Japan – Low ROE, But Low Cost of Capital

[JEast]

I have been studying the ‘lost decade’ of Japan for the last several years and its potential implications it may have for us in North America. As such, I just returned from a trip in Northern Japan. The trip was mostly a holiday excursion, which was wonderful, but did spend some time on the research front trying to understand the deflationary aspects of the culture as it now stands. My view, (though cursory), somewhat backs up the conventional wisdom that the country is indeed getting older. This is implied by the contrast of my touring South America extensively with that of Japan. In South America, there are children and babies almost everywhere you go. In contrast, the babies and small children I saw in Japan were far and few in between in over 8ookm of back road touring of many cities, restaurants, and just normal observation.

 

With that introduction, many shy away from Japanese stocks and for good reasons over the last 20+ years. However, even if Japanese companies have low ROE, they also have a very low cost of capital. Is this not like just having a simple carry trade, except that it is a company versus a Goldman Sachs currency trade?

 

As I indicated in an earlier post, I had the opportunity to discuss very briefly the Toyota Industries investment by Third Avenue Funds with Marty Whitman back last year in 2009. I asked him at that time if Toyota Industries was not a value trap. His response, to paraphrase, was that as long as the balance sheet was strong and it was cheap, there is no such thing as a value trap. As the fallout from the Toyota Motors recall tainted Toyota Industries, I pulled the trigger as Toyota Industries fell below $2500¥ since my analysis indicated that a conservative book value was roughly $3700¥. In addition, I like the fork truck aspect which nearly 40% of the business.

 

?? Can one make money with a low ROE, if the cost of capital is low.

?? Are all of us value folks delusional and Japan is indeed a value trap.

 

 

Cheers

JEast

 

[Myth465]

My only issue with Japan is the lack of catalyst. Its been cheap for 10+ years. Time value of money worries me especially as a small investor. If I was Whitman I would feel a bit better about it because he has the capital to create a catalyst, but Japan doesnt really have great governance either. I prefer safe cheap plays such as HRP-D or SSW (thanks for the HRP recommendations, I didnt get into the SSW) and dirt cheap deep value stocks such as ATSG, or SFK Pulp.

 

[Parsad]

James, Japanese corporations have terrific balance sheets, and in and of themselves are very cheap.  But in the context of the future likelihood of a devaluing yen, any investment in those companies would be compromised.  I cannot see how the yen will not eventually collapse with any significant rise in interest rates.  Cheers!

[JEast]

One would have to agree when investing globally that you are also taking a currency position. As such, there has been much work done on whether to hedge, or not, (See Tweedy, Browne Company comments) ,and in general, if you are long-term (3+ years) then hedging costs you.

 

Also with respect to a Japanese currency devaluation, one has to ask the obvious question of a possible devaluation compared to what? Many are saying the same for the US currency, yet it is now rebounding. Given the amount of reserves that the BOJ has, and that domestically they can fund their own debt, I find it a higher probability that the Yen does not devalue against especially the Euro, or the US dollar, which I am based in. However, if you are 'Loonie' centric, then maybe you have cause for concern.

 

Rates may indeed increase at some point in Japan, but I am currently not buying Doug Kass' thesis even given the aging population and a high Debt/GDP. I will give him the benefit that he is smarter and has more resources than I, and that he will probably make money on shorting the debt. However, we are talking specific companies here and the ingenuity that their management and employees have, or do not have. Would you not think that management is also aware of the possibility of a deflation?

 

 

Cheers

James

[Parsad]

In regards to reserves, Japan can sustain their debt to GDP levels for some time through domestic savings, but at some point they will not be able to.  Especially in light of their underfunded retirement system, interest payments if rates rise, and a rapidly aging population.  Not sustainable.

 

You are correct on the management of a corporation though.  If management is astute enough to understand what is happening, and is equally gifted in hedging for it, then you are ok...but that would be a rare gem.  Cheers!

[Rabbitisrich]

I'm not savvy on Japan's economy, but if cost of capital is below the returns on incremental capital, then shouldn't ROE actually be quite high? Allocators should borrow until the incremental ROA matches cost of capital, in which case we would see companies with fairly high leverage earning decent amounts on equity.

 

If, as you say, ROE has suffered despite a low cost of capital, then there are either serious impediments to efficient allocation, or there just aren't that many good opportunities.

 

 

EDIT: My mistake, I see that you are referring to a carry trade. If you can hedge out currency risk, rollover risk, you can get non-recourse debt and you have the resources to ignore volatility, then why not?

 

 

[SharperDingaan]

 

Your premise is borrow in Japan AND invest in Japan. If you bought somebody with not much more than a high % of the domestic Japanese health care market, this might make sense (growth from the population ageing), but its a very narrow segment. Its really borrow in Japan AND invest OUTSIDE of Japan.

 

Not said, but fairly obvious, is that fewer goods will actually be made in Japan over time - as there just isn't the workforce. As Japan still needs to import, what goods are made locally must become increasingly higher value, & the competition around those goods is a lot fiercer (Germany). If you continually run your BOP down, your currency must eventually devalue.

 

To hedge the Japan specific risk you really want higher growth (or its not worthwhile), a currency more likely to appreciate vs depreciate (MOS), and to be long in something material/significant that Japan doesn't have (MOS). Borrow in Yen & buy a significant Cdn oil/gas producer to hold over the long term; makes a whole lot of sense. A trade that some folks (JCS Lau/Husky Energy) have been doing for a very long time.

 

SD

[JEast]

Its really borrow in Japan AND invest OUTSIDE of Japan.

Yes, and reason for the original carry trade reference for many Japanese companies.

 

I am not attempting to 'sell' anyone on the Toyota Industries idea, just using this example in an attempt to 'invert' my thoughts about a company specific carry trade idea with low costs of capital.

 

Of specific interest to Toyota Industries though, Toyota Material Handling Corporation is the #1 market leader for fork lift sales in North America with Toyota and Raymond. In addition, with BT Industries and others, they have about a 20% world market share.

 

I suspect the key question is whether one believes the planet with drive more cars and/or produce more 'stuff' over the next 5-10 years. If the answer is yes, then this would answer the question why Toyota Industries is now building a plant in Brazil in partnership with Denso Corporation. So if your revenue is truly global like many mulit-national companies, will your local currency valuation help or hurt your company. Is anyone willing to take a position that the Yen will depreciated before the Euro in the next 3 years?

 

 

Cheers

James