 What is your overall equity market outlook for 2002?
We live in difficult times. Japan is already in recession, and this may well also be the case with the US. For many this is enough to make one adopt a bearish stance. But remember that markets have been falling for almost two years and thus have already discounted much of the negative economic and corporate data that is now emerging. The question for investors is not where the economy is now but where it will be in nine to 18 months. On this basis I think a little cautious optimism is in order.
What would you see as the major risks to this view?
Obviously the international situation remains very fluid. Within Japan itself, there remains a question mark over the banking sector. In 1998, the stock market crumbled, as the banking sector teetered on the brink of systemic collapse. The Obuchi government then initiated a program of restructuring and capital infusion, which triggered a dramatic market bounce. The banking sector is now back below its 1998 levels, prompting fears of another 1998-style crisis, possibly triggered by the planned imposition of a limit to deposit protection from next April. As yet, apart from stock prices, there are few signs of systemic distress, and I do not expect a full-blown crisis, but this is a situation that requires constant monitoring.
How do you expect small/mid cap stocks to perform in this environment?
Traditionally, it has been believed that the small cap segment is particularly economically sensitive; thus one would expect these stocks to have performed particularly poorly as the economy has been in reverse for at least the last year. I would expect this to continue.
Why do you think this is?
The Japanese market tends to be very value-driven, i.e. investment strategies based on buying undervalued stocks tend to deliver outperformance. If one screens the Japanese market for cheapness, a disproportionate number of the stocks selected will come from the small and mid cap segment.
Is it merely that small companies tend to be cheap?
Not at all. It is possible, within the small company segment, to buy both growth and value at the same time. It is sometimes said that Japan is a market which overvalues excellence and undervalues mediocrity. If one wants to buy quality, one thus tends to have to overpay. This is much less the case in the small company segment.
Why does this apparent market inefficiency persist?
While the number of analysts covering the Japanese market has risen over the last decade -- even as the market has been declining -- they have tended to focus their coverage increasingly on the larger companies and certain sectors, most notably technology. The consequence is that are many even mid cap companies -- and even whole sectors -- which would once have been covered but which now get very little analytical attention. With small cap stocks, the situation is even worse. And without the guidance of analysts, many institutional investors are reluctant to get involved. The other structural problem is lack of liquidity. Inevitably, smaller stocks are less liquid than larger ones. At times of market uncertainty -- and the equity market in Japan has been uncertain for most of the last decade -- investors have placed an excessive emphasis on liquidity (this was most pronounced during the potential financial crisis in 1998).
Are there any signs that investor attitudes are changing?
Yes. Much of 2000 has been notable for the relatively poor performance by most of the large stocks and large sectors (banks, communications, and electric machinery). Most large funds will have most of their assets in these stocks and sectors and will have been disturbed to see their smaller competitors, who do not have the same exposure to the large caps, performing much better. This will tend to shift attitudes. We have noticed in recent client visits that fund managers, who have previously focused almost exclusively on large caps, are actively shifting their funds down the size continuum. It is also noticeable from recent shareholder filings that international fund management groups are increasingly prepared to take very large, say 10% or higher, stakes in individual companies.
Liquidity is an area in which the CB market can help the investor. In Japan the CB market has, in recent years, been dominated by smaller companies. In many cases the CB offers the investor the chance to get greater exposure to the company than the equity market itself, and this liquidity, unlike in the underlying cash market, is generally relatively constant. For example, Arc Land Sakimoto (9842) is a home center operator based in Niigata with an enviable record of profit growth. Over the last six months of 2001 the shares traded on average around 13,000 shares per day, with volume dipping well below 1000 shares. And yet via the CHF CB, it has been always possible to buy or sell at a time CHF1 million worth of bonds which are equivalent on a cash basis to 50,000 shares. Even if one adjusts for a 50% delta -- which is being conservative -- one has exposure to 25,000 of the underlying shares.
Globally there has been a dramatic slowdown in primary listings of new shares. Has the same happened in Japan?
To a surprisingly limited extent. In the United States, September 2001 was the first month since 1974 in which there were no IPOs at all. In fact there were no new issues between August 14 and the beginning of October. In Japan, on the other hand, there were 16 IPOs during the month of September. It is both important and encouraging that the IPO flow has continued, since the small company universe needs constant replenishment.
One of the long-term structural arguments used against investment in Japan has been its lack of entrepreneuralism. It is certainly true that on most measures of entrepreneuralism, Japan has ranked toward the bottom of the global league table and a long way below the United States. Sometimes this is explained by reference to allegedly deeply rooted cultural factors which somehow prevent the Japanese from being entrepreneurs (unlike, for example, the Chinese). However, this is inconsistent with the historic evidence. Many of what would now be regarded as lumbering corporate bureaucracies, such as MEI or Hitachi, were founded by charismatic entrepreneurs. And there was a particular surge of entrepreneuralism after World War II, out of which sprang current global giants such as Honda and Sony. There is some evidence of at least an upsurge in such activity in the 1990s, and it's these companies which are now coming to the market. One used to call these companies "New Japan" until the phrase was reserved for Internet/high-tech companies which boomed in 1999-2000 and have since fallen back to earth.
What would you see as the main differences between "Old Japan" and "New Japan"?
Japan has become a country in which companies find radical change difficult and are thus, to some extent, imprisoned by the legacy of their past. During the long post-war boom, companies expanded, adding assets and employees, and financing this expansion, where necessary, by increased debt. These habits, in many cases, persisted into the 1990s -- Mycal, for example, was still borrowing aggressively for expansion in the early 1990s, seeing the slowdown as temporary and thus a good opportunity to fight for market share. (Mycal is, of course, now bankrupt.) New Japan companies grew up in the 1990s, after the bubble, when the days of easy money and high growth had ended. Typically they had much less reliance on debt, much more focus on profitability, and much leaner cost structures.
Does one find these companies in all sectors?
There are some sectors which are quintessentially Old Japan (utilities, non-life insurance, shipping, etc.) and some areas of technology, especially the Internet, where most of the companies are New Japan. In very general terms, New Japan companies will tend to be clustered in services rather than manufacturing -- in many ways a better reflection of the changing Japanese economy than the manufacturing-dominated TSE First Section. But the most interesting examples of the attractions of New Japan are in sectors where there are numbers of both old and new companies. Three, in particular, spring to mind -- all areas in which the Old Japan companies have been under particularly intense pressure.
Firstly, retail. This is an area in which there have been a number of prominent bankruptcies (Yaohan, Sogo, the aforementioned Mycal) and where there are a number of venerable companies still crippled by their past, when they buried large amounts of money to develop what are now arguably obsolete formats on expensive city center sites (Takashimaya, Mitsukoshi, etc). On the other hand, there are much younger companies who have taken advantage of lower property prices and liberalization of regulations to build up chains with more innovative formats. One which intrigues me is Can Do (2698) which is in the very contemporary business of JPY100 shops -- the company was founded only in 1993, and it was listed in June this year. No longer cheap -- it has tripled since the IPO -- but clearly dynamic.
Secondly is real estate, and more specifically condominium developers. Most of the more established companies in this area (Daikyo, Towa Real Estate) are still struggling with the borrowings and land banks built up during the bubble era. Thus even when we have seen some indications of a pickup in condominium sales, these companies have in general been unable to benefit. Consider, on the other hand, Goldcrest (8871), which was founded in 1992, listed in 1999, and generates JPY100 billion worth of sales with only 55 staff. It generates more than half of the sales of Towa Real Estate (8834) and twice the profit with less than a tenth of the staff.
And finally, there is the banking sector. There are no New Japan banks, or at least none that are listed. But there are the consumer finance and shohkoh companies which are in the business of lending money and which have been expanding and making money at a time when the banks -- their natural competitors -- have been doing neither. It used to be said that while a Japanese city bank would charge 3% and suffer default rates of 20%, a consumer finance company could charge 20% and suffer default rates of only 20%. And the consumer finance sector boasts balance sheets the banks could only dream of -- one of their problems may be that, by international standards, they are insufficiently leveraged, a charge that can never be laid against the Japanese banking sector. A number of these companies have, it must be said, had their problems, especially in connection with accusations over their collection methods, but they can still show profit records at times of economic distress that are quite exceptional.
And finally, one should mention the venture capital sector itself. One of the reasons frequently cited for the lack of entrepreneuralism in Japan has been the lack of the sort of vibrant venture capital industry which has played such a key role in, for example, the development of Silicon Valley. Traditional Japanese venture capital, as represented, for example, by JAFCO, has been excessively conservative in its attitude, but recent years have seen the launch of new venture capital companies participating in the development of New Japan, and some of these have themselves come to market. One such is Venture Link (9609), which combines venture capital with the development of franchises, another form of business operation relatively new to Japan. And they also have the advantage of being able to offer an attractive Euroyen CB. @
|
