Where Value Funds Are Dabbling in Japan
(Clarification: A quote by fund manager Taizo Ishida in this story implies that all hospitals in Japan are in need of renovation. Many are in need of renovation, he says, not all.)
Japan is the market everyone loves to hate, with good reason. Since the Nikkei stock market index peaked in December 1989 it has lost 75 percent of its value, dropping sharply at first and then drifting aimlessly. The country has an aging population and a massive budget deficit. With its tsunami and nuclear meltdown and its tumultuous political scene, the picture just gets darker.
To assume every Japanese stock is worthless, however, is foolhardy. In fact, value fund managers like Jeremy Grantham at GMO, Charles de Vaulx at IVA Funds and Kimball Brooker at First Eagle argue that Japan may be one of the few places to find bargains. “There’s a perception that Japan is a graveyard and will continue to be that way,” says Brooker, co-manager of the $11.4 billion First Eagle Overseas Fund. “One has to separate the market from its components. Not every business in Japan is a bad business.” Japan has become so cheap that even some companies with strong earnings growth fall into the value manager's net.
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One business Brooker particularly likes is Secom, a security company that controls 60 percent of the Japanese alarm system market. More of the country's aging population wants security systems not only to protect assets but to help notify hospitals and health-care professionals if there's a problem. Secom, Brooker's third-largest equity holding, trades for seven times the company's cash flow, less than half the 17 price-to-cash-flow ratio of U.S. security systems company ADT, he says. The manager also likes the fact that Secom had a 23 percent profit margin in the past year, has a 2.3 percent dividend yield and has a "pristine" balance sheet.
The graying of Japan is an investment theme that Taizo Ishida, of the $99 million Matthews Japan Fund, is also interested in. He's buying shares of Ship Healthcare, the largest Japanese design consultant to hospitals renovating buildings and upgrading medical equipment. Ishida says there are about 8,000 hospitals, that need renovation in Japan, many of them 40 or 50 years old. The company has seen earnings grow about 20 percent a year over the last five years and has a price-earnings ratio of 11.4.
A more obvious value play is in multinationals such as Komatsu, says Lei Wang of the $27 billion Thornburg International Value Fund. Komatsu is one of the top heavy equipment manufacturers in the world; Wang compares it to Caterpillar in the U.S. He values its exposure to China and other Asian countries, since he expects the region to have massive infrastructure investments in the future. Wang also likes how he can buy the stock at a price-to-book ratio of 2.2, compared with Caterpillar’s 3.5, even though he thinks Komatsu’s Asian exposure gives it better growth prospects.
Whatever industry a bargain is in, investors need to consider currency issues. The yen has risen 26 percent against the dollar in the last five years, making Japanese-made goods more expensive in the U.S. and hurting Japanese competitiveness.
The newly elected Liberal Democratic Party plans to use aggressive monetary and fiscal policy to stimulate the economy, which could lead to a weaker yen. That would be great for the export sector, says Ned Gray, manager of the Delaware International Value Fund, which has 18 percent of its assets in Japan. He notes that the first round of yen devaluation in November brought "very dramatic" increases in auto and technology stocks.
A weaker yen would hurt investments in dollar terms, though, unless the currency risk is hedged. As the yen falls against the dollar, those dollars that were converted into yen to buy Japanese stocks fall with it. If you sell that stock, your yen will be converted back into dollars at a higher price, which cuts into returns.
First Eagle's Brooker, whose fund has 28 percent of its assets in Japan, hedges yen exposure for just that reason. Others, such as Delaware’s Gray, remain unhedged. Gray holds stocks that already benefit from a weaker yen, such as Toyota, and doesn't want to make currency bets. Just two exchange-traded funds, the $651 million WisdomTree Japan Hedged Equity and the $4.8 million DBX MSCI Japan Currency Hedged Equity Fund, eliminate yen exposure.
Anyone venturing into Japan must have a long time horizon. Brooker and other value investors are by definition patient. The First Eagle Overseas Fund has a turnover ratio of 12 percent, which indicates that it has an average holding period of eight years. Some bargains can stay on sale a long time before the market takes notice of them.
(Lewis Braham is a freelance writer based in Pittsburgh.)
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