A reader recently emailed me regarding a potential investment in a Japanese microcap stock, which set me thinking about Japanese stocks in general. Japanese stocks are really cheap right now. There are many Japanese stocks trading below book value. In fact, some stocks are trading below even the value of cash on their book. Yet Japanese stocks have been trading at depressed levels for close to a decade now, and show no signs of reviving. In a normal stock market, corporate raiders would have long ago taken over these companies and dismantled them for a profit. The problem, of course, is that the Japanese stock market, and indeed Japanese society itself, does not function normally. Foreign hedge funds have tried to shake up Japanese companies, but have been stymied by the Japanese courts. Basically, Japanese companies are not run for the benefit of their owners, but for their employees. In addition to the notoriously shareholder-unfriendly courts, the rapidly aging Japanese population and shrinking economy also puts a damper on valuations. And finally, interest rates have been scraping the bottom of the barrel for a decade now, and companies see no reason to turn to the stock market for capital when loans are so easily available. So really, there is no downside to treating shareholders like dirt.
Can all these obstacles be overcome? In my opinion, yes, but the timing will be tricky. The key to understanding the timing issue is to realize that the root of the Japanese problem is the generational struggle that is currently occurring. In short, Japanese society is run primarily for the elderly. The Japanese culture intrinsically respects the old, the old dominate leadership positions, and increasingly, the old are beginning to outnumber the young. Therefore, it is no surprise that Japanese society enacts policies that favors the old. Despite the demographic problems, the Japanese currency has been a safe haven for investors, because a hard currency favors the old. The Japanese yen has been flirting with deflation for a decade now, and young Japanese employees are used to seeing their wages go down every year rather than up, but this situation is perfectly acceptable to Japanese retirees, who see their expenditures go down while their savings stay up. Bonds are sacrosanct to the elderly, of course, and to protect bonds, companies will happily soak equity holders to keep cash on the books to preserve their credit ratings. Sometimes, of course, a Japanese company is just so badly run that the cash flow that supports the bonds becomes threatened. Nissan faced just this scenario in 1999, and a large foreign investor in the form of Renault had to be brought in. Renault took a controlling stake in Nissan, and its CEO Carlos Ghosn undertook a brutal cost-cutting campaign, laying off many young workers, while paying back its bonds in full within two years, and becoming that rare example of a foreign investor successfully taking over a Japanese company.
Demographic destiny cannot be denied, but it can be delayed. Currently, with the global financial crisis in full swing, Japanese bonds are in demand, and Japanese stocks are likely to continue to languish. It’ll take a sustained bout of inflation to wean the public off Japanese bonds. And when that happens, the pendulum will finally swing in the direction of the equity holders. Demographic trends move incredibly slowly, so I’m not about to invest in Japanese stock for now. But I am keeping an eye out for distressed Japanese companies, aiming to take a stake shorted after a foreign investor has gained a controlling stake.
