the exact parallel, but you know, like I do think Japan in the 80s like buying Rockefeller Center at the absolute top of the market for crazy premiums, you know, like it does. And when you say, oh, they own pieces of this like I could hear, hey, these guys are the equivalent of Goldman Sachs and they're investing into operating assets at like really smartly and they're using their trading knowledge to kind of inform that. Or I could also hear, hey, these guys were worried about their business. like kind of going out so they went and they played you know they were the suckers at the table right they paid top dollar for mining assets and they got raked through it you know they went to some australian mining company and they paid you know 500 times reserve value for a 40% non non controlling stake so which is it it has i'm guessing it's the former it's like smart

but did they kind of get right through the coals when they were going through this or were these kind of good investments. Okay, so we don't even need to sugarcoat this, like straight out, like they stopped as in this. You can imagine, right? Like a bunch of old school trading guys, you know, deciding suddenly, you know, we're going to start, you know, spraying our equity states around the world. Like, no, like, it was a disaster. And at the beginning, I'm not even sure if they even cared about, like they, they saw this that, you know, trading guys were running the show in the company. And they saw that that's so purely a way to secure distribution price. And so, you know, they all overpaid, they, you know, recorded a lot of impairment losses and so on.

So it was a failure. But the key is that over the – so this was back in, you know, the late 80s, early 90s, over the next two decades, things would change dramatically. So the investment decisions at the trading companies, they became detached from the trading operations. and they learn through their mistakes and then essentially they turn more into just like real capital allocators and you know business run by management who actually understand these things. So this transformation is actually

I think when I look at the literature today you know, like coverage on trading company through the major media outlet. I find this to be actually a single most important thing that I don't think really covered adequately undercovered. I think so let's go let's fast forward today so Buffett has made a nice return right I think his annualized return since he invested in them about three years ago is over 20% am I remember that correctly maybe more because yeah I think yeah they've doubled so yeah it's probably

over yeah yeah but and then you know that's that's just the annualized return on the investment obviously as you said he was doing it as like a little bit of a young carry trade they borrowed some of Japan at zero to buy these. So like the returns to equity would be even better. But let's talk about, you know, he generally buys and holds forever. It's not unheard of for him to sell things. But he, it does seem he's in here for the long call. But why is he, he's taking something that was an inflation in quantity of play.

And as you said, turned into quality of play. So what do you think he's kind of seen in the overall evolution that's causing him to hold these today? Yeah. So I think he's seeing the management, improvement in capital allocation, which has come a long way, but continues to improve. Come a long way since they were getting their face ripped off, making those. Oh, yeah, yeah, yeah, like, absolutely. And, you know, Buffett recently went to Tokyo, right? And method management became away very impressed.

I think what he also sees is that the management of these companies, the Japanese CEOs, are also very, very receptive, actually, to Warren Buffett. And they have publicly, they want to learn from that. You know, as you know, there's a whole corporate governance reform and all this going on in Japan. And in fact, the trading companies were among the first to implement a lot of these, you know, government governance best practices and, you know, change themselves. And they've been at the forefront. So, can I actually pause it? So this is one of my later questions was talking about, you know, the capital allocation of the governments.

I mean, famously for 20 years, people would invest in Japanese. companies stocks and be like, oh, it's trading below net cash. And the answer would kind of be like, yeah, but they're never going to return the cash. The corporate government is awful. So can you just talk? What are some of the examples of corporate government exchanges and capital allocation changes that the trading companies specifically have made that it have kind of improved them? Okay.

Okay. Um, so, so, so just like, just to give you a sense of the changes there, right? Like, you know, back in the early 2000, trading companies collectively were making zero profit. All of them added together, zero, right? And last year, collected with $30 billion. And, yeah, you can say, you know, there was a commodity and all that which held the profit. But I think that's not the only thing. There was a huge, huge improvement, organizationally, internally.

And so, you know, I think one of the key observations for me personally in this is just, like, the trading companies have always had the best asset, you know, the best people. And it was kind of like a matter of time that you can make money with these companies if you just run these, like, real companies. And so, okay, so what kind of organizational changes have they made since then? A lot of it started actually pulled, bubble with low, you know, Japanese bubbles. And then after that, one of the first things they did was they, you know, they get fit of spring and praying, you know, and with the equity states,

go over the place, they started making more concentrated investments, they started actually treating these as, you know, things that you need to do due diligence on, you need to, you know, do proper valuations. They implemented a lot of accountability into the system and, you know, having hurdle rates, for instance, and dissecting businesses that underperform, so on, which sounds very basic, but you'd be surprised how leads were not part of the company before this. And it's not just talk, right? And so one of the huge part of the reform was management comp. So, you know, Japanese companies, and this is not just limited to trading companies, but overall, a lot of large Japanese companies in the past, they only paid a base salary to even their CEO. Like,

you know, something like $3 million, $4 million per year, base salaries. But now, if you look at the trading company CEO comp, 80% is variable com tied to net profit. type of cash flow, in some cases even type of ROE. And then you look at their stock ownership in the past. They held no stock. Today, at the top trading companies, the top guys, their own three to four times their annual comp in stocks.

And where it's really impressive is, for example, Mitsubishi, which is the most impressive to me, where management variable comp actually goes to zero if they cannot meet their cost of capital. And I did some calculations around this. And, you know, just to make sure that they're not low-walling the cost of capital or things, but it's actually pretty legit. Like, they, you know, I think it's still something like 8% cost of equity that they have to achieve.

Otherwise, you know, 80% of their pay is gone. No, look, again, it sounds silly. As you're saying, like, a lot of these things you hear and you're like, these are very basic reforms, like almost, not every, because I can, point you to some pretty messed up companies in the U.S., but almost every company in the U.S. has something similar, but as you're saying, I can't tell you, I haven't really dove deep into the Japanese companies in a few years, but I can't tell you how many times I'd find, hey, here's a Japanese company. It trades for 200 million market cap. It has 300 million of net cash

on the balance sheet. Why does such an opportunity exist? Because they don't pay a dividend. They'll never buy back shares and they never do anything. And they just let the cash hoard up. and if you just let the cash hoard up and like you're really just betting one day these guys will sell and when they do you'll probably make a nice time but if they sell net tomorrow you'll make a great IRA if they sell in 10 years your IRA is actually awful because you basically just sat on a ton of cash for 10 years and like the cash was worth so much more than the business so like the one you I'm rambling but the one you said that really jumped out to me is the the return on equity because when you institute a return an equity requirement or a cost of capital requirement

like they basically have to pay out that cash or at least put it to kind of good use because cash even today cash in japan earns basically zero so if you don't invest that it's such a huge anchor you'll never be able to yeah like the stuff i said was it might have sounded kind of basic but just to give you like a sense of how far this has come right just if you entertain me for a few minutes i can tell you about what how bad they used to yeah yeah you know like if you had looked at these companies back in the 1980, you would have said they are totally uninvestable, right? First of all, you've got to recognize a lot of the management, the top management at that time, at most of the Japanese companies, were actually military men who participated in the war.

They were completely indoctrinated with the whole, you know, the imperial Japanese government and the war machine and they fought for the glory of their country. They lost, which was a huge shock to most of them. And what they actually did was they decided to, you know, pursue in the private sector, you know, we're going to restore glory to our country. And so what they ended up doing was they were, with that mentality, that led to kind of like an entire building mentality in everything that they do, right? They chase scale, they chase top line, you know, they would engage in financial engineering, invest in real estate, invest in golf courses, everything it took to become bigger. because this is just my opinion, but I think they were trying to recreate an empire in the private area. Hey, if you're trying to do something for the glory of Japan, you know, this is one of the things about trophy assets, right? Hey, who cares if you're not going to get a return on your asset?

You know, I mentioned Rock. Was one of the trading houses one of the ones who bought Rock? I can't remember. Rockefeller. I think, yeah, one of the training houses were a bank or insurance. I think he was Mitsubishi. I can't remember for sure. Yeah, yeah.

You know, if you're trying to recreate the glory of the empire and you say, hey, you know, we're going to go by the Rockfella Center. That's some of the, it's what, one of the 10 most known properties in the entire world, S&L's film there. Like, every NBC show seems to be set there. We go by that. Like, who cares if we make a return on investment? We're storing the glory of Japan, baby. Oh, yeah. We lost the war, but look, now we only are trophy assets.

Yeah, who's the winter now? Let's go by the Seattle Mariners. Do we know anything? Well, Japan actually knows a lot about baseball now, but do we know anything about baseball? But do we know anything about baseball in the 1980s? Maybe not, but you know what? There's only 30 baseball teams out there as America's pastime. Let's take it to them.

Let's get Japan into America's past. You can really see how that would play out. And at no point, is there any type of financial return there? No, no. So all of this just kind of went out of control, right? Like all this building, empire building. And then eventually you had the, you know, collapse of the Japanese bubble.

And then that was actually a near-death experience for a lot of the training companies you have you have consolidation happen around that time and and basically the survivors were left with a choice you know you either run like a proper business or you're going to you're going to so that's where all these changes were forced upon them you know they had no other choice let me i just want to ask one more thing on the fast word today on the kind of corporate government like famously in japan you get a job and it's a job from life at the company, right? And I do, I think to, we mentioned the Goldman McKinsey comp earlier, right? And famously these guys have Goldman and McKinsey have up or out policies, right? If you're

not moving up the ranks, you've got to go. And part of the reason is, as you mentioned, like these guys, the trading houses have tons of people all through Japan governments and probably who used to work there. Like McKinsey Goldman, one of the reasons for the up or out is they, A, you need to have like one top person with a hundred people underneath them to make the economics work. But B, they love having, hey, this guy worked at McKinsey for four years. Then he went to IBM, and now he's hiring McKinsey to do his consulting projects, right? So they have that, but I do wonder, how does the up or out or that type of movement you need for the analysts, the best and brightest coming in, working with you for a few years? And then most of them having to move on to make the economics work.

How does that work with the Japanese kind of job for life culture here? Because I'm sure they make it work, but it strikes me as different than what I've seen in a lot of Japanese company. so just kind of curious on that um i think it's gradually changing uh you know it used to be a lifetime employment and nowadays uh they've kind of changed that you know it used to be that japanese company would really underpaid everybody but but in exchange for that you got uh guaranteed stability um but yeah nowadays that's been changing but very slowly so even like Even if you look at the trade, yeah. Let me ask you, do the training companies have a different expectation of job security than your average Japanese company?

I think, I mean, not, maybe compared to the average Japanese company, yes, but compared to a Goldman or McKinsey, no. Well, maybe they are somewhere in between. Okay. That's perfect. That's perfect. Let's turn to, so there, you mentioned Buffett, there are, what, seven trading. companies in total, Buffett bought the five biggest as a basket. Maybe you could just quickly go through, I don't know, I don't want to go

through all seven, but maybe highlight like the one that you think that's the most exciting, the most interesting. And I say exciting, it could mean from your trade standpoint, they are the cheapest and the most interesting investment right now, or you could just say, hey, this one is the largest or the second largest, but they've got the most interesting history. They've got the most interesting assets, however you want it to mean. Yeah, yeah. Okay, so let's see. So when we look at the different trading companies, I would say there are two main differences. One is business portfolio and two is the management quality. So in terms of the business portfolio difference, obviously every portfolio is different, but the way you can categorize is energy resources exposure versus oil. So, um, Ito Chu is known for having the lowest resources

So they've decided from very early on that they want to shift away from it They want to focus on you know services industry to retail and that's also one of the reasons why Ito Chu has more of a premium valuation compared to the other time But it's you know resource exposure is about 30% So you know even the lowest guy at 30% so you can't really ignore that piece of equation in the trading company Then we got to the Mitsui and Mitsubishi, which has the highest exposure to resources 60%. So that's kind of the range everyone else in between.

But more interesting than this whole thing is the difference in the management quality. I think there's a huge, huge gap still between the Tier 1 and the Tier 3 players. So just quickly, I would say Tier 1 would be Ethel Chir. It's Tier 1, Management. Tier 2, Mitsui and Mitsubishi. And then I would put everyone else at tier three. And okay, so then you might ask, okay, how do they compare between the tiers, right?

Well, first of all, like, you just look at the impairments that these companies, that these businesses have made. If you look at the tier three companies, Mitsubom and Narbeni, they impaired 30% to 40% of their equities over the last 10 years. compared to Ethel Chew, which has, like, practically zero. When you, you know, and obviously, like, it's on paper, it's already very obvious when you look at the ROE, the ROE, the ROSB,

you know, ETO2 appear above the other. But just like qualitatively, right, when you, you know, because I've met the, you know, management of these companies, also these trading companies, management. And when you listen to them, it's just complete night and big in terms of, like, the stuff they tell you, right? And so you talk to Ethelchute, CEO, and he's talking about profit, cash flow, et cetera, right? Returns.

And then, I'm not going to mention which company, but one of the tier three companies, when you listen to the CEO, it's just greenwashing from third to finish. It's like, we're going to add value to society. We're going to be in all these businesses. You ask them, are there businesses you're looking to get out of? Because the returns might not be there. And they're like, no, no, no. How are you going to add value to society?

if you're going to get out of business. The difference between a tier one and a tier three is, I mean, it sounds to me, the tier ones have, they have the modern, they have the more modern approach that you've talked about, right? Returns on equity incentives for management teams. They're looking to make economic value add. They're looking to make a profit, return to shareholds. Whereas the tier three are almost, they still have that 1980s for the glory of the country.

Yeah. And then, you know, it's so simple. I'll just summarize it in one sentence, which is. The tier one companies aren't doing any magic or any sort of like rocket science. They're just running the companies for the shareholders. That's all they're doing, which is what you'd expect. But in Japan, that makes it a tier one because the rest of the companies are not doing that. It's funny how much of a low bar it is.

Like if you started if you started talking about only like tier one here is average in the U.S. But you know, average can one of them. Let me Buffett invested in five of them. Of the five, he invested. you know, how many would you label as Tier 1, Tier 2, Tier 3? Yeah, so Tier 1, He told 2, Tier 2, Mitsubishi, B2, and Tier 3 would be Marraveni and, you know, I would say. So he got all of the ones that you would qualify as Tier 1 and Tier 2 banks, Tier 1 and Tier 2 trading companies. And then he, you know, he bought 5, he bought a basket, so he got some of the Tier 3 as well,

because you only think three of the kind of 7 are Tier 1 or Tier 2. Yeah, yeah. Okay, perfect, perfect. And now a quick break to remind you that this episode is brought to you exclusively by AlphaSense, the AI platform behind the world's biggest investment decisions. AlphaSense gives you the tools you need to provide better analysis for you and your clients. As yet another value podcast listener, visit Alpha-Sense.com slash FS today to beat FOMO and move faster than the market. That's alpha-dash-sense.com slash FS.

All right, this has been great. Let's see. anything else you think we should I think we've done a pretty nice job of summarizing the whole thing up anything else you think listeners should be thinking about obviously these are

it's five of the largest most interesting companies in Japan but I think we've done a nice job with the overview anything else you think people should be thinking about or we should talk about before we wrap this up yeah maybe I'll just highlight one last thing that it's a small point but one that I thought is kind of interesting which is

you know lots of discussions around, I should say, lots of interest on Japan at the moment as an investment destination. Part of that is because of, you know, what's going on with China, geopolitical reasons. Japan's kind of seen as this beneficiary coming out of all with this, right?

And if you want a good example of this, actually just look at the trading company. And the reason why I say this is because, like, ask yourself, how are these trading companies, right, able to get equity states in the best assets around the world, you know, the most important resources and energy projects, right? The top tier, so these things are competitive.

They go through a tender, like, highly competitive. And I think one of the tailwinds that these trading companies have now is that more than ever Japan is welcome as a co-investor in a lot of places that is in particularly the Western economies like Australia, where, you know, China's kind of dominating the global commodity landscape, right? And these companies, these countries are looking for a hedge to China. And, you know, you got, we're in this world where, like, they kind of don't want more Chinese exposure, but then you got, like, the U.S. and European multinationals. That a lot of them are obsessed with ESG and, like, they find it difficult to commit capital to

be a project. And then here's where, like, Japan is, like, this perfect spot where, you know, they're like a friendly nation. They're great to do business with trustworthy. In addition, they can do large volume. Keep in mind, but Japan still the third budget is on the world. So then, you know, Japan, I feel like Japan has brought this like really great deal. Can I ask two questions on that point? So number one, I certainly do hear you, right? Like I'm very familiar with no European or Western company wants to touch coal mines, right? So I do hear you on, hey, if you're running a coal mine in Australia, your two sources of capital might be a co-invest from China who might be, you might, there might be international and political worries there or a co-invest from Japan. So I hear you in that. But my counter would be when I hear, hey, you know, Japan is going to invest in a lot of politics were brought into the discussion you had, like either explicitly or implicitly. And I worry like, oh, that does sound to me like I am the national champion. I am going to invest in like strategically politically politically important projects in Australia.

I didn't hear anything about shareholders there. Like, yeah, maybe everybody's bullish coal. I don't know. But I worry when you get into that is like, hey, that doesn't. sounds like the old for the glory of the country ignore the shareholders and you know we're talking about co-invest into coal mines like i i can't think of something that has a more fraught history than being the minority investor into any type of mining projects no i think i think that's a very valid like criticism um for this right and um yeah i think

it does take a bit of a leap of faith there that knowing management has changed in that they would kind of balance the different interests right uh the other thing you mentioned is um I think one of the, touching on one of the risks of this part is, it's just that they kind of have to manage this revertis transition at the same time. So, you know, focus on coal and, you know, iron ore, but how do they transition this into some of the more, like, relevant reverses today, like the electrification metals, right, copper, lithium, things like that. And so there is, there is also that sort of risk that they have to manage here. Last question here. So just on the ESG front, right? Like, I do hear you. I think Japan, especially as an islandation, that basically imports all of their

power, I think they might be a little bit more open to, hey, we need, we need coal, we need all this sort of stuff. But, you know, obviously these guys are taking huge stakes in coal mines. I think in the Western world, at least, you know, the largest players have been disincentivized from investing this type of stuff. I don't want to say ESG as like a bad word or buzzer, but has ESG or has like sustainable investing, have they started to get hit with those, either have they started to implement it or have they started to be like, you know, the larger investor starting to say, hey, you know, maybe it's time to start looking at that or is that just not a concern? And you can say the trading companies, you can say Japan in general, like, is that just

not a concern? If they started implementing these, but they haven't, I would say they haven't gone to kind of the extreme, like, so you come back to the Western markets, right? where just like, I've seen stuff like, you know, insurance companies not, you know, insuring certain projects just because, right, like not insuring the oil, oil rigs or things like that. And university endowment is just like shutting their door completely to be passive enough. I'm not seeing that play out to that extent in Japan. One, I mean, one of the nice things about having Buffett as your largest shareholder is I do think

Buffett has, I don't think he particularly cares about a lot of this stuff, right? Like, if you look at Buffett's history, I think he is much more, like he's an oxy when a lot of larger investors with his scale might just be like, do I really need to bring like the people who ate energy down on me? Maybe I've sacrificed a little bit, but I mean, I think he's in general quite bullish. Munger's the one who had that, hey, you know, we should be importing as much oil as we can because this is a declining resource. We should save all of ours until it's like really geopolitically useful, but I do think he has a very perfect. Anyway, I think that was it.

Any last words you want to part with before we kind of wrap this up? No, I think we covered both of the. We went through a long bit. It's a really interesting company, as I said, but like Day has a, it's a two-part write-up. So a lot of the history, especially what we covered is in part one. I'll include a link to that. And then there's part two, which dives more deeply into a couple of the training houses in particular, but I'll include a link to those in the show notes today. This has been

fantastic. I really appreciate you coming on and looking forward to next time Buffett makes a international investment. I know we'll be having on to break it down. When you see another Japan investment, just call me up. I'll come back. Day dang from Value Bunks. Thanks. A quick disclaimer, nothing on this podcast should be considered an investment advice. Guests or the hosts may have positions in any of the stocks mentioned during this podcast. Please do your own work and consult a financial advisor. Thanks.