If This is Failure - Give Me More!

Jack Lowenstein

Ellerston Capital

After a week in Tokyo – the thought arises: “If this is failure – give me more!” A stunning, safe and friendly city, with an economy enjoying its best, most consistent growth in a decade and unemployment at previously unimaginable lows. With a stock market trading at low multiples, despite being at 20 year highs, surely there must be enticing opportunities?

When we first visited Japan in the 1980s, Japanese politicians and business leaders expected to dominate the world – and many outside Japan feared they were right. The Nikkei stock index rose to nearly 40,000 and families took 100 year mortgages on tiny homes to get into a soaring property market. Over twenty years, the yen quadrupled in value against the US dollar, foreigners winced at submitting their business expenses, and taking a vacation in the land of the rising sun was laughable.

In the 1990s every bubble burst. Asset prices collapsed – and kept falling. Wages stagnated. Public debt ballooned. At all turns, the government and the Bank of Japan (BOJ) seemed to do too little, too late. Every hint of a recovery was met with a policy error

Figure 1 – Nikkei 225 Index

Source: Bloomberg

Through it all however, Tokyo just got nicer. Four new subway lines augmented the world’s best megalopolis transport system. Air quality improved and jobless men who had briefly filled tent cities in many Tokyo parks, found new work and homes. Today Tokyo thrives. Nowhere has mankind mastered dense urban living so graciously. Years of deflation have left Tokyo affordable by Sydney standards – and a viable tourist destination. But the scars live on. Tokyo’s gain has been Japan’s pain, as the capital economy and population grew at the expense of the rest of the country.

In late 2012, a frustrated populace turned to an unlikely hope: a failed former prime minister, with what many found a disturbing agenda for constitutional change to allow Japanese forces to fight overseas. Shinzo Abe proposed three arrows to break the decline: a big lift in public spending; new BOJ leadership committed to massive money printing to end deflation; and a broad agenda of structural reform, including improved corporate governance and boosting female participation in the economy, both of which badly lag standards in other rich countries.

Five years on, the report card of so-called Abenomics probably scores a “B+”. Some may see even this as generous, perhaps underestimating the scale of the challenge. Nevertheless, Japan has been growing above its ‘potential’ growth for most of this decade.

Figure 2 – Japan Potential and Actual GDP Growth

Source: Minack Advisory

So where is the inflation? With modern Japanese pessimism, most companies we saw feared rising labour costs and stagnating selling prices! In our view, the biggest risk is that the BOJ turns off the printing press too soon again once it feels pressure from a tightening US Federal Reserve. This would be a shame, as not only are we ‘not there yet’, but the money printing and government bond buying has eased anxiety about Japan’s massive public debt, a large part of which is now owned by the BOJ and will inevitably be ‘forgiven’.

When no one expects inflation, most corporate executives think this is ‘as good as it gets’, and stock prices seem cheap, risk of disappointment seems low. We reflect this view with stakes in three Japanese real estate related companies that we own:

Haseko, Japan’s largest condominium builder, trading on a forward PER of 6.4x, which we feel reflects too negative a view on long term growth and margins. Upside could come from a rising dividend rate, which is currently only about 20% of profits.

Open House, a central Tokyo focused property developer, with a highly entrepreneurial culture and a commitment to good capital management, trading on a forward PER of 8.6x.

Investors’ Cloud, a fast growing ‘virtual’ property developer, that uses online marketing to match investors with vacant land to build small apartment blocks for the rental market. It extracts high development margins without tying up much capital, and a growing pool of ongoing management fees. While the stock isn’t superficially cheap on a forward PER of 24.5x, we believe it will get further re-rated as its unique business model is understood.

Partly hedging the above, we have a short position in Iida Group, an ultra-low cost housing developer in outer Tokyo. The stock looks cheap on a forward PER of 6.9x. Governance also appears weak, with no overhead savings following a six-way merger of companies controlled by different family members three years ago. The various subsidiaries, mostly run by sons of the founder, are investing in high risk overseas ventures, which we believe will end in costly write-downs.

For further insights, including the full article on our visit to Japan, please visit our website

Jack Lowenstein
Joint Chief Investment Officer
Ellerston Capital

Jack co-founded Morphic Asset Management in 2012. As a stock picker Jack has invested in a variety of markets and sectors, but developed in-depth knowledge of markets in Asia-Pacific region as well as global finance and resources sectors.

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