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Are you willing to pay a substantial amount to have schools reopen tomorrow? I would gladly give you my investment portfolio. I daydream about quiet office spaces without children disrupting the atmosphere. The long summer vacation is taking a toll on remote work.
It has been four weeks since I wrote about selling US equities, and three weeks since I suggested that if I am bearish on the largest market in the world, it would be logical to abandon my other stocks as well. However, I decided to retain my Asia ex-Japan fund. Now, let’s shift our focus to Japan. Hopefully, unlike me, you are not dealing with constant tantrums, and you may have noticed that the country reported robust second-quarter growth figures on Wednesday, exceeding economists’ predictions by doubling the anticipated rate.
One might think this is a positive development, right? Although the weak yen and the recovery of car exports contributed to the impressive number, it is crucial to note that Japanese corporate earnings are highly affected by output growth, with nearly double the sensitivity compared to US companies. So yes, these figures have a beneficial impact.
However, I am not the best person to seek advice from. If you believe in behavioral biases when it comes to finance, nothing has distorted my perception of the world more than managing pure Japanese equity portfolios from 1995 to 2000. It was a period of devastation for me and my former team. While our colleagues in US equities or fixed income retired long ago, we found ourselves in completely different professions, such as teaching, landscaping, or journalism. Nowhere else have I witnessed such a destruction in value, careers, and aspirations.
So why have I allocated 11% of my pension fund to a Vanguard FTSE Japan ETF? Perhaps I cannot let go of Japan because it still intrigues me. Or maybe I am trying to compensate for the losses my clients incurred years ago by assuming recent gains will continue. Valuation also plays a role in my decision. Despite the fact that Japan has disillusioned more astute investors than myself, the main Topix index remains approximately 20% cheaper than other developed markets when considering earnings. This discount is likely even more significant due to the stricter depreciation practices in Japanese accounting.
In fact, the latter can create significant distortions, especially when comparing to US companies that tend to overstate their profits. For global comparisons, I recommend focusing on cash flows, which are calculated before depreciation.
The price-to-cash flow ratio for the Topix index is currently around 10 times, making it up to a third cheaper than the S&P 500. For those seeking absolute returns, this is also significantly lower than at the beginning of 2021.
Personally, I am less concerned about price-to-book ratios than the average investor who is infatuated with Japan. These ratios are remarkably low, with half of all companies in the Topix trading below one. Similarly, approximately half of these companies have more net cash than liabilities.
However, this ratio is irrelevant when considered collectively. I hold a similar view regarding European banks, some of which have also had price-to-book ratios hovering around one throughout the years. In theory, you could sell their assets and generate profits. Nevertheless, if everyone were to do the same, prices would plummet, bringing down book values with them.
Therefore, buying Japan solely based on this ratio makes sense only if you anticipate a renaissance in profits. According to financial theory, shares should only trade at a price-to-book ratio below one if investors believe that returns on equity will remain lower than the cost of equity capital.
Indeed, I initially bought my Japan fund in anticipation of an earnings recovery, as did many others, including Warren Buffett, who took a gamble on it in recent years. However, the Topix index has already priced in a significant rebound in profitability, reaching multi-decade highs.
Can this upward trend continue? How would Japan fare if US shares experience a downturn? I began examining the obvious numbers—an easy yet tedious task that AI should be capable of performing effectively—and discovered that someone has already done it for me.
Hooray! More time to wipe ice cream off my son’s face. UBS analysts, including James Malcolm, a former colleague whose wisdom on Japan I can vouch for, analyzed three-month returns of Japanese stocks under various S&P 500 scenarios going back to 1990.
Past performance does not guarantee future results, blah blah. However, there were no instances where the Topix index rose while US shares declined by more than 8%. Moreover, Japanese stocks only yielded positive returns less than 25% of the time when the S&P 500 experienced even the slightest decline. On a relative basis, Japan underperformed the US more than half the time under such circumstances. However, when compared to European equities, the Topix outperformed them in roughly two-thirds of the periods when they both declined.
Now you see why my ex-colleagues and I lost our sanity? However, UBS delves deeper and offers a glimmer of hope. The periods in which Japanese equities did produce positive returns despite weak global stocks (2005-06 and 2012-16) remarkably resemble the current situation, with elevated inflation expectations and profits.
Unfortunately, this is as optimistic as it gets. Furthermore, my ETF has declined by 5% since late July, which is another reason for me to hold onto it. Additionally, a close friend who recently returned from Tokyo described it as vibrant and bustling.
These are straws I’m grasping at. There are other reasons to consider investing in Japan, of course. However, as I mentioned earlier, you would be better off seeking advice from anyone but me on this matter. I am too emotionally involved and scarred.
The author, Stuart Kirk, is a former portfolio manager. Contact: [email protected]; Twitter: @stuartkirk__
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