Investment insights from 10 days in Japan

Jack Lowenstein

Ellerston Capital

We recently returned from ten days visiting more than 20 companies in Japan.  Two things struck us: the vast increase in the number of tourists, and how cheap it seemed compared to Australia. The last was born out by the fact that persistent low inflation means that Tokyo is no longer even in the top ten most expensive global cities, unlike Sydney, or for that matter Singapore.

Japan is booming, unemployment has hit 2.4%, and Japan’s overall workforce has hit a new high of over 65 million.

Correction: Tokyo is booming, Nagoya is doing OK, Osaka and Fukuoka and a few other large cities are recovering, but the rest of Japan is in decline!

This is an important driver for two of our investment themes: big city real estate, which we like, and outer suburban retail, which looks like becoming a bloodbath, and where we are finding shorting opportunities.

Real estate in Tokyo and other big cities is still doing well. While Japan’s population as a whole may be falling, Tokyo’s rises by a net 50,000 a year. As more and more people chose to live alone or as DINKs (Dual Income, No Kids), and old housing becomes increasingly decrepit or non-viable under current earthquake standards, demand for new and replacement housing is robust, to put it lightly.

Many companies exposed to this are still attractive investments. We met management from one of our largest investee companies, Open House, which has gone up six-fold in the last five years and will probably go up another 25% over the next year. These guys buy small plots of land other developers can’t handle and build three-story town houses and 10-story apartment blocks, as well as buying and refurbishing run down old apartment blocks. They should have at least 20% EPS growth per annum for the next three years, and the share price is still trading around 12x PER.

Many other construction companies are also unreasonably cheap because analysts are convinced there is going to be a big drop-off in activity after the 2020 Olympics.

Company managements are much more hopeful (and this is a country where management generally always wants to look on the dark side of life!). They think the rate of urban renewal in Tokyo will accelerate as soon as the Olympics preparations are over, and we believe them. At present, they are turning down work because there aren’t enough workers and subcontractors. This constrained capacity means their present pricing power could stay in place for a decade. We continue to buy more of these and find attractive pairs trades.

The flipside is retail madness in suburbia. Five years ago, we used to own shares in a number of drugstore chains in Japan, when they were trading on 15x PER and growing a 10%+ a year. Now they are trading on 25x and about see sales growth slow and profits flatline due to relentless and absurd competition. We are shorting the most aggressive of these companies.

A key problem is that many of these companies are sitting on oodles of cash, which they refuse to pay out to shareholders in dividends.

Instead, they would rather use it to beat each other into the ground with. The company we are shorting, for example wants to triple its store network over the next decade, and force operating margins down from an industry-wide 4-5% to 3%.

Sadly, this points to an area where are still waiting to see our expectations bear fruit: improving corporate governance.

The key development we keep pressing for is for companies to stop hoarding cash, and increase dividends, or if their shares are cheap enough, buy back their shares. Progress is glacial. However, we are pleased to say that following a fairly terse meeting with Japan’s largest specialist apartment block builder Haseko, a company we have invested in for some time, we were rewarded with a rise in dividends from 40 yen a share to 50 yen. The frustrating thing is that even this is scarcely more than tokenism. Because the company is doing even better than expected this year, this still only equates to a 21% pay out of its profits rather than the miserly 18% originally planned.

Note to selves: keep up the pressure!

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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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