Investing Compass: What can we learn from Japan
There has been a lot of investor excitement around Japan. It is the tip of a decades-long story.
Mark LaMonica: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.
So today is going to be the last plug for the conference, so come
Shani Jayamanne: Maybe.
LaMonica: Maybe - I don't know. Come to the conference October 11th and 12th streaming online. 12th is in person in Sydney, so come visit in Sydney and meet Shani.
Jayamanne: And Mark.
LaMonica: There you go.
Join us in-person or digitally on 11-12 October at the Morningstar Investment Conference for Individual Investors. Click here to register today.
Jayamanne: Good pitch alright. So today we're going to talk about Japan
LaMonica: Just the country of Japan.
Jayamanne: Just the country of Japan. But you, you actually visit Japan quite a lot, Mark. So if I gave you 3 words to describe it, how would you describe it?
LaMonica: Well, 3 words is a lot cause I don't have a very good vocabulary.
Jayamanne: Okay did you do school in the US. Is that what it was or?
LaMonica: Wow. So that will make our American listeners happy. So I'm going go with one word. Delicious.
LaMonica: Yeah. So I don't know. It's hard to put in words how good the food is in Japan and all of it. So like the fine dining and some humble little restaurant like, it's just all perfect.
Jayamanne: Okay, so I'm actually going to share your Instagram handle Mark because you share a lot of your food from your travels on, on this Instagram account, including Japan, so it's @marksmovablefeast. So if you can find that, go follow him. He's got 63 followers at the moment so.
LaMonica: Yeah. No, it's crazy. And it's my little, you know, Hemingway, my nod to Hemingway.
Jayamanne: Well, there you go. Alright so we're not going to use 3 words today to talk about Japan, though Mark, we're going to talk about 3 lessons.
LaMonica: Okay well that’s good, well Japan has been a hot topic in the investing community recently. And that’s because there have been stellar returns in the recent past and investors are trying to find any and all ways that they can get exposure to go along for the ride. And one of the reasons we are going to talk about Japan today is because it has lots of lessons for investors.
Jayamanne: And when we talk about Japan, it is a multi-dimensional tale. So, to some investors, it is cautionary. To others, it is about missed opportunities. We’re going to start with a history lesson, Mark so why don’t you take it away?
LaMonica: Alright you know I love history lessons. Well so Japan has a lot of lessons as we talked about. And if we go back and look at Japan’s story, it includes the complete irrationality of an asset bubble. And then we have a crushing downturn. And of course we have a lesson of how corporate governance and culture – so business culture, and how that can impact investors. So all sorts of lessons today.
Jayamanne: Alright so where are we going to start this story?
LaMonica: So we’re going to go back to the early 1980s Shani – when I was young and you did not exist. And that’s when the Japanese asset price bubble starts. So everyone investing in Japan believed that the Nikkei and Japanese land could do no wrong. Between 1985 and 1991, commercial land prices rose 302.9%. In the years between 1986 and 1989, the Nikkei returned 43.85%, 14.58%, 39.86% and 29.04% - it’s a log of numbers. And there was overconsumption, overconfidence and what we soon figured out were overvalued assets.
Jayamanne: And the market peaked at the end of December 1989 when the Nikkei hit a high of 38,917. The asset price bubble burst. What followed was an excruciating tumble that continued until 2009. The consequences of the bubble bursting were severe and drawn out. Japan had next to no economic growth, and low interest rates and inflation. There were several glimmers of hope for a recovery along the way, but the Nikkei was anchored. In the 34 years since, it has never recovered to the high reached in December 1989.
LaMonica: Which is crazy right because people always talk about how the sharemarket bounces back.
LaMonica: 34 years – that’s a long time.
Jayamanne: And we’re still not there.
LaMonica: and 34 years is older than you or longer than you’ve been alive so pretty crazy. And we’ll put a link in the episode notes to some of the charts that Shani has put together on this, but it illustrates the stagnating market that Japan endured for over two decades from when that bubble burst.
Jayamanne: And for many new investors, their first proper experience with a bubble bursting would have been the GFC. It would’ve been experiencing a relatively quick recovery and would have little to no exposure to an event like this that takes decades of recovery.
LaMonica: That’s right Shani. And global investors avoided Japan after the country did not pick themselves up after the collapse. And they saw most Japanese companies had poor balance sheets due to of course this asset price fall and were struggling to strengthen their financial position.
Jayamanne: Basically - many of these companies had been burnt and did not want to take on any business risk so they stagnated.
LaMonica: And part of the rising success of Japanese companies has been attributed to Shinzo Abe’s corporate governance code which was introduced – and he of course was the prime minister – in 2014. It forced companies to act in shareholders’ best interests instead of holding onto subpar assets and hoarding cash. This has helped with profitability, along with improving economic conditions.
Jayamanne: Many global value managers have been touting the attractive buying opportunities in Japan for over a decade, and that includes Morningstar Investment Management. I found an article from 2018 – so not too long ago – and it kind of encapsulated the positive prospects that many value managers were eyeing as regulatory risk decreased.
LaMonica: The article says that they’re willing to take a shot after the corporate governance measures were introduced. And it said, and this was Morningstar’s opinion, that we find Japanese equities looking reasonably attractive with valuations that look encouraging compared to other key markets, even after they’ve accounted for a margin of safety because of the relative risk of Japan. And their, or our – Morningstar’s, main concerns were that there was still some volatility in cash flows, and some concerns that profitability is at a cyclical high – and that was tempering their enthusiasm.
Jayamanne: And Morningstar Senior Portfolio Manager, Bryce Anderson, recalls that the asset management division has had a position in Japan for quite some time. 10 years ago, they started seeing the corporate governance improvements that showed great value with manageable risk.
LaMonica: So let’s start with our first lesson. In the right circumstances, being contrarian can reap rewards for you as an investor. In the last 10 years, the Nikkei has outperformed the ASX/200. If you had invested $100,000 in July of 2008, and $1,000 every month from there, you would have close to $450,000 from the Nikkei 225. You’d have $320,000 from the ASX.
Jayamanne: It’s uncontroversial to say that taking an outsized position in Japan in the 20 years following 1989 would have made you a contrarian. Being contrarian is hard because you lose the validation that comes from traveling with the herd. You want that validation as an investor, especially as investing your hard-earned money is an inherently emotional endeavour.
LaMonica: Contrarian investors can be rewarded handsomely. The secret to investing is not to follow the crowd but to anticipate where the crowd is going next. And if that sounds hard, it is because it is hard.
Jayamanne: Being a contrarian investor is at the heart of value investing. It means investing in unloved assets that the crowd is straying away from. There is no better description of Japanese assets during the last two decades.
LaMonica: And purchasing assets at lower prices means that there is greater potential for returns, and therefore less risk that the investor is taking on. This of course, works out well if the asset in question is a quality asset. This was the issue with Japan.
Jayamanne: There were regulatory and market risks impacting these companies. These risks lead to uncertainty of cash flows. Some companies are riskier than others. Take for example two vastly different companies.
LaMonica: We don’t know – or at least I don’t know, maybe Shani knows – how much Coca-Cola is going to make next year. We can state a few statements with certainty. Coca-Cola isn’t going to double its sales next year. Their sales next year also aren’t going to fall by half. They aren’t going to go out of business. They are a mature company that is in good financial shape.
Jayamanne: Alright, we’re going to move onto the next lesson Shani. let’s look at the next company and that is a mining company in WA. They’ve purchased land that may or may not have lithium. They have some funding and no sales – there’s nothing to sell yet. They need to dig something up in the next year to sell or they will run out of money. Their cash flows may be zero and they may go out of business- or they might strike the motherload and make a fortune. The point is that their cash flows are more uncertain, so investors need to account for this by having a bigger margin.
LaMonica: Alright our next lesson is understanding risk and reward. And part of understanding the risk and reward is understanding the full spectrum of risks that impact the company. A like for like investment in an Australian company would not carry the same risk as one in Japan over that period.
Jayamanne: Putting aside the corporate regulation risk and the poor balance sheets, there were issues with transparency. Until relatively recently, Japanese companies had a cloak of invisibility to their company results and records that are not afforded to listed companies in most of the developed world. It was difficult for investors to understand the true positions of these companies. This was particularly difficult for foreign investors as there was no stipulations for the language of the public reporting – they were often in Japanese.
LaMonica: So one of the keys to successful investing is understanding what you are investing in. This not only allows you to understand whether an asset is right for your portfolio and for your financial goals, but it also prevents poor investor behaviour as you have confidence in your investments.
Jayamanne: And this wasn’t possible until reforms to corporate governance and stock market operations changed the landscape of Japanese companies and equity markets to become investor friendly.
LaMonica: We mentioned some figures around the success of investing in Japanese equities across 20 years. investors were rewarded for the risk that they took on for Japan in money weighted returns, especially compared to domestic equities. Now that these assets have appreciated, they have become less attractive for the risk that they carry. And asset managers like Morningstar Investment Management have trimmed their position. So Bryce Anderson, he’s the portfolio manager we were talking about earlier, adds that after the investor excitement, valuations have become less attractive, and we’ve reduced our exposure to Japan.
Jayamanne: Lesson 3 is that you don’t have to pledge to a single church. And there are many investing churches. Value vs growth. Active vs passive. Technical vs fundamental. Dollar-cost averaging vs lump sum. And we could go on and on, but this lesson is about the push and pull between strategic and tactical asset allocation.
LaMonica: Strategic asset allocation is your long-term asset allocation target. That is the process of defining your goal, calculating your required rate of return and then figuring out how to allocate assets to get that return. So you may decide that you need 90% growth assets and 10% cash to achieve your goal. Part of the 90% growth would be an allocation to international equities, and part of this international equities exposure would be to Japan. Meanwhile a tactical asset allocation may be a short-term deviation from this strategic asset allocation that you make based on market conditions. This would be increasing your exposure to Japan because you believe in the prospects for the region, and/or that it is currently undervalued.
Jayamanne: Making a tactical asset allocation decision should not be done lightly because regardless of the rationale, this is market timing. However, investors can take advantage of undervalued opportunities given the circumstances – they have liquidity, they are not deviating too far from their strategic asset allocation, and they have the time horizon required for the investments that they are investing in.
In many cases a tactical allocation decision involves cash. An average investor is probably not going to move 2% of their portfolio from listed property to infrastructure because they see some anomaly in the relative positioning of those two asset classes. Similarly, an Aussie investor’s international exposure is not likely to be invested by individual geography, and they have the ability to pick and choose between weighting these exposures. It’s more likely somebody might invest extra cash in shares or broad-based ETFs if they see an opportunity or build up a bit of cash if they don’t see opportunities.
LaMonica: As an investor, this is an underrated aspect of cash. Having some cash in your portfolio allows you to take advantage of opportunities. Just like having an emergency fund ensures you don’t have to sell shares when you don’t want to, having some cash in your portfolio means that you can buy shares when they are on sale. This is an investing lesson within itself.
Jayamanne: So where do we see unloved assets now? Well, you’re able to find this at any time you want on Morningstar.com.au’s market section. Did you like that plug?
LaMonica: I did, I did. And I would like to add that I feel like an unloved asset sometimes unrecognised asset, maybe that's a better way to describe it. But Morningstar’s Fair Value estimate helps investors understand whether a stock, or a market, is undervalued. When looking at markets, it takes the fair value of our overall coverage to provide investors with a bottom-up value. This helps them see past the current market price. We currently see domestic and US markets close to fairly valued. Asian markets such as Singapore and China appear undervalued. Fair Value estimates also indicate opportunities in some European markets including the UK and Italy.
Jayamanne: Warren Buffett said investing is simple, not easy. The simplicity comes from acquiring quality assets at a cheap price. The not easy comes in when you have to determine what is a quality asset, the value, its price and its future prospects. Having uncertainty in one’s portfolio is inevitable when investing in equity markets. Investors can utilise margins of safety to protect themselves when taking advantage of opportunities.
LaMonica: All right. So we hope you enjoyed our lesson on Japan and it wasn't so much a whole podcast on Japan, as using Japan as an example to try to help people make better investment decisions going forward. And if anyone has not been to Japan and likes to eat, that is a great investment as well.