What our trip to the US and Japan is telling us about the economy

In the latest episode of Stocks Neat, Harvey Migotti and I discuss what we learned on our recent travels to the US and Japan.

Our trip started in Chicago, at an industrials conference, which gave us a temperature check on what is happening in the US economy. We visited Tokyo to meet with a few companies undergoing transformational changes in the IT space.

LISTEN TO THE FULL EPISODE TO FIND OUT.

“In that industrials space, I think there are some very helpful tailwinds going on in the economy. A lot of companies have been saying to us that [the US stimulus] has been helpful but it is not even yet at its full run rate“

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[0:00:39] SJ: Hello and welcome to Stocks Neat. I'm Steve Johnson, Chief Investment Officer here at Forager Funds. This is a podcast where we talk stocks, and sometimes sip a few whiskies. I'm joined today by Harvey Migotti. Harvey, you and I have just got back from a little trip around the world. You were away a bit longer than me. We're not having a whiskey today, a bit much on the plate, but did you try anything interesting on your travels?

[0:01:07] HM: I did. We were in Japan for a few days and I got a chance to, obviously, drink some of the classics, Yamazaki, etc. I think the one that stood out as really good value is the Suntory Ao. It's a bit of a weirdo. It's a blend of whiskeys from five different countries made by Suntory. Really drinkable, especially if you do it neat. I think if you put ice in it, it ruins it. You'd think it's a scotch for a second, I would reckon, but there's a kick of bourbon and rice bison there. I really enjoyed it.

At the airport, you could buy it for $48 Aussie. When I was coming back from Japan, and I looked at the prices here and it's the minimum one I could find is a $178. Not so easy to grab here in Oz. If you do find it, I still recommend it. I think it's a great little interesting idea that Suntory is doing. Ideally, if you ever go to Japan, you pick one up off the shelf there, or even just in the regular stores in town. I mean, it was still a third of the price. Yeah, that was pretty fun.

[0:02:03] SJ: Yeah, we found quite a bit of cheap stuff in Japan, but our first stop was the US. Anything but cheap with the exchange rate where it is at the moment, found it extraordinarily expensive. Personally, in Chicago, where we were, we went out and had a steak at the end of the week before we flew out at an admittedly very nice steak restaurant, but it was $80 US each for just the steak piece and a glass of wine each. We racked up $300 US dollars pretty quickly on the bill. $500 for a steak and glass of wine for the two of us was a pretty expensive night out.

That was a bit of a shock to the system for me over there. I think we just forget here in Australia how much the currency depreciation has been a fairly painless adjustment for the Australian economy in terms of when you think about house prices and asset prices, and you now convert it to US dollars at 63 versus parity, where it was five or six years ago. Most of the prices haven't changed that much. Yeah, very expensive place.

[0:03:03] HM: Well, they've actually – I’ve been going there about two to three times a year for the past five years. You see it sequential drift higher, whether it's hotels, which are now two to three times for the same hotel, and at the same time period as they were prior to COVID. Even in that post-COVID period when things opened up again, it hurts a bit. I have to say, other things as well. I think beef prices are have at least doubled. That's in the Costcos of the world, right? Not by doing your fancy steak restaurant. Having said that, I still remember that steak. I would do it again, gladly.

[0:03:38] SJ: It was quite delicious. What was your general impression? I mean, inflation has been high, has been coming down much quicker than it has here in Australia. On the official figures, we met with probably 40 companies between the two of us across a two-day conference put on by bed, all industrial companies. That's what the conference is. It was a really, really enjoyable conference. Maybe kick things off with, I guess, the general state of the economy from the companies that you met with over there.

[0:04:07] HM: Yeah. I mean, look, it's still chugging along very firmly. The macros is still weighing on companies and it is weighing on certain end markets given higher rates. It's obvious, but consumer is definitely feeling the pressure more and more and some of those savings built up during the COVID stimulus times. They are waning. You're starting to see that in retail figures. China has been soggy for some industrials. Exporting out abroad, and plus a strong dollar that is hurting them.

But the domestic US economy, especially on the industrial front is doing quite well. There's many themes that are playing out there, which we'll discuss in due course here. I think companies are generally positive, especially about the three to four-year outlook. There's a few macro factors and government stimulus factors converging.

[0:04:50] SJ: Yeah. I mean, it's possible if we were at a consumer conference. It would have been a very different vibe about the place. A lot of US companies are quite dependent, or certainly for their growth on that Chinese consumer, which has been very, very weak. In that industrial space, there's some, I think, very helpful tailwinds going on in the economy. A lot of companies saying to us, it's been helpful, but it's not even yet starting.

[0:05:18] HM: Hasn’t even started. Yeah, that's a 100% correct. I mean, look, so what we saw is the building product distributors had a pretty optimistic tone. Most predicting decent growth, and single-family housing starts next year. Obviously, they're coming off a pretty low base in 23, but they've navigated extremely well. I would say, most of the high-quality ones, at least. Repair and modeling activities is holding on pretty steadily. Some people are trapped in their houses, given they've locked in really good 30-year mortgages. What do you do when you have some excess cash? You don't go out and upgrade a house. You build a new kitchen, just like you're doing now, Steve. I think we're seeing that happening.

It was categorized as a consistent and resilient pocket there. We have some stocks that are exposed to that theme, so that felt good. We did hear about various other pockets of strength out there. HVAC, so air conditioning, and so forth, that they continue to see double-digit price increases there with companies. Distributors such as Ferguson, which is one of our largest positions continue to see tailwinds there, both from pricing.

There's also a few regulatory factors coming into play. There's a refrigerant transition happening in 2025. New models have come out that are much more energy efficient. I think people are looking to save on their energy costs and using this as an opportunity to upgrade their home air cons, or commercial or conditioning systems, and so forth.

[0:06:35] SJ: It was really common across almost every company I met with talking about acquisition opportunities in this space. We live in an economy here in Australia that is dominated by oligopolistic industries. There are only two or three giant players. That process of consolidation is almost feels like it's accelerating, if anything in the US. There are some industries where it is already towards the end of its cycle. Lots of companies that we met with where they’re the largest player in the sector, but 13% and 14% market shares and gobbling up all of these smaller operators. It was a really consistent story across a fairly wide range of companies.

[0:07:15] HM: Yeah. It's what's allowed a lot of these ultra-high-quality businesses, Watsco, Ferguson, POOLCORP that are market leaders in their areas. As you mentioned, still a small portion of the market share, a very fragmented mom-and-pop market to continue growing for many, many decades. I mean, a name like Watsco has had 40 years of consistent growth, both organically and through acquisitions. I don't think we're anywhere near done in many of those cases. It's an exciting end market to have some exposure to.

[0:07:46] SJ: The advantage of just being a giant self-contained economy in that respect. I think most of the – that happens here in Australia as well. Normally, it's private equity rolls up pretty quickly, you can roll up a sector in the whole Australian economy. Then you bring the stock market and it's already fairly –

[0:08:05] HM: That’s already done.

[0:08:06] SJ: - mature. We've had exceptions. I think the JB Hi-Fis of the world that have done very well in certain spaces. Reese here and spoke to a couple of competitors of Reese over in my meetings in the US, they're doing pretty well over there in the US as well. There are examples of companies that have done it well here. Just the number and the runway in the US is quite striking. I felt like it was pretty consistently playing into more resilient margins in this more difficult economic environment than I would have expected historically. I think as you get more consolidation in these sectors, you get more rational behavior, both during downturns and on the other side. We heard a lot about that as well.

[0:08:45] HM: No, exactly. It's not exactly great for the customers, or perhaps the consumers, but it's a beautiful setup for many of these businesses. I think generally, the profit margin commentary across the board was pretty positive. Most companies were talking about achieving price cost neutrality. They're seeing benefits from positive pricing, but also self-deeming freight expenses, which have been a big headwind over recent years, as you can imagine, particularly in that 2020-2021 period.

I also heard from a number of companies how they're seeing lower labor turnover and less cost inflation from labor, which is obviously has been another pain point. Not just getting people, but also the amount you're having to pay them and wage hikes. That's also very positive for some of these larger businesses.

[0:09:29] SJ: I guess, across the spectrum of companies you looked at, there's a lot of talk as well on government policy. It's been a huge change with the Biden administration around what sectors are getting the money and how much money they're getting. Who are the big winners out of some of that regulatory and government stimulus backdrop?

[0:09:55] HM: Well, there was definitely a great deal discussion on these mega projects and secular drivers that are happening over the next few years. You've got the US infrastructure stimulus, the Semiconductor Chips Act, and the continued reshoring happening in the US. I think, all these companies realize they can't rely on a supply chain that's sitting in China and all these other places. They do want to bring more manufacturing capacity in-house. They should provide really strong tailwinds for many types of US industrial coming years. I heard from a few that the real acceleration is only going to start in 2025. You're just seeing the – one categorize that as not even halfway through the first inning as of today.

[0:10:40] SJ: It won't surprise anyone to hear that the actual mechanisms, the policy has been passed, but the mechanisms are actually getting the money into the company.

[0:10:47] HM: No, that’s right.

[0:10:48] SJ: There's been very slow and –

[0:10:49] HM: There's a labor shortage in the construction side and lack of equipment in certain areas. It's not going to be a straight line. It's not going to just zip upwards. I think cumulatively, when you look back in 2026 or 2027, when you look back and stack it all up, you would have seen the boost that a lot of these companies have gotten.

[0:11:08] SJ: Are there any companies, or I guess, sectors that you would say are bigger winners and beneficiaries out of that than others?

[0:11:15] HM: Yeah. The ones that are expected to benefit the most are certainly the infrastructure, industrial infrastructure businesses, or things exposed to road construction, bridges, and so forth. Cement players, aggregate names, equipment rental companies.

[0:11:30] SJ: I was trying to have a sleep on a – we did a day of company tours and I was fresh off the plane after a long flight. I was trying to have a sleep. About every 10 seconds on the bus, we hit a massive, I don't even know that it was a pothole. It was more like the road was actually collapsing every 20 or 30 meters.

[0:11:45] HM: The state of infrastructure there is absolutely awful.

[0:11:47] SJ: I’d whack my head against the side of the bus. Yeah, it was impossible to catch a sleep.

[0:11:52] HM: It's tough driving there sometimes. We've popped a few tires on our trips. It's not because there's a nail on the road. It's because there's all this gravel and there's potholes all around. It needs to be fixed. It really does.

[0:12:01] SJ: Labor on private, giant F100s.

[0:12:05] HM: It really does. Others that are supposed to benefit are semiconductor equipment names, obviously. Picking shovel suppliers to this chips arms race that's happening globally. Automation companies, labor savings and so forth. Anything to do with internet of things providers. There's a decent stimulus going on in terms of broadband and expansion to rural areas in the US and companies exposed to that. Also, obviously winners. These were just some sectors off the top of my head. There's many others, I'm sure.

[0:12:35] SJ: Yeah. Fascinating that the federal government deficit over there is seven and a half percent of GDP at the moment. There's all of this expenditure still to come. Neither side really, the Republicans, nor the Democrats are talking about doing anything about that in terms of this next election cycle. I think it's worth worrying about the mid-term consequences of that. I think it will be inflationary and that this inflation problem is not going to go away as quickly as markets are currently anticipating. Certainly, this next four or five years, there are no signs of anyone cutting back on some of this stuff.

[0:13:12] ANNOUNCER: Stay tuned. We'll be back in just a sec.

[MESSAGE]

[0:13:15] ANNOUNCER: Are you a long-term investor with a passion for unloved bargains? So are we. Forager Funds is a contemporary value fund manager with a proven track record for finding opportunities in unlikely places. Through our Australian and international shares funds, investors have access to small and mid-sized investments not accessible to many fund managers in businesses that many investors likely haven't heard of. We have serious skin in the game, too. Meaning, we invest right alongside our investors. For more information about our investments, visit foragerfunds.com. If you like what you're hearing and what we're drinking, please like, subscribe and pass it on. Thanks for tuning in. Now, back to the chat.

[EPISODE CONTINUED]

[0:13:54] HM: I mean, at least we're seeing some softening in things such as food prices in the US. If you look at the chart, it looks like a parabola going up and they were going up 10%, 20% year-in-year, and others stabilized at a low single-digit rate. There's some positive signs out there, at least from people that don't want inflation.

[0:14:11] SJ: Yeah, you're definitely going to get lower headline inflation numbers over the next 12 months, while some of those temporary things flat – reversed in some examples. You have negative contributions that doesn't mean in three or four years time that some of the more permanent issues aren't coming back to the fore. We left Chicago and went directly to Tokyo. We've been wanting to get up there for some time. There's some really interesting things happening in the Japanese economy. It was also, how many thousands of dollars was it cheaper to fly home via Japan?

[0:14:42] HM: It was 4,000, or 5,000. It's crazy.

[0:14:44] SJ: It was a crazy price differential. The ticket that was found for us was much more attractively priced that way. As I said, we've been meaning to get up there for some time, and some really interesting changes. It's not new, but it feels like it's gathering some momentum up there in Japan.

[0:15:03] HM: Yeah. No, there's a bunch of real positive initiatives taking place. Both the government and the Japan Stock Exchange Group, they're pushing for companies to boost returns to shareholders, improve investor communication. They're trying to make Japan a much more interesting place for foreign investment.

The Japan Stock Exchange Group actually came by here. We met them in our office two months ago now. It was funny, because they weren't talking about their stock themselves, like you should invest in the Japan Stock Exchange Group. They were talking about why they are creating, or changing Japan to be a more interesting place to invest. They're going to be naming and shaming companies that aren't hitting those metrics. They're going to be naming and shaming companies that are sitting on a pile of cash, doing nothing with it, thereby, lowering returns for shareholders and not optimizing, I think, the potential share price appreciation. That is a big change, I think, from the Japan of five, 10 years ago.

[0:15:56] SJ: What are the key things they want companies to do?

[0:15:58] HM: Those are some of them. They want people to start deploying some of their money that's been sitting on the balance sheet for many, many, many years, improving investor communications, being more transparent, setting longer-term targets at their AGMs, or annual meetings, and communicating them clearly. They're separating the token stock exchange into prime and standard. Only the companies that hit some of those metrics and those box – tick those boxes, get onto the prime exchange.

They're also going to be launching active ETFs. We have them in the US. If you want to invest in a semiconductor ETF, you have that. It's a more actively managed number of companies. You don't have to worry so much about picking them yourself then. If you want to invest in quality, there's a quality active ETF, and so forth. Japan hasn't had that. They've had ETFs that are basically just tracking the index, and they're starting to do that themselves.

That could be really interesting, because you might want to be investing in a certain thematic in Japan, but not necessarily in the overall index. I think that just opens up the gateway. It's the first year in many where we've seen some real positive inflows into that market as well. It's been one of the best performers, I think, this year.

[0:17:05] SJ: Yeah. It has actually been the best performing major index in the world. The topics are the main Japanese domestic index up there and outperformed even S&P 500, which has been on a bit of a tear over the course of this year. Certainly, investors are getting enthusiastic about it more and more international investors getting on the bandwagon. Are you actually seeing companies changing? I was up in Tokyo 10 years ago for an investor conference. The government has been pushing for change for a long time. There's been a lot of talk about the potential upside. If companies can unwind some of these cross-share holdings and return excess cash to shareholders and not a lot happened for the subsequent 10 years. Are you actually seeing companies change their behavior?

[0:17:51] HM: Well, we've seen some really good case studies with the likes of Sony that embarked on this journey back in 2014-15, or whatever it was. We bought it back in 2019 on the back of that. They've clearly had excess returns over and above the markets since that period. Investor communication has improved. They've been doing some very rational stuff with the portfolio. There are examples where it's been happening. You're slowly starting to see that trickle down to the smaller, or the more mid-cap size companies and not the large international behemoths. I think that's really, really positive.

First early innings, I would say. I'm certain that many will not just refuse to budge. If you can find the ones that do, we've clearly seen some really good examples when they do it. It makes for a great little investment.

[0:18:37] SJ: Yes, is a very common answer up in Japan, whether they mean yes or not. I think you're absolutely right. I think directionally, it is very, very real. Whether it happens as quickly as some investors are now anticipating, I think there's probably potential for some disappointments as that process on one direction, etc. I also just think the economy, a lot of the companies up there that have really suffered from China's rise from a global trade perspective are pretty well placed, because it's still dramatically cheaper to manufacture something in Japan than it is in the US.

With a lot of companies turning away from China, or seeing China as a source of risk in terms of the supply chain, Japan's really coming back to the fore. I think some of the greener incentives around the world also play into a lot of these Japanese companies' hands, because they've been at the forefront of some of those technologies.

For a long time, one, that really interested me in some of our company visits is some of the grid infrastructure. It's a really boring topic. If we are going to have a greener electricity grid, there's an enormous amount of focus on solar panels and wing farms and different types of technology to generate the electricity. But we also need dramatic, dramatic change to the grid to deliver that electricity to people's houses. There's trillions of dollars around the world that needs to be invested in that, and a fairly small number of companies that can actually deliver that infrastructure. There's a lot of optimism, I think, about the governance changes and a fair bit of optimism as well about the position that Japan as a country has in the global trade.

For the first time in a really long time, I think they've been on the losing end of China's rise. Now, companies have seen a fair bit of real inbound demand for their products, because of exchange rate and because of a change in perception.

I was surprised. I know the index is up, but a lot of the small and mid-cap companies that we talked to people about up there have seen dramatic share price increases over the past 12 months. In that context, was there anything interesting that you came across from an actual investment perspective on our trip?

[0:20:40] HM: Yeah. No, we've been doing some work on the Japan IT space and domestic IT spending for a few months now. I think that our meetings there just confirmed that there's potentially a multi-year story. I mean, what's happening? The government has started to enforce digital invoicing and receipts. Well, that sounds like something obvious that you do. Many Japanese companies, especially anything outside of those large multinationals and they're really higher quality companies, they're still invoicing using paper and stamps. They're really far behind, I think, the West in terms of digitization.

[0:21:12] SJ: Which is bizarre, because you see so much technology in their country as well.

[0:21:15] HM: I know. It's really weird. It's too short almost. There's a real drive towards investing into software and cloud that's starting up there. The Japanese SMEs, they are at least a decade behind the West when it comes to this digitization process and getting used. What really kickstarted was COVID, when you couldn't really go to the office. You had to start using a PC to communicate and doing stuff digitally. That really growth, this change from, I guess, a sleeping giant pool of companies there. The government also, I think, realized that we need to take dramatic steps to move this forward.

There's also significant labor shortage in the country already. It's set to get much worse, given demographics. Investment into digital productivity tools, software IT, they're really important steps to try to mitigate some of the pressures that will come from these labor shortages that are already there, but are going to be getting worse.

[0:22:07] SJ: We checked into our hotel when we arrived, without talking to a person at all. They've got these little kiosks. You type your details in, you scan your passport, or whatever ID, document you've got on it, print you out a room key, and tells you, you need to go.

[0:22:19] HM: If you wanted, you could step to the left and speak – get the check-in staff. There were three of them. It's not like, there weren't, but it was just so efficient. I love just not having to deal with anything.

[0:22:27] SJ: You didn't have to tip it.

[0:22:30] HM: That's more the US, when you last were tipped to check you in. We also found some interesting ideas in the video game space and within the semiconductor supply chain, which were kicking the tires on now already as a team. Should be exciting. I genuinely think it's going to be an interesting place if you pick your bets right and you pick your sectors right in a place where you can really earn excess returns over the coming years.

[0:22:51] SJ: I know you don't want to talk too much about names, but we have to tell the funny story about TOTO.

[0:22:58] HM: Okay. Yeah. I'll let you do that one.

[0:23:01] SJ: I don't know how many listeners are familiar with been to Japan, familiar with the TOTO toilet. But it's an experience that any visitor to Japan will never forget from the west. I'm actually a huge, huge, huge fan. I think when you talk about cultural differences, a lot of people from Japan must come here and say, “I can't believe the way you go to the toilet.” It's very, very, very backwards. We think they're backwards with their invoicing systems. They must think we're both right backwards with the way we go to the toilet.

Anyway, there's a listed company that makes these very, very technological toilets that wash your bum and keep you warm and do all sorts of things while you're sitting on the toilet. They retail for $10,000 here in Australia. It's very expensive, but a very mature, but profitable business listed in Japan. We went to a lunch where the guy who covers TOTO was very adamant that we should not be thinking of it as a toilet business.

[0:23:53] HM: That's right. It's now apparently a semiconductor business, because half of their earnings and all of their growth over the next few years is going to come from the semiconductor business that they've bought, God knows when. We just thought, that was really funny. Who would expect that I make toilets and also make semiconductor components, or parts of the supply – feeding in the chain. It was bizarre.

[0:24:14] SJ: Only in Japan. What's your gut feel about it? Is the opportunity in a broad sense, gone for investors, given the price movements? Do you think this is just the early days of a longer period of improvement in terms of returns from that market over there?

[0:24:28] HM: I feel it's early days. Maybe the run this year, maybe there's a bit of a pause coming, yes. But you can clearly see attractive valuations, some really high-quality businesses. If you really get that shift and they start deploying, some of these companies are sitting at 20%, 30% of their market cap in cash, they do nothing. It's not even invested. It's just sitting in the bank account at 0% interest. If that starts happening, it could be really exciting.

There are definitely sectors there that already are exciting. We own Sony for that reason. We're looking at various Japanese IT domestic service names for that reason. There's a multi-year growth story there. If you can merge that with overall excitement about the index and as a country to invest in itself, I think that could be potentially quite powerful. It certainly won't be a straight line upwards, I don't think.

[0:25:18] SJ: No. Some disappointments might be helpful in terms of us getting more of the portfolio invested up there over time. One other really interesting thing for me when I got home, just thinking about the whole experience. I haven't done a lot of – you've done a lot more travel than me, but I haven’t done a huge amount of travel over the past few years. I was flicking through The Economist on the way home and you get to the second last page, and they've got the OECD 20 countries at the back and just, it's a page full of data. I was just reflecting on the stimulus going on in the US and the impact on government fiscal situation over there running a 7.5% deficit.

You go down the column that is fiscal deficit and it is most developed countries in the world running massive fiscal deficits, fours, fives, seven and a halfs, eight, nines, Brazil, most of Europe. It's happening all over the place. You've got Norway and Australia sitting there running fiscal surpluses. Not surprisingly, Norway's got oil. We've got the iron ore. It may just be good luck. It's certainly not good management, given what we've seen from the politicians over the past few years. With the currency where it's at, I think India is showing really, really strong signs of being another China in terms of demand for these resources.

If I was sitting outside and had all my money invested in US dollars, I'd be looking at this part of the world and thinking, oh, that’s a pretty sensible place to be invested over the next 10 years with that setup, relative to how a lot of other countries are positioned. All righty, Harvey. We will wrap it up with that. It's been a really interesting chat. It was great, fun traveling with you and a nice reflection on some of the opportunities that we've seen out there.

[0:26:58] HM: Thank you. See you all.

[0:26:59] SJ: Hope you enjoyed listening in. As always, any questions, or comments you have, fire them through to admin@foragerfunds.com, or feel free to be old school and give us a call. Thanks for listening in.

[0:27:11] HM: Thank you.

[END]