The Investors

Back to Contents of Issue: August 2001

For professional investors focused on Japan, it's been a great summer to sell in May and go away. But what are their strategies for later?

by Bradley Martin

Matsunao Yoshitake of Meiji Dresner Asset Management, in his Omotesando office

WHAT'S HOT IN THE stock market this summer, and what's about to get hot? We'll tell you first what's not. Highly unlikely to take the market by firestorm is your very own New Economy startup -- just in case you were contemplating an IPO any time soon. "Don't expect another 1999 for a long time," advises fund manager Simon A. Ross of AIMIC Investment Management Ltd. "If you're a gaijin entrepreneur who just wants to get whooshed up a thousand-fold, you'd better go back to California."

And in case it's your own money you contemplate plunking down, by the time you read this you may either be glad that you sold all your stocks and chilled out for the summer -- or wishing that you had. "If there was ever a year to sell in May and go away, it's this one," according to Stephen Bronte, who manages Sakura Fund, a California-based Japan hedge fund. In Bronte's view, just about anything -- buying US Treasury bonds, shorting the yen -- would beat owning Japanese stocks in the sideways market expected to prevail during the summer.

But now autumn is fast approaching. Pros such as Bronte -- who did sell all the Japanese stocks in the $100 million worth of funds he manages and arranged to go on a mountain climbing expedition in Switzerland -- will soon be back at their desks. Meanwhile, "value" investors like Edwin C. Merner, president of Atlantis Investment Research Corporation, may never have left their desks, because they love a down market and the chances it provides to pick up good stocks at dirt-cheap prices. "When everything is certain and good, you already have to be fully invested," Merner says.

Both for those who are ready to get active in the market and for those who are only ready to enjoy the tail-end of the summer while maybe thinking a bit about the market, the approach in most cases will not be to buy or sell Japan generally but, rather, to go in for a very careful sort of picking and choosing. For example, Bronte, Merner, Ross, and Masanao Yoshitake of Meiji Dresdner Asset Management Co. all will be watching for signs suggesting when the worldwide slump in semiconductor sales might bottom out; they'll be hoping to get the timing just right when they buy back into shares of certain market-leading Japanese semiconductor manufacturing equipment companies.

AS FOR THAT PROVERBIAL "rising tide that lifts all boats," alas, it has not been sighted lately from these shores. But in the market, they say, even a dead cat will bounce if it falls far enough. Thus, in March, "We had the dead-cat bounce off the back of Nasdaq, from 11,300 to 13,000," recalls Bronte. Then in April, "the Koizumi feel-good rally took it from 13,000 to 14,500; we've since given all that up. We're at the stage now where foreign investors need to see actual hard-core results before they put money into the market." Why is it so important what the foreigners do? "Without foreigners, nobody goes into the market," Bronte says. "The Japanese are still unwinding cross-holdings; when the foreigners buy, they sell." That's the "sideways market" that, in Bronte's crystal ball, will last until autumn. "Then we'll see if Koizumi can produce" on the promises of reform that briefly got the market excited when the prime minister was fresh in office. If the prime minister turns out to be the real thing, Bronte sees the Nikkei going to 18,000; if not, back down to new lows. "It's that simple."

Meanwhile, "you can sit on the sidelines and do nothing, which is what I'm doing. If you have to be in the market, you can go for value domestic stocks like chemicals, housing, consumer finance, steel companies -- stuff that did well in the '80s but hasn't since then. You definitely don't want to be involved in tech. For that, you need a new bull market in the US, and that's probably six months along. Don't expect any leadership from the US in tech any time soon. But when the US takes off, you want to own Advantest, Kyocera, Tokyo Electron, and even big names like Sony and Matsushita Electric. NTT DoCoMo will be a leader in any future technology rally."

Stephen Bronte, manager of Sakura Fund

The way Bronte's funds are set up, "I don't have to be in the market all the time," he says. He's at 100 percent cash now. "I can go from 100 percent cash to 200 percent invested with one phone call, and I can go in and out for an hour if I want to." With that kind of flexibility, "you're better off buying US treasury bonds than equities. Shorting the yen around 118 may not be such a bad idea either. Equities are at the bottom of the list." Bronte says he pays no attention to small companies, because "in a bear market, the liquidity on those is so poor that I can't really get involved." It's still vivid in his memory that many big hedge funds were heavily into small caps -- and got creamed. "People took 98, 99 percent hits to their net worth."

A high-flyer literally -- he's a licensed pilot -- Bronte nevertheless is more cautious as an investor than some of his fellow hedge-fund managers. "The fact that he's still in existence says something," observes Merner, "because a lot of those people have disappeared."

"We lost money last year, but nowhere near as badly as some of the more aggressive tech funds," Bronte says. "We really got hit with the index changes; we had used the Nikkei futures as a hedge. When they changed over one weekend we lost a lot. But otherwise we did everything right: sold all tech stocks in March of last year, stayed out of the US, and started shorting the yen a lot. This year we stayed out of the market in the first quarter and made about 10 percent in the big dead-cat bounce. I don't expect anything to happen anywhere until the fall. August will probably be a good time to start buying."

Does Bronte think the New Economy has a future? "Yeah, I do, but not for a while. We hadn't finished unwinding the first bubble, real estate in the '80s, when they ran up a second bubble, tech in the '90s. Now both are overhanging the Japanese market."

THE MARKET ROSE AFTER Koizumi's election as prime minister, not because of actual policy changes -- those are still yet to come -- but because of "relief that Koizumi was better than Mori," says Ross of AIMIC, which has $3 billion under management. Stocks that benefited from raised expectations regarding policy changes then -- "all the real garbage that went up by 50 to 100 percent" -- tended to be the shares of companies with low ratios of market price to book value. These companies owned, for example, quantities of land or big inventories of housing materials, assets whose prices would be expected to increase if deflation should be replaced by inflation.

According to Ross, a breezy Englishman, the problem with those companies for the longer term was that their low price-to-book ratios really reflected poor fundamentals in their business lines and/or the quality of their management. "I had some," he says. "We invested in serious junk when we thought the market would go up 30 percent because of the style of the market." That was shortly before Koizumi issued his policy calls. AIMIC's picks then included Sekisui Chemical and Komatsu. "We took a style call and it paid off. We bought on the rumor; we sold on the fact. The day that Koizumi made his big policy speech is when we dumped all that stuff." As Ross and his colleagues had anticipated, the Koizumi psychological lift to the market quickly "played itself out. Now we're back to fundamentals."

After that brief foray into sectors that, most of the time, "foreigners abhor," Ross, like Bronte, planned to "chill out" for the summer. He and his colleagues wanted to take some time to evaluate whether to go into service providers, publishing companies, and telecoms, and to what extent they should return to the export-oriented "businesses that we all know and love," such as Toyota, Honda, and Sony, as well as electronic parts companies whose business cycles follow theirs. "Do we buy back Sony? How are the PlayStation sales? How is Toyota doing in US market share?"

Meanwhile, there is Nintendo, a company Ross owns out of "long-term conviction. It's one of my long-term, never-sell situations."

Only time will tell whether Koizumi is going to be able to deliver on reflating the economy and pushing structural change, and whether the Bank of Japan has an effective monetary policy. Thus Ross's view that "the summer's going to be slow as we take stock of what's going on in the States and Europe" -- and, in Japan, ponder "whether to really take a style bet that the sick companies will be getting better."

Companies he's thinking of buying include PC parts producers. "Pentium came out with its new P4 chip, and the pricing is very attractive. Intel wants to go for volume, sell lots and lots of boxes. That would be good for the Japanese PC parts industry" -- for example, hard-disk parts companies Hoya and TDK. The latter "is priced to have its GMR head business never recover. I'm buying things that are priced to stay on their backs but whose business models are OK. Takasago Electric, for example, which I already own. That's very different from owning a company that is structurally distressed."

Ross also owns shares in consumer finance companies and in an Osaka condominium company that has completed units ready to sell (he refuses to name the company) and that is priced at only five times earnings. He sees the condo company as "a free option" on housing tax incentives that the parliament may well enact in the spring of 2002. "The market says the housing business is finished. Some of the companies will go under, but if you pick up good companies in a bad business you can do very well."

As for the New Economy, Ross says, "Intuitively people want to believe that [Softbank founder Masayoshi] Son will make a comeback, but they are not going to believe that [Hikari Tsushin founder Yasumitsu] Shigeta will." Ross himself is highly skeptical about Son as well as Shigeta. "Softbank owns 48 percent of Nippon Credit Bank. In America, if anyone owned 48 percent of a distressed situation you'd think they know what they're doing. But ask a senior person at Softbank how they'll deal with NCB's non-performing loans, its balance sheet, and you'll be told to go and ask NCB -- and not to worry because 'Mr. Son knows what he's doing. And isn't Mr. Son great? He was in Forbes once!'" This, Ross notes, "is not necessarily confidence-building. We'd all like to be back into Softbank, but unfortunately there's no cash flow. We're not interested in paying for dreams anymore."

That's not to say that all beaten-down New Economy companies got their just desserts in the tech crash. "Cyber Agent and others were massively oversold," Ross says. In Cyber Agent's case, the market capitalization at one point reached lower than the value of its net assets. "If you acquired the company at that price and sold it after it went up again, you would have made 30 to 40 percent." But comebacks in general are no more in the cards in this sector than is a repeat of the wild and woolly 1999 pricing for brand new companies, Ross believes. "Everything in Japan is about turnover. If you look at the previous small-cap booms, very few companies made it back. The next New Economy stocks either haven't come to market yet or they have, and we should be pounding the pavements to cover them."

One that Ross has been looking at is Photonics, a nanotech company that he calls "thematically stunning. The photon is the next boom." With interesting technology for making chips smaller, the company as of late spring was "not excessively priced" at a market cap of around ¥15 billion, 10 times sales. The company might have done better if it had not listed on Nasdaq Japan, Ross reckons, "because people are leery of the Softbank connection" with the new exchange. "Who knows? In the next two years, maybe it's worth ¥30 billion." But it will take at least that long for it to become profitable. Meanwhile, "is the market going to sit through the next two or three years? I doubt it. We're years away from the time when a Chicago investor is going to want to buy a nanotech company on Charles Schwab through Nasdaq. It's just the association of Nasdaq Japan -- that it's burned people. People say, 'Whoa! Softbank built this Nasdaq Japan thing. Do I want any part of it?'"

Ross sees similar problems for companies listed on the Mothers board of the Tokyo Stock Exchange, which likewise started off by burning investors big-time.

Companies are trying to shake things up in the market by splitting their stocks and reducing the maximum trading units to make them accessible to smaller investors. That's all well and good, says Ross. "When the market is going up and people want in, it helps. But they're doing it now because it worked before -- and meanwhile, investors have wised up."

MEIJI DRESDNER'S YOSHITAKE IS another fund manager who anticipates few surprises before autumn. "The electronics sector is suffering from slowing demand," he notes. "I expect poor earnings in the first half, hope for recovery in the second half" (of fiscal 2001, which began April 1 for most companies).

His company is a joint venture between Meiji Life Insurance and Dresdner RCM Global Investors. It manages about $20 billion in assets and ranks sixth in size among Japanese pension fund managers. The company follows San Francisco--based Dresdner RCM's growth-stock approach, picking individual companies rather than making sectoral bets. Meiji Dresdner mainly buys large-caps, but its funds own a few smaller companies such as Kyorin Pharmaceutical, maker of a new antibiotic called Tequin, now being prescribed widely in the US.

As for the New Economy, Yoshitake sees it injecting new blood into some tired old industries such as bookselling, where such a bricks-and-mortar company as Kadokawa Shoten is following something like Barnes & Noble's model of online sales and "could survive on the Net." But he hasn't bought Kadokawa because it's too small for his funds -- and because, generally, "selling books is not good business in Japan," where big inventories and small margins are the rule.

An old economy company that Yoshitake's funds do own is Ariake Japan, a seasoning company that has enormous market share in soup stocks, such as those used in ramen noodle dishes. There are "no actual competitors in Japan," Yoshitake says. One by one, mom and pop restaurants in Japan that used to make their own soup go out of business, losing out to chains that outsource from Ariake. The company has factories not only in Japan but in China and the United States. (It has none in Europe, so it is not immediately concerned by the outbreaks there of mad cow and hoof-and-mouth diseases.)

A big story for Yoshitake is his expectation that Japan will be closing the gap with the United States in use of computers and computer systems -- to which companies here have been devoting around 30 percent of capital investment, versus around 40 percent in the US. While US investment in those areas has begun to slow, Japanese spending on systems remains strong -- to the benefit of supplier companies. Banks, for example, are becoming more competitive through mergers and expansion into new business areas such as selling investment trusts. In the process, Yoshitake notes, larger banks with sufficient cash flow, such as Mizuho, "are aggressively investing in network systems." He sees year-on-year growth of 15 to 20 percent in this market. Beneficiaries include such companies as Nippon Systems Development, a leading software developer, and Fuji Soft ABC, a developer of software and communication infrastructure whose name reflects the mergers that created it. Yoshitake's funds own both companies.

Also keeping communication and computer systems suppliers busy, notes Yoshitake, are Nippon Telegraph and Telephone and its spinoff, NTT DoCoMo, which continue to invest in infrastructure. The more aggressive of the two is DoCoMo, which hopes to be number one in the world in next-generation cellphones and is investing in infrastructure at a rate that has grown about 20 percent each of the last couple of years. One beneficiary is Macnica, a trading company that imports advanced devices mainly from the US -- such as programmable logic devices made by Altera, for which the company is Japan agent -- and sells them to NEC and other equipment manufacturers.

As for semiconductor manufacturing equipment, Yoshitake and his colleagues are "still looking for the timing to buy back, when we confirm some recovery in demand." One possibility is THK, a leading producer of linear motion gearing, which is used in place of ball bearings on the machines that mount devices on the chips. "Demand for linear motion gearing continues strong, but companies like this will have poor earnings the first half of this year due to the sales slump and the consequent capital expenditure slump at makers like Intel," Yoshitake says. "It's a recovery story."

LIKE BRONTE AND YOSHITAKE, Ed Merner of Atlantis likes the semiconductor manufacturing equipment recovery story. But when will it be time to get in? It's hard to say. "You know things will bottom in the next one to two years. Some people say this year." Among the top 10 firms worldwide that will benefit from that, at least half are Japanese, he says. "Tokyo Electron, Advantest, and Tokyo Seimitsu will do well over the longer term."

Edwin Merner of Atlantis Investment Research Corporation

Tokyo Electron and Applied Materials are companies that "will be around for a long time," Merner adds. Then there is Hoya, which makes blanks of photo-masks used in chip-making. Dai Nippon Printing and Toppan Printing make the masks themselves. "Shinkawa could do well in the next cycle," Merner believes. Its machinery connects the wires, a technology that may change. Union Tool makes drills for the boards. Merner also points to materials used in manufacturing semiconductors. In making photo-resist silicon for chips, the chemicals change as the number of lines increases and wafer size changes. "Shinetsu is trying to become a player in photo resist for 300-mm wafers," Merner notes. Other companies in this sector that he mentions are Tokyo Oka Kogyo, which makes the photo-sensitive resin that goes into photo-resist silicon; Sumitomo Kagaku; and JSR.

Nikon and Canon produce steppers, multimillion-dollar machines that are used to put the patterns on the chips. Their main competitor is a Dutch microlithography company, ASML. The lines on the chips keep getting thinner and thinner, and current stepper technology is running out of room to accommodate such advances. So new stepper systems are being developed, and "the stepper business will change radically in the next three to four years," Merner says. "It's uncertain which of the companies will be winners or losers. It depends on which system works best, which is the cheapest, which is the most reliable." For investors, this is thus a tricky call. "Canon is a good company, but steppers are a very small part of its business that can neither save nor destroy the company. At Nikon, on the other hand, cameras lose money and steppers could end up accounting for more than 100 percent of the company's business. Nikon will rise or fall based on the stepper business." How to play it? "You could buy all three companies," suggests Merner, "figuring that what you lose on one you would gain on another."

Merner boasts that the assets Atlantis manages are small enough -- totaling $650 million or so -- to provide an advantage: The funds can buy even micro-caps, in the small quantities that typically are available in the small-caps' illiquid markets. While he notes that high-tech stocks generally have been suffering from poor fundamentals, Merner sees plenty of juice in the market for adapting imported software to Japanese clients' needs, which is what some companies, such as WoodLand, Obic, and Toyo Business Engineering, do.

Like many other fund managers, Merner sees manufacturing in general as a declining slice of the Japanese pie. "I can guarantee you that manufacturing as a percentage of GNP will shrink in the next 5, 10, 15 years," he says. "So we stay underweight in smokestack industries," the ones that are shifting to lower-cost labor environments such as China. But although in the long term China's prospects are great, it's risky to invest there because "you have no rules and there are a lot of frauds. So lots of people say buy Chinese plays -- Japanese companies that manufacture mainly in China." These include coil-maker Sumida and appliance-maker Funai.

If you should run into the white-haired, professorial Merner some evening after work and ask him to name one company he likes, he might well mention yet another China play -- Mabuchi Motor, most of whose production is overseas. Although you may never have heard of it, the company makes the small electric motors that raise your car's aerial and move the seat, that power your camera and tape recorder ... Merner can go on and on citing the uses for those motors. We'd list more of them -- but, hey, summer reading shouldn't be too heavy. Enjoy the beach.

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