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JAPANESE INVESTMENT PORTFOLIO UPDATE

PREPARED BY: Chris Stanford 

DATE:1/17/24

 

The Japanese economy is witnessing a remarkable resurgence, exemplified by the soaring performance of its cornerstone corporations and the Nikkei index. Since 2020, Mitsubishi has seen an impressive rise of over 100%, while Mitsui’s value has surged by more than 150%. This growth trajectory reached a pinnacle with the Nikkei recently scaling a 34-year high, largely driven by the dynamism of Japanese trading companies. These entities have carved out a niche for themselves, adeptly seizing short-term opportunities across diverse economic sectors. Their agility in navigating the economic landscape has caught the attention of astute investors worldwide.

THE MACRO PICTURE

Japan’s macroeconomic challenges have been well-documented, and they have contributed to the skepticism surrounding the country’s investment potential. A two-decade period of decline, coupled with a series of missteps by the central bank, has led to a perception of stagnation. Moreover, Japan holds the unenviable title of being the highest debt-to-GDP nation globally, with its national debt standing at a staggering 264% of GDP. This key performance indicator has often deterred investors from exploring opportunities within the Japanese market.

 

RECOVERY SIGNALS 

Japan’s economy is showing promising signs of revival, contrasting the underperformance of other Asian economies against Western markets. Economists anticipate a slight moderation in Japan’s real GDP growth, projecting a deceleration to 1.5% in 2024 from 1.9% in 2023. This forecast still places growth above the potential long-term rate of 0.9%. Key drivers for this growth include robust private consumption, supported by wage increases and a one-time tax refund in 2024.

 

CONTRAST TO ASIA MACRO 

In comparison to other Asian economies, Japan’s situation is unique due to its advanced economic status, demographic challenges, and specific policy responses to global economic trends. The broader context of Asian economies shows a region in recovery, but with varying degrees of susceptibility to external shocks and internal challenges.

 

LOOKING BEYOND 

However, it’s crucial to look beyond the macro picture and examine the transformative changes taking place in Japan. The nation has embarked on a journey of reinvention, fueled by technological advancements, policy reforms, and a renewed focus on innovation. While the challenges are evident, so too are the opportunities for growth and revitalization.

MARKET REFORMS

Japan’s recent pivot towards more robust corporate governance structures signifies a strategic evolution in its business ethos, underscoring a commitment to enhance the intrinsic and enduring value of its enterprises. Central to this metamorphosis is the revamped Corporate Governance Code, a cornerstone in Japan’s journey towards aligning with global best practices in corporate stewardship.

 

Elevating Board Autonomy 

A pivotal element of these reforms is the recalibration of board composition within Prime Market listed companies. The mandate now requires that at least one-third of the board comprise independent directors. In certain scenarios, this threshold is elevated to a majority, underscoring a shift towards a governance model that prizes independent oversight. This move is more than a procedural change; it’s a cultural shift towards embracing diverse viewpoints and mitigating the risks of insular decision-making. Japanese companies are known for dictatorial corporate governance practices. This approach strives to mitigate potential conflicts of interest, ensuring that the board’s decisions are aligned with the broader interests of stakeholders.

 

Revitalizing Subsidiary Governance

The reforms extend their reach to the governance of Prime Market listed subsidiaries. These entities are now obliged to either appoint independent directors or establish a special committee dedicated to addressing and resolving potential conflicts of interest with their parent companies. This move is designed to assure minority shareholders that their interests are safeguarded and that corporate decisions are made with a balanced view, prioritizing the subsidiary’s growth and sustainability alongside that of the parent company.

 

Cross-Shareholdings

Another critical aspect of Japan’s corporate governance reformation is the unwinding of cross-shareholding practices. Historically, Japanese firms have maintained cross-shareholdings – holding stocks in their business partners as a gesture of mutual business commitment and stability. This practice, while fostering strong business alliances, has often obscured true company valuations and muddled governance transparency.

The gradual dissolution of these cross-shareholdings is a nod towards clearer, more straightforward corporate governance. It represents a significant step in untangling the complex web of corporate interdependencies, allowing for more accurate assessment of a company’s performance and value. It also heralds a new era of corporate relations in Japan, one that is built more on strategic alignment and performance, rather than historical loyalties.




UPDATE ON OUR HOLDINGS

Japanese corporate giants have been exhibiting robust earnings growth, capturing the attention of discerning investors. A key differentiator setting these firms apart is their conservative management approach, a stark contrast to the often aggressive tactics seen in U.S. companies. Japanese firms are characterized by their long-term strategic planning, creating a fertile ground for investors in pursuit of stable, uncorrelated returns. However, it is crucial to acknowledge that our investment exposure remains measured, as the improved business climate in Japan is not devoid of industry-specific hurdles.

The  Role of Trading Companies

In 2020, our investment focus shifted towards two eminent Japanese trading firms: Mitsubishi ($MUFG) and Mitsui ($MITSY). These entities, central to global commerce, act as intermediaries in international trade, expertly navigating the complexities of buying and selling a diverse array of products across borders, without direct involvement in their manufacturing.

These investments were not merely asset acquisitions but strategic proxies, providing a broader exposure to the fluctuating world of commodities and shipping. The year 2020 witnessed a surge in these sectors, primarily fueled by supply chain disruptions. While our analysis indicated that these upward trends were ephemeral, by the time our investment strategies were formulated, the peak benefits had largely been realized. Nevertheless, Mitsubishi and Mitsui presented an intriguing opportunity. Despite their strong correlation to shipping and commodity prices, their market valuation was disproportionately low, trading at only 6-7 times earnings at the time.

Our Investment Thesis

We previously believed that these trading companies, with their vast data reservoirs and resources, were uniquely positioned to capitalize on market trends. Their agility allows them to dynamically shift focus away from diminishing opportunities. This flexibility is a stark contrast to companies solely dedicated to a single commodity or shipping, which are often shackled by inflexible, long-term costs and cannot pivot as market conditions change.

An additional aspect enhancing the attractiveness of these firms is their dividend yields. When juxtaposed with their equity appreciation, Mitsubishi and Mitsui, both offering dividends at 2.5%, stand out in the market. This yield is particularly appealing in the current economic landscape, providing a balanced blend of income and growth potential.

Strategic Advantages

Mitsubishi and Mitsui are exemplary in their multi-faceted operations, spanning an impressive array of sectors. Their involvement ranges from energy and metals to sophisticated machinery and chemicals. This diversification strategy effectively mitigates risk and maximizes opportunities across various market segments. Their comprehensive global networks offer them an extraordinary advantage, providing insightful market intelligence and expansive access to resources. These conglomerates are more than participants in their respective supply chains; they are pivotal contributors to their stability and efficiency. The agility ingrained in their business models empowers them to nimbly navigate the ever-shifting tides of global market conditions, an attribute that is invaluable in today’s unpredictable economic landscape.

Mitsubishi $MEFG: Mitsubishi is directly involved in the manufacturing process in several industries, including aerospace (including aircraft and rocket manufacturing), automotive (components and engines), shipbuilding, energy (including power generation systems), and machinery.

Mitsui ($MITSY)- Mitsui & Co., Ltd., part of the Mitsui Group, operates more as a general trading company (sogo shosha) and is less directly involved in manufacturing compared to Mitsubishi. Mitsui’s primary role is in trading, investing, and facilitating business operations across various sectors. However, it does have involvement in manufacturing through investments and joint ventures. Mitsui has investments in companies and projects involved in the chemical industry, iron and steel, and other manufacturing sectors, but its role is typically more in the realm of management, investment, and logistics, rather than direct manufacturing.

OVERALL CONCLUSION

As we look ahead, we remain optimistic about the growth prospects of Mitsubishi and Mitsui, the two firms in which we are significantly invested. Our positive outlook for these companies is set against a backdrop of a somewhat less encouraging economic forecast for the broader Asia region. While economists are projecting only moderate growth for the Japanese economy in 2024, we believe that the strategic positioning and diversified operations of these firms position them well to outperform general market trends.

That said, we advise prudence when considering further investments in these entities at their current market valuations. The current pricing of these stocks may not fully reflect the underlying economic uncertainties and the potential for market fluctuations. This caution is particularly pertinent given our limited global exposure outside of the United States, a strategic choice influenced by a variety of factors including the geopolitical landscape and pivotal issues of corporate governance.

 

Japan, as an investment locale, continues to present a complex and nuanced picture. While there are opportunities for growth, particularly in well-established firms like Mitsubishi and Mitsui, the overall investment environment demands careful consideration. Investors should be mindful of the unique challenges posed by the Japanese market, including its distinct corporate culture and economic idiosyncrasies.

In conclusion, while we maintain a watchful and optimistic stance on our current Japanese holdings, we emphasize the need for a balanced and cautious approach in navigating this intricate and evolving investment terrain. As always, our strategy is to balance potential rewards with a clear-eyed assessment of the risks involved, ensuring that our investment decisions are both judicious and well-informed.




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