Talking Money

Still a raging bull of Japan – Hugh Sloane

20th April 2016

Hugh Sloane is the founder and a partner in Sloane Robinson, the fund management firm, and one of the most successful UK hedge fund managers of the last 20 years, rarely heard in public. In a recent Talking Money podcast we talked about Japan. Hugh is very much a raging bull when it comes to the prospects of the Japanese equity market. It won’t be a great stretch, he says, for the market to be back at its 1989 highs within five years. Read on to find out why…

Interview

JONATHAN DAVIS: You’ve been a bull of Japan for some time. Can you tell me when you started to adopt this view and the main reasons for it?

HUGH SLOANE: In the summer of 2012 it became clear that we would have a government change in Japan and that the new incoming Prime Minister would replace the prior Bank of Japan Governor and that together Abe-san and Kuroda-san would embark on a policy of reflation and capital efficiency. They called it the Three Arrows, but really it was down to those two things: reflation and capital efficiency.

It was very helpful that the Japanese market, measured by price to book, was cheaper than all but a handful of days since the Second World War. We were trading at 0.8 of book at that point, and there was very widespread scepticism that anything healthy could be achieved in Japan. It was an excellent backdrop to become more optimistic.

And that’s partly because there’d been a bear market in the Japanese stock market for more than 20 years. And the country has also been afflicted by deflation for most of that period, which most people intuitively interpret as being a negative rather than a positive. So, as a result of that, the market was already cheap and what you needed therefore was a conviction that there would be catalysts to bring about a change in that.

Exactly.

We’re two and a half years on from the election and the arrival of Abe and Abenomics. The market rose strongly but then fell off quite sharply in the recent bout of market weakness. Should that be a cause for concern? Does it invalidate your thesis?

It doesn’t invalidate it at all. I’ve said all along that whereas one can have a very high level of conviction about the direction of change and the slope of the trend, many investors will be, and have become, impatient for more rapid change.

In terms of capital efficiency, Japan’s profitability is at record highs for the last 45 years as measured by return on equity, and a record amount of this was paid out to shareholders last year. The total payout ratio is 46%. But Japanese balance sheets are still quite lazy. There’s a lot of cash on the balance sheets. The companies fully adjusted to the deflationary environment and haven’t changed their expectations around inflation that much. So there’s a lot more that they could do in order to improve profitability without much of an improvement in margins. They’ve got to do more in terms of asset turn and they’ve got to do a lot more in terms of leverage.

When, as in the first weeks of this year, you have fears of a global slowdown, it’s not too surprising that you have extremely large selling from what are called “investment tourists” (who mainly live in Boston). But the basis for believing in reflation of the Japanese economy remains strong and the long-term improvement in capital efficiency is pretty much undoubted.

It’s worth bearing in mind that Japanese policymaking is very conservative, but once they make up their mind the policy framework is likely to be stable for several years, maybe even several decades. It took Japan 15 years to decide to reflate but every constituency in Japan is now in favour of reflation: the Government, the Bank of Japan, MoF, the Keidanren, and the voters. There’s a phrase in Japanese called “nemawashi” – it means root-binding. There is no opposition in Japan towards the changes characterised as Abenomics.

In other words, the climate for reform and for change has improved, made a decisive turn, in your view and it’s not going to be interrupted anytime soon, whatever others may think. But can I then ask you a couple of more fundamental questions which have come up from talking about this to other investors? First of all, despite the improved profitability of the corporate sector, the Japanese economy is still not growing by any significant margin, or at least we can’t see that yet, and the immediate target of returning to inflation of 2% is still a long way off, at least according to the reported figures. How do you respond to that?

Well, the inflation one is the easiest one. Whether by accident or design – I tend to think it’s by design – Kuroda-san is targeting the only measure of inflation in Japan that hasn’t picked up: headline CPI. Every other indicator of inflation is up: wages, rents, land prices, house prices, wholesale prices (at least until the oil price fell). So it’s true that this core indicator has not improved, but everyone knows that headline CPI is a very imperfect measure of inflation.

Having said that, more worryingly, it’s also true that there’s not much evidence of a pick-up in inflationary expectations. So the period of monetary reflation has had to be extended, and it wouldn’t surprise me if it was extended further and it becomes a permanent feature of Japan’s monetary landscape over the next five years, until we get a really big change in inflationary expectations.

With regard to the economy, it just depends what your expectations were and what’s realistic. The Bank of Japan’s and MoF’s estimate of the potential growth rate in the Japanese economy is only around 1%. In a fragile global economy I wouldn’t have expected – and have not expected – the Japanese economy to grow very rapidly, but I don’t think that is a necessary or sufficient reason for doubting that you can have a big improvement in profitability.

Total factor inputs in Japan are growing rather slowly, and there’s no quick and obvious reason why they should improve a lot – so I would not think that the Japanese economy would grow much more than 2% even at the best of times. But one shouldn’t regard that as a failure and one shouldn’t be disappointed by it. And it doesn’t mean that the stock market and profitability cannot improve.

On the other hand, one could say that Japan has been one of the major beneficiaries of the fall in oil prices recently…

Yes.

And it’s also had the benefit of a much weaker currency. And you might expect, in those circumstances, that you would have seen more of a response in terms of economic growth than we’ve actually had, even in this short period of time.

It’s plausible, I agree. We’ve had a big improvement in Japan’s terms of trade, in spite of Yen weakness, which I think is your point. Yes, we could have seen growth rates of 1.0%, 1.5%, over this period. The specific reason why the measured growth is somewhat disappointing in the second half of last year, and probably into this year, is inventory de-stocking, and that occurs against various cycles that are common to industries across the globe. Components and autos are both in something of an industry-wide inventory de-stocking cycle.

I think that will work its way through. Against this, however, is the strength of the labour market. The proportion of the workforce that’s unemployed is down, the proportion of the participation rates are up very strongly, the proportion of part-time workers is down, the proportion of contract workers is down – in time this will be reflected in higher wage rates and more of a feel-good factor, even in Japan.

Picking up on that point about the currency, a number of investors – whether they’re in Boston or elsewhere – like to draw a chart of the movement of the currency and the Yen against the Dollar and then overlay that with the performance of the stock market. And it appears at first sight to be quite a close correlation, from which they deduce that somehow the only reason the stock market is going up is because of the currency depreciation. You would say that isn’t the case and that this correlation would not persist indefinitely?

Japan_and_dollar_yen_April_2016

There has been an extremely tight correlation between the value of the yen (against the dollar) and the level of the Japanese stock market.

It’s annoying, isn’t it, that that chart still persists! So here’s what I think will happen. During the period of deflation and stasis in the Japanese economy, which I think finished in 2012, of course it was the external business cycle that mattered most, and changes in the Yen had a big translation impact on that. We had the coincidence of a fundamental change in the approach to corporate management and economic management in 2012, which obviously was going to be associated with a weak Yen. The correlation persists.

The Yen, last year, was relatively stable. It began the year at 1.20 and ended the year at 1.23, and Japan was the strongest of all the major markets. So there’s a hint that the correlation is breaking down. And it should, now that what happens in the domestic economy is as important as what happens in the global business cycle. The Yen fell by 50%. It’s at the cheapest level that it’s been since 1971 in real effective exchange rate terms.

With the Yen at 1.20, I don’t think that it matters too much whether the Yen is 1.15 or 1.25 for the trend in overall profitability in the Japanese market. If the Yen was to go back to 1.05 and stay there, then of course it would have an impact – that’s a very material difference from the assumptions that companies were making when they announced their own forecasts for profits.

On that point, if you are an investor outside Japan, it has been worth your while – until last summer at least – to hedge your investment into the Japanese market.

It’s been essential.

Are you saying that’s no longer necessary?

That’s exactly what I’m saying. Our portfolio was strategically hedged against the Yen for the whole of 2012, the whole of 2013 and the whole of 2014.

At the start of 2015 a lot of commentators were extrapolating the trend – a number analysts thought the Yen was going to 145 and 160 and then 200, and they were fairly vociferous and shrill on that point. But what you have to do is to try and envisage what the basic balance of payments looks like in Japan. It’s a reliable indicator. It just comes out rather too late to have any impact.

So at the beginning of 2015 I wrote that my guess, based on an assessment of basic balance of payments, was that the Yen in 2015 – starting at 120 – would trade in a relatively wide range, between 110 and 130, and end the year slightly weaker. Which is more or less what happened.

I’ve written exactly the same thing this year, saying that it’s more likely that the Yen will go to 110 because of incipient weakness on Wall Street. It’s more likely that we’ll have a risk-off trade. Of course, I didn’t think it would happen exactly in the way that it has! But the Yen centred around 120 is where the Japanese authorities would quite like it to be. Japanese exporters now enjoy the most favourable exporting environment in terms of pricing that they have had in two or three decades.

Incidentally, it’s worth noting that the reasons for Yen strength during the deflation was that, uniquely, the Bank of Japan targeted 1% CPI. Everyone else in the world targeted 2% CPI. It’s no surprise to me that the Yen was strong. Now they’ve moved to a 2% level it’s unlikely that the Yen will be stronger for longer against the dollar because both monetary authorities are targeting the same objective, which is sensible. FX trading is sometimes common sense.

If the Yen goes to 110, I will hedge my exposure, and if it gets back to 120 I’ll take most of it off. In the early stages of this change, it was essential to have a view on the Yen in terms of having a view on Japanese reflation and the Japanese stock market, and it isn’t now in my opinion.

One more question on that topic before looking at the Japanese market itself: what impact could the slowdown in China and a possible depreciation of the Chinese currency have if those things were to happen to the extent that some people believe? I don’t know where you stand on that but…

Have you been talking to Kyle Bass?

Everyone’s heard from Kyle Bass!

He just loves the limelight, that guy.

He loves the limelight.

It’s obvious that they’re adverse developments for Japan, and it’s obvious that they are particularly adverse for some companies. If China slows a lot, the component companies that provide sophisticated passive components for iPhones would continue to be hit. It’s obvious that what are called the robot stocks – Fanuc and so forth – would be adversely affected. There are very many beneficiaries but Japan is in no different a situation to a large number of exporters: Korea, Germany, the Apple chain. This isn’t a unique feature for Japan.

Fanuc_vs_Nikkei_Apr_2016

Robot maker Fanuc has also seen a sharp correction in recent weeks.

By the way, and we’ll see this in a year’s time, there will be no depreciation of the Renminbi. It’s really…

This is just a scare story…

This is just a scare story and those who are short the Renminbi – it’s quite a big trade and they’re in some very bad company.

I think the Chinese authorities are incredibly well-aware of the scale of the bet against them and they’ve chosen to wrestle with elephants and horses. It’s the wrong bet. More to the point, China wants to be a responsible global economic citizen and they understand a large depreciation would be deeply unsettling and perceived as selfish and self-centred, and it is against their long-term interest. I think that all the responsible officials have said as much.

Finally, who cares about the capital outflow? So what? No one worries about the capital outflow in America or the UK. It’s entirely rational and it will be with us forever, and it’s not as if the money is leaving the country – it’s just going to Hong Kong and being denominated in Dollars.

I like the force with which you said that, and I’m sure you’ll be vindicated by what happens this year. But if we just go back to the Japanese thing and how to invest in Japan, that perhaps is the next question, because your case I think is that valuations are still low, profitability is high and still rising, and there are other catalysts coming along, such as possibly a reduction in tax rates and so on.

Yes.

So that’s all good, and I think you believe the return on equity could go as high as 15%, which would be a remarkable figure.

Yes.

So if one looks at the Japanese stock market and how to invest in the Japanese stock market, it’s obviously not just about the Toyotas and the big exporters that most people have heard of. What sort of balance are you looking at in terms of domestic versus exporting companies or in terms of sectors? Where are the hotter spots going to be and where are the not so hot spots going to be?

You’ve got to the nub of this immediately – you used the word “invest”. Japan is not a trade anymore. It was a trade from 1986 to 2012, but now you can compound gains.

I’m less exercised by sector selection than I am by which companies get it – which companies are actually improving their return on equity, improving their returns to shareholders, and which ones are going to do so on a reliable basis in the future. That is not really a sectoral choice. It’s about individual company management, individual companies’ approach to corporate governance, as well as their entrepreneurial zeal.

I think you get some quite strange and unexpected conclusions. There are companies where the government has very large holdings and is trying to take a lead in doing what other companies need to do, which is have total pay-out ratios that exceed 100%. Not surprisingly, these stocks have done really quite well. For instance, there’s only GNP growth in the telecoms business in Japan, but this is a good example of where you can have strong stock market returns in a mature economy, in a mature industry, through improved capital efficiencies. It’s worth looking at the history of share buy-backs from returns to shareholders over the last five years.

Having said that I’m not exercised by sector selections, conversely the auto industry has been very slow to grasp what they see as the nettle of improved returns to shareholders, and that’s been led by Toyota. Car stocks, up until the second half of 2014, had their best period of outperformance in markets since perhaps the 1980s, because everything was going right and was in their favour.

Toyota_vs_Nikkei

The share price of exporters such as car giant Toyota has fallen in line with the market and the exchange rate.

But they’ve underperformed subsequently, even with a weak Yen, or with the Yen at very attractive levels, and I think the most important reason for that is the slowdown in some of the key export markets. These companies have been pretty slow to boost payout ratios and return cash to shareholders, so they’re rather unappealing.

They haven’t quite got the new religion…

They haven’t got the new religion at all. I think that you’ve got to be quite attracted to some of the property-related companies. The market is strong there.

Topix_real_estate_vs_Nikke_Apr_2016

Japanese REITs, such as Nippon Building Group, look particularly attractive in a ultra-low inflation environment, Sloane thinks, with yields that are 3-4% higher than those on government bonds.

Commercial property is a derived demand from profitability. Profits are at record highs. Rents can still rise another 15% just to get back to the levels of 2007. So, the REITs, which are priced on cap rates of 4% and yield 3.5%, are attractive, and some of them are actually quite well-run. That’s a good example of where, in the end, an improvement in inflationary expectations will have a tangible impact on investor behaviour towards these stocks. We’ve seen what happens after a multi-year bull market in the UK: the cap rates on prime property are exactly the same as gilts.

Which is improbable and unsustainable…

And won’t be sustained – that’s absolutely clear. But the gap between, say, JGB rates at the square-root of zip and cap rates of 4 is unsustainably large, I suggest, and you’ve got the obvious improvements in rents coming through, not just on reversion but for new rents as well. So I think those look very interesting.

It’s hard to research and analyse small stocks in Japan. There are a lot of them and that’s where I think that there is huge opportunity. Obviously, you don’t want to generalise about small stocks, but there are huge gains to work. They’re dramatically under-researched. And in these small stocks, the entrepreneurial zeal and ability to galvanise can be pretty dramatic, so I like that as an area – but it’s hard to execute.

Topix_small_vs_Nikkei

There has been little sign of a small cap effect in Japan in recent years, but there are plenty of under-researched opportunities in the lower tiers, according to Sloane.

If one was to rely on stereotypes, one would not necessarily characterise Japanese management as being entrepreneurial and dynamic. But that is changing?

That’s absolutely changing. I completely accept that the risk in Japan is that change will be relatively slow – but that’s really it. Is it sensible to be thinking about compounding return on equity in an economy that only grows 1%? I think it’s easily defensible, but I recognise that it might be a bit of a leap!

If there is one development which could occur in the environment we’re talking about, and which we wouldn’t have to pay a cent for, it’s the creation of a market for corporate control. That one development would change management’s view of their balance sheet overnight. I’ve never thought it likely before but it is conceivable now because the Japanese financial establishment is alive to it.

It’s just one of those obvious things, but no one even considers it. It’s off the radar – but it can happen just as quickly as the Yen moved from 80 to 100.

You can see that companies that are cash-rich have begun to outperform in the market. Investors are taking the view that the liquidity on the balance sheet is undervalued, that it’s an asset, not just a dead-weight.

It can be used either for activity or for returning money to shareholders.

Yes.

Okay. Final question. If you just take the crude measure of the Nikkei index, we all know that famously it was at 39,000 or so back in 1989 – it’s been down to 8,000 since. And it’s now back up some of the way: it clawed its way to over 20,000. But now we’re at 16,000, 17,000, that sort of area. Do you think it could go back to where it was at the peak?

Absolutely. People forget the power of compounding. It can easily get there in five years.

In five years?

In five years. Compound at 15% a year for five years, and put it on 1.6 times book, and you’re there. Hardly anyone thinks about the market in those terms.

Listen to the original interview:

Hugh-Sloane-600x600_openeurope

Hugh Sloane

Hugh Sloane is the founder and a partner in Sloane Robinson, the fund management firm, and one of the most successful UK hedge fund managers of the last 20 years

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