Some (rare) macro investment thinking I've been doing lately has lead me to Japan. From my post early this week I highlighted how Japan is certainly below average when looking at the world markets from a profitability perspective. I will be the first to concede that low profitability may be a non-intuitive place to unearth investment ideas, but in the case of Japan, there may be something interesting lurking underneath the ugly numbers.
Japan has a couple of issues which I believe have really compressed corporate profitability:
1) Historically high valuations - Japan in some ways is still recovering from the massive excesses of the late 80's when the market took complete leave of its senses and bid anything Japanese up to stratospheric levels that would make a .com speculator in 1999 blush. After more than 15 years of property market declines and a >75% routing of the Nikkei, I believe expectations in Japan are about as close to zero as you can get.
2) Broken Regulation - The financial sector in Japan has been operating under a rather buerocratic leadership for some time. With the initial proposal recently by the Japanese Financial Services Agency to derugulate the stock exchanges and to loosen some rules on investment funds, there may be a change in the wind for the economy. Add to that the fact that the Japanese Post is also going to be privatised via a staged IPO process over the next few years and you have a few quiet rumblings that may be the beginning of a trend.
Some interesting statistics about the Japanese market (from S&P):
Net Margin - 4.26% (lowest of any country/market)
Price / Sales - 0.79x (second lowest of any country/market)
Price / Book - 1.68x (third lowest of any country/market)
Return on Equity - 8.69% (third lowest of any country/market)
Based on the above, the argument can be made that the tough, low interest rate enviroment in Japan right now is (rightly) causing the pain. The contrarian in me thinks that the outcome of Japanese economic purgatory continueing for 10 more years is already baked in here. It is reinforced for me when I looked at the Emerging Market statistics and they basically look like the above stats for Japan; just multiplied by 2 or 3x. It wasn't so long ago that Emerging Markets were in purgatory themselves... it is amazing how fast things can change when margins improve quickly (like they have for EM over the last 7 years).
All said, I think that Japan at this time offers several compelling investment traits:
1) Rock bottom expectations
2) Very attractive revenue/book valuations
3) Earnings well below any reasonable trend or mean for a country
4) Positive and changing regulatory environoment
5) Large pent up demand for Japanese citizens savings (both from the Japan Post deregulation as well as the low interest rates in Japan)
Any combination of the above could be a strong catalyst for Japanese shares.
Ok, so let's assume we've made the leap to invest in Japan, the immediate question becomes "what vehicle to use?" Well, given the proliferation of CEF/ETFs these days, we have quite a few options:
1) iShares MSCI Japan Index (EWJ)
2) iShares S&P/TOPIX 150 (ITF)
Both of these two are essentially cap-weighed straight Japanese index funds. The ITF is only the top 150 shares in terms of size, while the EWJ ETF holds nearly 400 stocks.
3) Japan Equity Fund, Inc. (JEQ)
This is a CEF that trades at a slight discount (7%) and has a reasonable expense ratio. However, historical performance has been poor. Perhaps more research would unearth some things here, but at first blush, I'm not interested.
4) Japan Smaller Capitalization Fund, Inc. (JOF)
This is another CEF but with no real discount and fairly high expenses. The portfolio seems actively chosen (not a closet indexer) and historical performance has been good. The high expenses here are a turnoff.
5) SPDR Russell/Nomura Prime Japan (JPP)
This is essentially the same as EWJ.
6) SPDR Russell/Nomura SmallCap Japan (JSC)
This is the small cap Japan ETF. It is market cap weighted and holds roughtly 400 companies.
7) PowerShares FTSE RAFI Japan (PJO)
This is a Japan based fundamentally weighted index based on the RAFI fundamental weighting. There has been a lot of hub-bub recently about fundamental weightings for indices (even though it's been around for 25 years...) and this fund may be a good play for those who view that fundamental weighted indices are the way to go.
8) WisdomTree JP High-Yielding Equity (DNL)
9) WisdomTree JP SmallCap Dividend (DFJ)
10) WisdomTree JP Total Dividend (DXJ)
On the topic of fundamental weights, the WisdomTree funds are similar to RAFI, but their only criteria is raw dividend amount. DNL focuses only on the highest yielding stocks in Japan and is very top heavy (50+% of assets in the top 10 holdings). DFJ is the small cap focused fund and DXJ is the pure overall Japan Dividend weighted fund (all capitalizations, all dividend payers).
My first instinct is to look to the smaller cap funds for Japan exposure as I think any economic improvement will be magnified in that segment of the market (due to the fact that small caps in Japan have lower overall margins than the big caps). Second, I want to own a fund that has lower valuation measure than the overall market by quite a bit.
For JSC I'm seeing that the Price / Book is roughtly 1.3x, and for DFJ I'm seeing it at ~1.15x. The DFJ index has a profit margin of roughly 2.5% shares trade at a price / sales of 0.40x. Both of these ETF shares are rather illiquid, but not to the point of being useless for most investors. The premium/discount on these ETFs is usually well within +/- 1.50%.
At these valuation levels, you have to assume that some component of it is due to the fact that perhaps the DFJ dividend weighting is selecting some non-optimal companies that are perhaps destorying value. Due to the governance issues in Japan, this is a real reason for concern. However, the thing I like about DFJ is that it only owns companies that pay dividends, which *should* eliminate a bit of the most unsavory corporate misdeads. Also, the wide diversification both by issue and by sector should also dampen any potential problem companies.
At this time I don't have a direct position any Japan ETF but I'm leaning toward possibly taking a small position in DFJ on any further weakness.
Cheers,
Ben Hacker
Wednesday, December 26, 2007
Tuesday, December 25, 2007
World Wide Margins: Just Outstanding, or Out of Whack?
A large focus for many professional and amateur investors alike is the determination of the appropriate level of valuation of the stock market. While often times you will hear some folks dismiss this topic as unecessary when hunting for superior individual stocks, I do believe that the discussion should merit at least a modest amount of focus.
Without a rough estimation of what the 'fair value' of a market may be, it (I believe) is speculation to dip too big of a toe into any individual equities that are encompassed by it. A prime example of where this may have gotten an investor into trouble was in 2000 in the US market. Investor enthusiasm for all technology issues distorted the valuation on many names to the point where the aggregate S&P500 was pushing up over 30x earnings. An investor specializing in large US equities, and technology names in particular would have done well to at least contemplate the underlying economic assumptions that a 30x multiple implies about a market.... and then immediately realize the lunacy that was taking place.
More importantly I think, are those investors/speculators who follow a so-called asset allocation investment model where decisions are more driven by overall valuations of an entire market as opposed to individual equities and bonds. These investors may be more keen to understand the level of valuation more, since individual valuations bear no weight on their decisions.
One of the rallying cries that have been made by myself and many other investors for the last few years has been that the aggregate profit margin level for the US stock market on a whole has been ominously high. Meaning simply that the portion of our economic output (GDP) that is flowing to capital (i.e., shareholders) is (too) high, and the portion going to labor is contracted. History has shown this is of significance because this margin level has been very consistently mean-reverting over the years, and the level has averaged to be ~6-7% over many economic cycles.
There are some interesting arguments as to why a rise above the mean may be sustained (it's different this time right?), but the two key ones that I think are relevant are:
1) The entry of additional labor markets from India and China (read: globalization) have shifted the balance of power toward capital for an extended (perhaps permanent) period of time
2) The US market cannot be taken in a vacuum as many high margin businesses with strong brands count toward the US figures but make much of their money abroad
The key conclusion for those who disagree with the above is that the current margin of the US (8.25%) is above trend, and is bound to mean revert. So the P/E of the market, is overstated by ((8.25-7.00)/8.25=) ~15%. Needless to say, if the net earnings of the S&P500 would drop tomorrow by 15%, the market would be lower than it is today.
While this line of reasoning has always resonated with me; it has always rung a bit hollow from the mouths of its vocal proponents because of an obvious omission. I have heard critics and pundits use the mean reverting profit margin argument probably over 100 times to argue that the US market is overvalued... but I've not seen a single article, blog, or speech by someone using the inverse reasoning to argue a bullish case for an asset class. As Charlie Munger says "Invert. Always invert."
It is often stated that the bearish case is easier to deliver because it makes one sound 'smart'. I fully agree that is the case, but I often believe that people are subconsciously effected by that truth. The reason in this case is simple. The reason margins get high is because everything is going right. Productivity is up, GDP is growing, unemployment is down. As a bear, you can always point to the profit margin and say "Be careful, the good times won't always be here..." Maybe some folks think you are an idiot, but you don't lose money by not buying... or better yet you can still be buying, but just voicing caution at the same. This is a prudent course of action.
On the flip side of the coin, you see Japan in its ultimate economic funk, with ~4% margins and you have a few things to wonder about:
a) Either one market has superior characteristics (regulation, ease of capital flow, strong human capital) AND those reasons provide a superior level of profitability at the expense of other companies from other countries.
OR
b) You believe that in the end, companies profit margins will revert to the mean as the global landscape for competition will push all returns to the mean.
So is the US strong because Japan is weak (simplistically speaking)? Or has the US just had a good run that can't last, and Japan has just had a bad run that can't last?
I personally believe that their may be a bit of truth in both, but I want to perform a little data reconstruction to see what the statistics show the market to believe. The following data set is from the S&P / Citigroup Global Indices (from 11/30/2007):
Immediately, you notice a few things:
1) The US isn't even in the 25th percentile in terms of profit margin.
2) The US is on par with the 'world' weighted profit margin (the implication is that the largest components of the index are toward the bottom, and the higher margin countries in this data set tend to be smallish)
3) Emerging Market profit margins are >11%!!!
4) Japan is dead last
5) Peru, Egypt, Hong Kong and Iceland are all up at 20% or above
The astonishing thing to me is that there continue to be people who not only claim that US equities are overvalued (they may be), but many times they are the same people who are advocating that you diversify out of the US and get foreign exposure without bringing up the same basic data point (net margin) with respect to foreign markets. Blind asset allocation won't help us!
I do believe that many educated folks do already understand this, and are acting on this knowledge already. Buffett for instance has made various overtures stating that the US markets are slightly to fairly overvalued... he has even offered up (in the past) his own valuation metric for the US market which is a price/sales ratio of 0.8x+ (and presumably rising based on his comments). By using a price/sales ratio Buffett is implying that there is a normalized profit level for the US market. On other occasions, Buffett has noted that he sees bargains in South Korea which is the second lowest country on the list in terms of margin level. Buffett has also actively made negative comments regarding Japan which implied that he took a long hard look at the companies there and just didn't find anything he liked.
Aside from Buffett though, there are many other who continually beat the 'mean-reverting margin' drum against US equities but don't seem to discuss the topic for any other markets. These pundits appear to have lost their way, or be parroting 3rd party research which they don't fully comprehend.
Of course there can be many explanations for *some* of the data points above (emerging markets tend to have much higher weight to metals / mining / energy companies which are currently generating substantial profits is just one explanation) but suffice to say that I don't ever see the data above shown much less explained. There just seems to be a lack of intellectual honesty about these things. Or perhaps they are just dumbing it down for their audience, i don't know.
I don't mean for this post to provide conclusions on which of these countries is a good place to invest. This list is only a starting point based on one piece of data, but it is instructive to always try to dig to the next level of data to understand what the masses are saying... and more importantly, what the masses are saying that is wrong.
Until next time,
Without a rough estimation of what the 'fair value' of a market may be, it (I believe) is speculation to dip too big of a toe into any individual equities that are encompassed by it. A prime example of where this may have gotten an investor into trouble was in 2000 in the US market. Investor enthusiasm for all technology issues distorted the valuation on many names to the point where the aggregate S&P500 was pushing up over 30x earnings. An investor specializing in large US equities, and technology names in particular would have done well to at least contemplate the underlying economic assumptions that a 30x multiple implies about a market.... and then immediately realize the lunacy that was taking place.
More importantly I think, are those investors/speculators who follow a so-called asset allocation investment model where decisions are more driven by overall valuations of an entire market as opposed to individual equities and bonds. These investors may be more keen to understand the level of valuation more, since individual valuations bear no weight on their decisions.
One of the rallying cries that have been made by myself and many other investors for the last few years has been that the aggregate profit margin level for the US stock market on a whole has been ominously high. Meaning simply that the portion of our economic output (GDP) that is flowing to capital (i.e., shareholders) is (too) high, and the portion going to labor is contracted. History has shown this is of significance because this margin level has been very consistently mean-reverting over the years, and the level has averaged to be ~6-7% over many economic cycles.
There are some interesting arguments as to why a rise above the mean may be sustained (it's different this time right?), but the two key ones that I think are relevant are:
1) The entry of additional labor markets from India and China (read: globalization) have shifted the balance of power toward capital for an extended (perhaps permanent) period of time
2) The US market cannot be taken in a vacuum as many high margin businesses with strong brands count toward the US figures but make much of their money abroad
The key conclusion for those who disagree with the above is that the current margin of the US (8.25%) is above trend, and is bound to mean revert. So the P/E of the market, is overstated by ((8.25-7.00)/8.25=) ~15%. Needless to say, if the net earnings of the S&P500 would drop tomorrow by 15%, the market would be lower than it is today.
While this line of reasoning has always resonated with me; it has always rung a bit hollow from the mouths of its vocal proponents because of an obvious omission. I have heard critics and pundits use the mean reverting profit margin argument probably over 100 times to argue that the US market is overvalued... but I've not seen a single article, blog, or speech by someone using the inverse reasoning to argue a bullish case for an asset class. As Charlie Munger says "Invert. Always invert."
It is often stated that the bearish case is easier to deliver because it makes one sound 'smart'. I fully agree that is the case, but I often believe that people are subconsciously effected by that truth. The reason in this case is simple. The reason margins get high is because everything is going right. Productivity is up, GDP is growing, unemployment is down. As a bear, you can always point to the profit margin and say "Be careful, the good times won't always be here..." Maybe some folks think you are an idiot, but you don't lose money by not buying... or better yet you can still be buying, but just voicing caution at the same. This is a prudent course of action.
On the flip side of the coin, you see Japan in its ultimate economic funk, with ~4% margins and you have a few things to wonder about:
a) Either one market has superior characteristics (regulation, ease of capital flow, strong human capital) AND those reasons provide a superior level of profitability at the expense of other companies from other countries.
OR
b) You believe that in the end, companies profit margins will revert to the mean as the global landscape for competition will push all returns to the mean.
So is the US strong because Japan is weak (simplistically speaking)? Or has the US just had a good run that can't last, and Japan has just had a bad run that can't last?
I personally believe that their may be a bit of truth in both, but I want to perform a little data reconstruction to see what the statistics show the market to believe. The following data set is from the S&P / Citigroup Global Indices (from 11/30/2007):
Immediately, you notice a few things:
1) The US isn't even in the 25th percentile in terms of profit margin.
2) The US is on par with the 'world' weighted profit margin (the implication is that the largest components of the index are toward the bottom, and the higher margin countries in this data set tend to be smallish)
3) Emerging Market profit margins are >11%!!!
4) Japan is dead last
5) Peru, Egypt, Hong Kong and Iceland are all up at 20% or above
The astonishing thing to me is that there continue to be people who not only claim that US equities are overvalued (they may be), but many times they are the same people who are advocating that you diversify out of the US and get foreign exposure without bringing up the same basic data point (net margin) with respect to foreign markets. Blind asset allocation won't help us!
I do believe that many educated folks do already understand this, and are acting on this knowledge already. Buffett for instance has made various overtures stating that the US markets are slightly to fairly overvalued... he has even offered up (in the past) his own valuation metric for the US market which is a price/sales ratio of 0.8x+ (and presumably rising based on his comments). By using a price/sales ratio Buffett is implying that there is a normalized profit level for the US market. On other occasions, Buffett has noted that he sees bargains in South Korea which is the second lowest country on the list in terms of margin level. Buffett has also actively made negative comments regarding Japan which implied that he took a long hard look at the companies there and just didn't find anything he liked.
Aside from Buffett though, there are many other who continually beat the 'mean-reverting margin' drum against US equities but don't seem to discuss the topic for any other markets. These pundits appear to have lost their way, or be parroting 3rd party research which they don't fully comprehend.
Of course there can be many explanations for *some* of the data points above (emerging markets tend to have much higher weight to metals / mining / energy companies which are currently generating substantial profits is just one explanation) but suffice to say that I don't ever see the data above shown much less explained. There just seems to be a lack of intellectual honesty about these things. Or perhaps they are just dumbing it down for their audience, i don't know.
I don't mean for this post to provide conclusions on which of these countries is a good place to invest. This list is only a starting point based on one piece of data, but it is instructive to always try to dig to the next level of data to understand what the masses are saying... and more importantly, what the masses are saying that is wrong.
Until next time,
Introduction
After some thought I decided it might be a good idea to start up a blog. My company site is fairly formal and I felt like it would be nice to have a place where I can jot down ideas that are seperate from the business and have a running record of my thoughts. This blog will be for fun to just throw ideas out there.
I don't imagine that this blog will be super-active in terms of posting, but my goal is to hit this blog with some of my thoughts at least once a week. I think there are some very interesting things happening the financial world these days, so there should be plenty of material for motivation!
With the above said, I think its time to get my nose back to the grind stone and dig up some interesting content and data.
I don't imagine that this blog will be super-active in terms of posting, but my goal is to hit this blog with some of my thoughts at least once a week. I think there are some very interesting things happening the financial world these days, so there should be plenty of material for motivation!
With the above said, I think its time to get my nose back to the grind stone and dig up some interesting content and data.
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