Back to Contents of Issue: October 2002

Four financials gurus put their heads together to discuss small caps, business confidence and more

Jonathan: Well gentlemen you've all been investing in Japan and particularly in small mid cap stocks or companies for many years now. I was wondering what approach you adopt, particularly towards the small and mid cap universe?

Ed: I think it's the same as looking at any type of company, we first try to visit the companies, and try to buy stocks that have growth potential and that look undervalued. In some cases it easier to analyze a company if they only have one business. If it's small and focused it's pretty easy to see how things are going and have a good idea where earnings are going for the next two to three years.

Curtis: I would agree, in general, it's the same. The biggest difference of course relates to liquidity. The smaller the company, the more sure you have to be of what you're doing because once you've made an investment it's very difficult to get out, so if anything, I would take my time in the case of smaller companies, just to confirm everything is in order. In some cases, I'd wait for another set of earnings to confirm things are heading in the right direction. The consistency of earnings is more important; you have medium to larger companies that rise on one good set of numbers, but it would be unusual for this to happen to a smaller illiquid company, because everyone knows it takes more than that to get in and out of this type of stock.

Mark: In our investment approach, we don't distinguish between small and mid and large cap. We are looking for great investment opportunities irrespective of size. We are looking for good companies at great prices, rather than a Warren Buffet style, which is looking for great companies at good prices. Part of the reason is that there are probably fewer great companies around in Japan than in the US. At the moment there are great investment opportunities, but they do appear to us to be mainly in the small and mid cap area. Now, if we try to build a portfolio purely out of small and mid caps we build up a very large risk exposure against large companies. Our risk control overlay on the portfolio has to reflect this risk factor, and to some extent this means that small and mid cap companies have to clear a greater valuation hurdle. In our portfolios roughly half of our long positions are in large caps and half in small and mid caps. But if you look at the valuation of those groups, the valuations for the small and mid cap portion are actually far superior.

Jonathan: Why do you think it is that the valuations on the small mid cap are much more compelling? Is there something that has changed over time?

Mark: There are some 3,600 companies in Japan. The top 100 companies by market cap account for about 60 percent of market cap, have a median P/E of 27X and a median P/B of 1.6X. By contrast, the bottom 1,000 companies by market cap account for 0.7 percent of market cap, have a median P/E of 11 and a median P/B of 0.5. They simply are far cheaper. The market clearly has very strong views about what's an appropriate valuation for a large cap, compared to a small cap and at the moment, the market is saying that the valuation of small cap should be roughly a third that of a large cap. If you go back it hasn't always been that way, in the late 1980s, or the early 1990s the valuations were similar for the two groups. Of course that was a good time for small caps globally, so perhaps the best we can hope for is that small caps trade on parity to large caps, but having them on a third of the valuation is probably still too low. And that's why I think, particularly in Japan we have still got a tremendously exciting investment opportunity, possibly one of the best investment opportunities in the world.

Jonathan: Moving on to liquidity, do you find this a major constraint and is this something that has changed over time in the small and mid cap universe?

Ed: I think liquidity has always been quite important, and of course, especially when things go wrong and things can go wrong. It doesn't matter how well you prepare or how well you study, things can go wrong very suddenly. I'd say liquidity now is better than in the past, but when you have a raging bull market in small cap stocks, liquidity is generally pretty good. Two to three years ago liquidity was much better but even nowadays it's much better than say 10 to 15 years ago.

Curtis: Yes, I think it is very much case by case, the good news is that due to the current uncertainty in the market, not many investors are looking at the more illiquid names which means you can take longer to make up your mind and invest. In some cases, it takes me three months to get invested. In a mid cap or larger name, I'd be much more worried about another institution coming in and competing with me for stock. I could be 25 percent of the volume for a few months without bumping into another institution.

Jonathan: How does this lack of liquidity impact on valuations in this segment of the market Vs the market average?

Ed: I don't think there is any real meaningful market average. There's such a disparity depending on the company. Also many of the small companies are not researched at all, not just very little but not covered by anybody. Looking out a few years because no one is covering these companies, thus no estimates; some of them are selling at ridiculously low multiples. So, there's a tremendous amount of value out there, if you can do your homework, visit the companies and really research them well. So I think there are a lot of opportunities.

Curtis: It's really a matter of going out and digging around. You have to have the confidence to be able to go out and do something no one else is doing, and it's difficult to do that if you're looking for a consensus, or a stock that has six analysts covering it. You may find a stock where there is only one other opinion in the market or perhaps none and you have to form an opinion of your own.

Jonathan: I think it's probably true to say that globally small caps have had this de-rating relative to large caps in recent years. Do you think this is due to a greater weighting put onto the liquidity advantages of larger stocks, which were not quite as important say five to ten years ago?

Mark: I think there's a bit of chicken and egg there. My view on that is that what has occurred in the last five years is that there has been an institutionalization of equity markets globally and the stocks that are commonly held by institutions are selected from a smaller universe. Because institutional money has focused within those smaller universes, those stocks have gone to a significant premium, and I believe this effect has been particularly strong in Japan. The result of that is that liquidity has dried up contributing to a vicious circle that causes that liquidity to dry up even more. I mentioned earlier, the bottom 1,000 stocks by market cap account of 0.7 percent of market cap but only 0.02 percent of market trading value so they are extremely illiquid. The bottom 2,000 stocks account for 2.9 percent of market cap, but only 0.4 percent of trading value. So, yes there is a real liquidity problem here, it is part of the valuation differential, but I think it's a vicious circle that has already gone an extremely long way and is already in the process of turning. Not that it's necessarily ever going to get there but it is now moving in that direction.

Jonathan: Has the coverage of small and mid caps by sell side analysts increased or decreased in recent years?

Ed: That depends on the weather. When small caps are going up maybe in the beginning nobody pays much attention but after a while, the brokers all figure out, yes maybe there's some business in these names so we'd better start following them. They set up one or two analysts and sometimes teams to follow the small and mid caps, then there's a boom and everybody is following them. It then goes to the other extreme when they do badly and soon the brokers drop coverage and cut their small cap teams. They may claim they are still following them, but that's not really the case. Then the whole pattern repeats itself. Each time you go through this, its new ground for most analysts, they've never seen this before.

Jonathan: Does that mean that the level of experience will tend to be fairly low in the analytical community?

Ed: Exactly and also many of these people are not specialists, they get thrown into some area and some of these companies are not easy to understand and they don't really build up much expertise.

Jonathan: Where do you think we are in this coverage cycle?

Ed: We are probably below average as the coverage has been dropping. Like the market it doesn't go straight down but bounces along, overall it has been falling the last few years.

Mark: I believe there's only one major brokerage covering small caps properly and a handful of mid-sized brokers covering them with varying degrees of thoroughness. It is certainly a neglected area of the market.

Jonathan: As a practical fund manager, this must present problems to increase physical contact with the companies, to contact them, to visit them.

Mark: No, I think this is a tremendous thing. I'm very happy that we have this inefficiency in the market. If we didn't have this inefficiency we wouldn't have so many opportunities!

Curtis: Coverage is down; we haven't hit the depths that we saw in say autumn of 1998. Or at previous lows where it was almost insulting to ask someone what they thought of a small cap. I think the same goes for the buy side. Investors who have a Japan mandate may or may not want to get involved in smaller names. They may have some flexibility e.g. 10 percent or 20 percent small cap, but I believe right now there are very few large cap managers even looking at this universe.

Jonathan: From your point of view that's not a bad thing.

Curtis: Short term it's bad, because stocks that deserve attention don't get it but medium to longer term that's where the out-performance comes from.

Jonathan: Looking at the market, Curtis I know you tend to be more a stock picker but are there any sectors, which look interesting?

Curtis: I'm more interested at the moment in domestic demand, which is where I spend a lot of my time. What the US has seen in terms of a consumption boom and even a high-tech capex boom doesn't come along very often, so I think going forward Japan can't really wait for the next big surge in demand from the US or from overseas. So, I think domestic demand is much more important to the recovery of Japan, if there is a recovery, and likewise those sectors are huge, particularly in small to mid caps, where more than half of the market is retail and services. If you focus on what the consumer thinks and what choices the consumer has, it means you have lots of choices. There are a thousand companies that are providing services in the retail area.

Jonathan: The service area is obviously a very large area of the Japanese economy but it's clearly under-represented in the main indices. What kind of weighting would you have in broad terms for services as opposed to manufacturing?

Curtis: If you included restaurants and other services, I would say a good 20 percent is in services, and at least 30 percent in retailing.

Mark: We hold companies in areas that qualify for what we call the '3Ds' -- disregarded, disliked and despised. These are areas where most investors switch off at first glance, such as areas like real estate which has been in a bear market as long as the equity market. Institutional investors may hold Mitsubishi Estate (8802) or Mitsui Real Estate (8801) but nothing beyond that. And yet, when you look at the real estate companies listed in Japan, there is a tremendous profusion and variety. Some of these have remarkably low valuations. P/E's of three, four and five are quite common. One example which has been a very good performer for us this year is LeoPalace21 (8848), which is becoming a more widely held stock amongst some institutions partly because liquidity has increased and partly because it's getting a bit more analytical coverage. It's gone up 2.3X and the P/E's still only 5X. Business is going very well, though it's certainly not without risk. Many of the 3D companies have problems and risks, but we are finding that these risks are completely priced in to the current market value.

Another area -- in which KBC has been helpful -- is steel. My view is that the Japanese steel industry has some strong technological abilities and quite an interesting future. There has been a substantial consolidation in the industry from five or six major companies to what is probably going to become two major groups. That will certainly make an improvement to the steel companies bargaining positions. Sumitomo Metal Industries (5405) is priced at JPY52. I see it as a company with little downside, but it's also a stock that could easily be trading at two or three times current levels in the next year. In the real world, SMI is a huge company but in terms of market cap it's probably a small to mid cap stock.

Jonathan: Do you think there are signs of structural change emerging with the emergence of smaller companies, especially in those sectors where the old incumbents are working off the excesses of the bubble era and it's easier for new companies to compete?

Mark: Yes, definitely, as an analyst in Japan in the 1980s I used to cover the real estate and construction sectors. I became familiar with companies like Daikyo (8840) and Haseko (1808) and they have carried an enormous burden of debt and poor assets, which has meant that they have been entangled in a web of problems during the 1990s. In the 1990s land prices have collapsed, down 70, 80, 90 percent in some cases. The good effect here is that it has become easier and more profitable to put up apartment and mansion blocks, especially in Tokyo. There has been a boom in this area over the last three to four years, because previously developers couldn't develop and sell apartments at prices affordable to average families. Unfortunately, for the majors such as Haseko and Daikyo who once had most of the mansion market they have been unable to take advantage of the situation. Instead we have a number of companies like Japan General Estate (8878) growing very strongly and presenting good investment opportunities. I am cautious to some extent because we have already seen a boom encouraged by lower prices and pent up demand from the bubble period. It will be hard for the overall market to grow and it may well contract, but I still think the new leaner, low debt companies will do better than the old guard. This is also true in many other areas, including retailing.

One risk is that these companies have grown up and expanded rapidly in a favorable mansion market environment. They have not really known tough times but these will come back so some of them may fail. We may have seen first indications of that with a company like Goldcrest (8871), which had incredibly strong momentum but which now appears to have stumbled. I think there are definitely risks here but with P/Es of three, four and five opportunities are still tremendous.

Jonathan: Ed, would you agree the best opportunities tend to be in services and other domestic demand related areas?

Ed: I think that applies across the board, this is not just small caps because if we look at Japan, manufacturing as a percent of GDP is going down, has been going down and will continue to go down. This is a long-term trend.

Jonathan: What we are seeing here is Japan just going the standard route of developed industrial nations?

Ed: Yes, so the smoke stacks are for the most part very unattractive over the longer term, and of course there are almost no smoke stacks amongst the smaller companies. There are almost no financials amongst the smaller names as well. Some companies that were relatively small, for example some of the shokoh funds and are no longer what we would call small caps. There are almost no banks, almost no brokers, so you are really confined to the non-manufacturing, which is overall good, although I would argue that longer term in high-tech on a very selective basis, and new materials, which is high tech, there's some very interesting companies, including some smaller niche companies.

If you look at a company like Don Quixote (7532) which is a company that was quite small when it listed, it's now listed on the First Section of the TSE, it's a pretty big company, it's pretty well followed and so on. So, a successful fast growing small company can become medium sized or big and can make that change very rapidly, within say four or five years. I don't care about sectors, I care about companies; I care about growth. Now it's true that for certain types of companies, it's very hard to make earnings forecasts for any long period of time, which of course means added risk if you can't make an earnings model for more than one or two years. It adds risk, whereas if you can make an earnings model for three to four years that you are comfortable with, it will mitigate your downside risk. 

Jonathan: Any particular companies worth highlighting?

Curtis: In the DIY sector, there is a company that deserves a mention and that's Arc Land Sakamoto (9842). It's expanding quickly, it's just launched a new large-scale store, it's only been open a couple of months but it's doing well, and well ahead of its targets. This industry is set for some consolidation; it's been a very fragmented industry but looking forward it takes some breadth and depth to open these large-scale outlets. The reason Arc Land has an edge in that is that for years they have been a wholesaler to other DIY chains, and so they are in a position to not only buy at very good prices for themselves but also to benefit from the added buying power of supplying these other chains. There will be a number of mergers in this industry and I expect Arc Land to be a consolidator and thus a survivor. Historically they've been fairly dull but now they are gearing up and opening these large-scale stores, taking advantage of their natural strength.

I would agree that investments in small caps are for the long term. I'd also like to add that you don't want to buy one small cap and think this is it. I'm sure we all get the same question which stock should I buy, tell me one that's going to double, and of course if we knew that one stock we wouldn't have a portfolio of 30. Anyone investing in small caps, should look to get a broad range of exposure, because the performance in any given period comes from a handful of names and none of us could tell you which those ones are going to deliver that performance.

Ed: Curtis mentions DIY, looking longer term I like Handsman (7636), which is a Kyushu-based DIY chain that is a real killer of a company because nobody can compete against it -- they have the best stores in their area. If you ask me how will this company do in the next few months or even a year, I'd say I have no idea, it might very well go down. Unless you are buying on a long term basis, you shouldn't even consider buying these companies, and I think I'd like to emphasize this very much: that you can't be dancing in and out of small caps or micro caps, if you try to do that, you have a very good chance of getting burnt very badly and this is exactly what happened to certain investors a few years ago. Small caps started to go down and they were very overweight in a selective number of smaller names, in particular some of the IT stocks, they couldn't get out, they paid too much and they don't know what they were buying, talk about not be able to pronounce the names, some of them didn't even know what the companies were doing!

Mark: There are some companies that are clearly attractive, such as high growth new-style retailers. Point (2685) is a company we've held for over a year. The remarkable thing about that is that it's gone up over six times since we originally bought it and it's still on a P/E of 11X next year's earnings. Sales growth is over 20 percent and profits are also growing strongly. Probably any investor in the world could look at a company like that and think that's an attractive investment. We certainly like to hold that kind of company.

Jonathan: Mark, you mentioned Japan General Estate (8878) and LeoPalace21, these are both companies that have recently issued convertibles (CBs), as an alternative form of investment. Is the convertible universe something you use in your own investment activities? Is it a useful adjunct for liquidity in the small cap universe?

Mark: It is definitely a useful part of the market. We are not specialists, but we like to hold up to 20 percent of our portfolio in convertibles. The level of course depends on the specific opportunities that are available and to some extent our perception of overall risks in the convertible universe, but for us what's great about convertibles is that we can get exposure to a larger volume of stock in some of these less liquid names while effectively being paid to have an instrument with greater liquidity. We estimate one alpha, which is our expected return from the equity, and also calculate a convertible alpha, which is the expected performance of the CB relative to the stock. Broadly speaking we can add these alphas together and for many CBs, particularly those that are issued with refixes or those that are trading close to parity and bond floor, the CB alpha is quite significant.

Jonathan: Do you expect this to persist?

Mark: Yes, though we are nervous at the moment about the overall level of the CB market, because CB arbitrage trade has been a successful trade for several years and so arguably too high a proportion of the market is now held by arbs. There is always a risk of an outflow of capital from hedge funds -- triggered by something like losses in the US equity market -- leading to a correction of the overall CB market. This is a clear medium term risk. However, I've been actively investing in CBs for at least 10 years and there are always interesting opportunities out there.

Jonathan: I think its probably fair to say that most of the CB arb activity has been concentrated in the more liquid names where stock is borrowable, where there are credit bids, and relatively little in names like Leo Palace and Japan General Estate because of lack of stock borrow, lack of credit bids and lack of liquidity. So that's already reflected in the much lower valuations.

Mark: That will certainly help, but we are a bit nervous about a knock on effect. If the larger CBs were to fall sharply, it would knock on to the less liquid names. However, it's not an imminent risk but rather something to be aware of in the medium term and we still think CBs are a worthwhile additional contributor to our portfolio return.

Jonathan: I also notice that Arc Land Sakamoto, which Curtis mentioned, is a company that has a convertible bond (CB). Curtis, do you use CBs in your investment process?

Curtis: In Arc Land I have both the underlying equity and the CB. The CB allows additional liquidity and I think it's attractive. Before the CB's premium disappeared I was fully invested in the equity, I wouldn't buy a CB at a premium but at the moment there is no premium so it's as good as holding the underlying equity with downside protection.

Jonathan: So, it's basically an equity substitute with downside protection. Ed do you use convertibles?

Ed: I have in the past and I have a few convertibles currently but most of the stocks I like do not have convertible issues, which are attractive meaning that I like to buy a CB that is below 110 in price, and which sells on a premium of less than 10 percent. If I can't get that I usually can't buy it. I also might buy them if they are down and out. If I can buy a CB that's say 40 or 50, and I think the company isn't going to go bust, and the CB only has a few years left before it matures, I might buy it. So there are some recovery situations, where you think the company will survive, they really should be thought of more as straight bonds, as more or less you're not betting on the stock going up but you're going to make money on the fact that the bond is going to be worth 100 at maturity and you're buying at 50 or 60. So it's almost a bet on the company surviving and being able to pay off the amount at maturity.

Jonathan: We saw a lot of bonds going down towards those levels in November 2001 and they have since recovered; something that happens when we have a credit crunch.

Curtis: You have to be careful, there are cases of where the bonds do default. I was the proud owner of Yaohan bonds -- of course there had never been a case in Japan of a listed First Section company defaulting on its bonds and Yaohan was the first. I bought them extremely cheaply and they went to zero. Of course in bankruptcy I got three cents in the dollar.

Jonathan: Of course you must remember that convertibles are ranked above common stock in case of bankruptcy so for Yaohan, Curtis, you got a relatively better deal than investors who held common stock and received zero.

Ed: You have to do your homework and in the case of Yaohan there was fraud involved with the Wada brothers. It wasn't just bad management it was fraudulent management. An interesting case was last year at Snow Brand, when there was a bond due very soon and they had already set aside the money to pay for the CB, and the CB collapsed due to the milk scandal. I think it dropped to 80 something but a month later it paid 100. So that was a great opportunity, for those people willing to do their homework.

Jonathan: You've all been investing in small and mid cap stocks for a long time now, I'd be interested in your views on where you see the market going or any trends or themes that stand out.

Ed: I think that the future of Japan rests a lot on the smaller and medium sized companies because; the larger companies seem to have to have very serious management problems and also seem to have a lack of focus. There are a few notable exceptions but most of them have many problems. If we take the steel, or chemical and even many of the electronic companies, maybe even some of the well known electronic companies, they have no focus. They have no strategy -- they say one thing they do something else. Maybe it's because they are spoilt, they know the government or their banks will bail them out if they get into trouble and give them more money, they have backing from their own keiretsu et cetera, but poor management continues, restructuring goes slowly, management should be changed but it isn't. These are not the sort of companies I want to invest in. In the small companies we see a tremendous difference, if they make a series of mistakes and they go bankrupt no one will help them and they have to be quick at changing their strategy, they have to be quick in doing the right thing and they have to focus. I'm finding these companies in the new Japan so to speak, not in the old Japan. If you're in a declining industry, what can you do, maybe you can stay alive but you're not going to grow or prosper, a good example of this is shipbuilding, they've done everything they can to survive, they are not bankrupt but you can hardly call them great investments. I want to invest in companies that can do well, even in a very difficult climate and companies that will grow even if the economy is going sideways or even slightly down. We are not always right but if earnings are going up, up, up year after year it will be picked up by a number of investors, and the stock will go up. It may take two or three years. I had one stock I bought six years ago, it finally did very well and the market picked it up. You will be rewarded if you are right on these stocks, while on shipbuilding you may be right for a month or two, as trading stocks maybe they are fine, as investments they don't appeal. I'm interested in investing not trading and there are lots of good opportunities. We can't expect the market to pull us up, the market is going sideways to down, at this point, and maybe we can see it going sideways to up if foreign investors stop selling.

Curtis: To expand on Ed's comments, in that there are very few companies doing the right things for the right reasons, and any eco recovery in Japan depends on a lot more companies in Japan doing the right things for the right reasons and that's why the recovery will be drawn out and take such a long time to emerge. The worst thing a company can tell me in a meeting if the economy gets better we'll do better, because of course things won't get better till companies make all the tough choices. Unfortunately there aren't enough companies making those tough choices at the moment and so we are forced to pick and choose amongst the companies that are and those ones will do much better than average. You then need to be patient as it can take years to be rewarded but as I said that's why you need to have a portfolio of companies. So at any given time, some of them will get recognized and re-rated and the rest will be forced to wait yet another six or 12 months. I like to compare it to being the first at the party and the first to leave. You leave without a hangover but still you miss a lot of the fun. It helps to be a bit antisocial and not go with the crowd. As soon as half a dozen analysts cover a stock, it's time to move on.

Ed: Being early out you can be a bit too clever, because you miss the big move. And if the company is really starting to grow 50-100 percent per year and the multiples are still reasonable, why not hold on or just sell some of your holdings. We have had some successes where we were very early in and we stayed for a long time and the stock just kept going up. Maybe the best example of that was Yahoo! Japan (4689), where we were one of the first investors in it before brokers were recommending it and we were well rewarded for that. Of course we did slowly sell our shares.

Curtis: One of the best examples in terms of being early in and early out that I have had was Fast Retailing (9983) where I bought at JPY600 and sold at JPY6,000. Of course I watched the stock go up to JPY15,000 before collapsing to JPY2,000.

Jonathan: Mark, what would your outlook be for the market?

Mark: I'm not going to make any short to medium term predictions for the market because I've never actually met anyone who can consistently do that. One thing that seems to me to be quite important and somewhat under appreciated is the sheer length of the bear market in Japan, which is already 151 months, and as we have just seen a new low in August so it may well be 152 months or more. I find it interesting to compare that with the length of the great US crash, the most famous bear market of them all, where the time from peak to trough was 35 months. That was a sharp and deep crisis but the Japanese bear market has already lasted more than four times as long, and to me that suggests that it has done very powerful things to psychology of investors who are involved with that market. That gives us great grounds for optimism, because when psychology has been so badly damaged for so many years, month after month, it has to provide many interesting opportunities. That makes me quite optimistic and excited about the investment opportunities in Japan.

Jonathan: How has your performance been?

Mark: We've made 77 percent after fees over the three years since the inception of the fund (Arcus Japan Long/Short Fund) with the market down 34 percent over that time. And yet the valuations on our portfolio are still as good as they always have been because we take profits in stocks that rise substantially. On the long side of our L/S fund the average P/E is still around 10X, as it has been for the last two years despite strong returns. This indicates that there are plenty of fresh opportunities out there if you go and look for them and leaves me optimistic that there's still a lot of money to be made.

Curtis: Well we've had a very good experience in these markets, markets that go nowhere in general support my way of investing; investors are forced to look at a broader range of stocks and companies they may not have looked at before. YTD the Prospect Japan fund is up 25 percent in dollars outperforming both the second section and the JASDAQ mid market by about nine percent and over one, three and five years the fund is in the top one percent percentile of all Japan funds.

Ed: My fund is not a small cap fund although I have a lot of small caps in there, in dollar terms we are up this year, but not so much. If you go back to when the fund was launched, the Nikkei index was about 20,000 and now is 9,000, our fund over that period of time has gone up, not a lot but it has gone up. I would say 60 percent of our fund is now in small caps. One-year performance is good to look at, but how you've done in the last three or five years is also important. I'm not really too concerned about how well or how badly I'm doing this year. I'm more concerned about how I will do in the next two, three and five years. So far the market is down over 50 percent and we are up over that period of time, which also puts us in a high percentile. For us to do really well over the long term we have to have a good market, so we are impacted by how the market does, not necessarily this month or this year but how the market does, over the long term. When the market is going up I would expect to outperform by a lot, and when the market is going down, I would hope to match the market or do a bit better. ii

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