- We started to invest in Japanese trading companies 15 years ago and have seen them evolve into diversified operating companies
- Warren Buffett’s Berkshire Hathaway has increased its stakes in Japan’s five biggest trading houses, and he now owns 7.4% of each company
- Against this backdrop we remain excited about the opportunity set of inexpensive quality businesses in Japan
Warren Buffett’s Berkshire Hathaway has increased its stakes in Japan’s five biggest trading houses, and he now owns 7.4% of each company. Buffet also indicated that he could continue to expand these investments – potentially raising the stakes to 9.9%. The trading houses, or “Sogo Shoshas” as they are locally known1, are Itochu, Marubeni, Mitsubishi, Mitsui & Co, and Sumitomo and are some of Japan’s oldest and biggest companies, each holding investments in a variety of industries.
Hathaway’s move means Japan is now the second largest bet in its portfolio of publicly listed companies. So, should other investors take note?
A decade-long bet for us
We started to invest in Japanese trading companies almost 15 years ago in portfolios and have witnessed their business models evolve from low value-added intermediaries for merchants to exchange goods, to diversified operating companies like Berkshire Hathaway. The business model is unique and hard to replicate given the breadth and depth of expertise within each business they operate.
Itochu2 is one of the biggest trading houses and the longest tenures in our portfolios, and thanks to our decade-long investment we have a great relationships with the management team. Itochu is uniquely positioned to create value through a business model which is deeply entrenched across supply chains in industries such as textiles, machinery, food, IT and financials. Many foreign investors have looked past the opportunity to invest in Japan’s conglomerates, while the term “trading company” has often been misunderstood. This has created an exploitable perception gap. The trading companies have been attractively valued to-date relative to various metrics such as assets, earnings and cash flow, while they have been buying back their shares and paying high dividends. As long-term investors we like the idea of the number of shares going down because the percentage of our stake in the company rises without making an incremental investment.
More to come
Japanese equities remain cheap. Approximately half of the 3,800 listed Japanese companies are trading below 1x book value versus around 5% in the US3.
Given this backdrop, the Tokyo Stock Exchange (TSE) has explicitly requested companies to seriously consider the cost of capital and their share price. They also mandated the requirement to disclose certain information to investors to close the deep valuation discount associated with a misallocation of capital.
Japan’s financial regulator, the FSA, also plans to formulate an action plan for listed companies with low valuations calling for reforms to improve corporate value4. It holds on to the remaining 0.5% as increased revenues.
The effects of bad debts
However, as the cost-of-living crisis continues to bite, bad debts are sure to rise among consumers. UK households in aggregate built up savings buffers throughout the Covid crisis when they were unable to go out and spend money how they normally might5. In addition, year ahead wage growth averaged at a high pace of 5.7% in February6. Our research suggests that while this is a hard time for UK households, most have enough wiggle room in their budgets to make them stretch – provided the breadwinners in the family remain employed. Once unemployment kicks in, however, it becomes much more difficult to pay the bills. Unemployment is therefore the primary input into banks’ forward-looking assessments of credit losses.
We examined what the impact might be of these two opposing forces – improving earnings and rising bad debt – on bank profits and capital. Our data science team took our analyst models and aggregated them up to the system level. We predicted how much net interest income could grow as rates rise and how much the bad debt charge (cost of risk) could increase as unemployment rises. We were then able to calculate what sector level profitability (ROE: return on equity) and capitalisation (Core Tier 1) would be at each interest rate and unemployment rate (Figures 1 and 2 respectively).
This is clearly a wake-up call for those companies who have earned lower returns versus their cost of capital, or whose price-to-book valuation has been persistently below 1x. Why is this important? As a result of these plans, companies will put excess cash to work by raising dividends, share buybacks or accretive mergers and acquisitions. This in turn would result in an increase in their return on equity and the valuation discount should be narrowed.
Against the backdrop of Buffet raising his stakes, we remain excited about the opportunity set of inexpensive quality businesses in Japan.
