I still remember sitting in one of my first ever investment presentations, a naive young buck, in Trinity College in the early 2000s.
The guy had a compelling pitch. At least to my ears.
Japan is cheap, he said. It’s so cheap it can’t get any cheaper. Ergo, it has to get more expensive. Buy Japanese stocks!
I was sold. The guy had charts and everything. Japan really was much cheaper than every other developed market. That didn’t seem right. Surely the valuations would converge somehow. Then I’d be rich!
The trade didn’t work out. I got bored of waiting and sold for a small gain a couple years later.
Okay, so my investing wasn’t terribly sophisticated back then. But I wasn’t alone. At City trading desks Japan was known as the “widowmaker” trade for much of the 1990s and 2000s.
The pros made the same mistake as me: they assumed prices couldn’t get any lower in Japan. They assumed consumer goods prices, or stocks, or interest rates, would have to rise.
For arcane reasons to do with central bank policy , Japan never did turn the corner. (Well, it did eventually. But long after all those traders / student investors got bored and / or fired.)
That’s the thing about value investing. It’s easy to buy cheap stuff. It’s hard to buy cheap stuff just before something happens which causes the price to rise.
Happily for us, we don’t have to worry about that. The “thing” has already happened. Abenomics, money printing, and reforms has kicked Japan into a higher gear. Stock valuations are just starting to move.
So today I want to look at Japanese stock valuations more closely. How much have they risen? How do they compare with other countries? Is there still value there?
A long grind downwards
First thing’s first — how have Japanese stock market valuations changed over time?
(I’m just going to focus on the price to earnings ratio for now, to give a sense of the overall trend. Later on, I’ll look at different valuations metrics.)
If we go way back to the 1980s and early 90s, Japanese stocks were incredibly expensive. In 1989, they made up 30% of the combined value of all companies on the planet. According to Blackrock, an asset manager, valuations peaked in 1994, at around 70 times earnings.
The green line on the chart below shows the forward p/e ratio for Japanese stocks. The blue line shows how Japanese stocks performed.
Japanese stocks vs Japanese stock valuations, 1990 to 2017:
Look at how long the time scale is here — nearly 30 years! What a sickener for Japanese equity investors.
In 2005 the valuation level hit 15 times earnings, and hasn’t moved much since then. A long grind downwards.
Cheaper than ever
So Japanese stocks’ valuations fell a lot between 1990 and today. That tells you something.
But how can you say what counts as cheap and expensive? To get a sense of that you need to compare Japanese valuations to other countries’ valuations.
Matthew Klein of the FT has looked at the enterprise value to EBITDA (EV/EBITDA) ratio of Japanese vs US stocks.
(EV/EBITDA is a variant of the p/e ratio. Like the p/e ratio it shows companies’ “market price” relative to their earnings. The difference is that it incorporates companies’ debt obligations, as well as outstanding shares, into their “market price”.)
Klein looked at the period from 2013 to the present day. He found there had been a big swing in the valuations of the two markets.
In 2013, Japanese stocks were 60% more expensive than American ones. Today though, they have switched places.
Right now, Japanese stocks trade on an EV/EBITDA ratio of 8.4, which is 51% cheaper than the ratio in the US.
This summer Morgan Stanley looked at the forward p/e of the Japanese market relative to the MSCI World Index, which is a basket of the world’s biggest companies. It found that the Japanese market’s valuation is near an all-time low compared to the rest of the world’s.
What about the big market selloff at the beginning of this week? The Nikkei is down 9% from its high at the end of January and the S&P is down 8%.
I’d say a couple of things about it. One, it appears to be over, touch wood. Markets have stabilised.
Two, a 5-10% pullback isn’t that unusual in historical context. One look at this pullback on long term charts will tell you that.
Three, it has hit more or less every equity market simultaneously, from Japanese to Europe to the US. Valuations in every major market have fallen by roughly the same amount.
So, my point about the relative cheapness of Japanese stocks stands.
When you start digging around in Japanese stock market valuations, you start to hear a lot about cash piles and corporate governance.
Best practice in corporate governance is to put the shareholders first. In places like the UK and the USA, company management tend to do a good job of looking out for them. They hold back from silly M&A, buy back shares and pay good dividends when there’s spare cash lying around.
One thing they usually do not do is sit on big piles of cash. American and British shareholders don’t stand for that sort of thing. They’ll put pressure on the company and the cash will find its way back to the shareholders one way or another, whether through share buybacks or dividends or what have you.
Japan is different. Japanese companies are happy to hoard big piles of cash, and Japanese shareholders let them get away with it.
Hoarding cash is a habit Japanese companies picked up in the 1990s and 2000s. In 1998 companies’ cash piles were about a quarter of Japan’s GDP, whereas today they’re nearly 70% of it.
Why do they do it? It’s a deflation thing. Through the 1990s and 2000s, the economy was stuck in low gear. Prices were falling rather than rising. And profits were low. In that world, and in that mindset, it made sense to hold onto cash.
This is important because cash piles distort stock market valuations. They make Japanese companies seem more expensive than they really are, because their share price gets inflated by the cash on their balance sheets.
So what I’m saying is — Japanese companies are even cheaper than I’ve shown so far, when you take into account the fact that cash makes up more than 40% of their market caps.
So investing in Japan has been a “widowmaker” trade in the past, but things are looking up now that the economy has gotten a kick. Stocks are cheap relative to history, and relative to other countries. And stocks are even cheaper than they appear, because Japanese companies are sitting on lots of cash.
Like I said earlier, the key is buying cheap assets at the right time.
There are two good reasons why now is the time. The first is the one I’ve written about lately: money printing has breathed new life into Japan’s economy. More people are working, corporate profits are going up, prices are rising.
The other is that Prime Minister Abe is pushing hard to reform how companies are governed. He wants western-style corporate governance. If he succeeds, the huge pile of cash held by Japanese companies will be making its way back to shareholders by way of buybacks and dividends.
Now’s the moment. It’s time to get off the sidelines.