Fear & Trembling in Japan

This is the first piece in our series on Japan. In this week’s piece, we set out to explore some of the common narratives about Japanese equities through the lens of one of our portfolio companies, Ishihara Sangyo Kaisha (ISK).

Every trade is an agreement driven by a disagreement: The seller thinks the company is worth less than or equal to the agreed upon price while the buyer thinks the company is worth more. Every time a stock changes hands, we see a bet between two people with different expectations. Efficient market theory suggests that this price is the true price, the right price, the price that incorporates all historical information into a Platonic ideal of value. But this view ignores the wide array of reasons why people buy and sell.

In this short essay, we offer five competing analyses of one stock — five rational arguments, based on historical data that provide a perspective on whether it is a good idea or a bad idea to invest in ISK. We could provide a multiplicity of financial models too, with different assumptions about future revenue growth, future margins, and future trading multiples (that would not make for good reading, though) that all come to different conclusions about the stock — all equally rational based on the historical evidence.

The difference among the scenarios isn’t a matter of imperfect knowledge. Everyone has the same set of facts. But the facts can be presented in a variety of different ways to produce a number of different investment theses. And most smart analysts could take any one of these basic hypotheses and develop a convincing position paper or PowerPoint deck supported by even more facts to make the thesis seem rock solid. Social psychologists call this motivated reasoning. Detailed analysis would increase our confidence without adding any predictive accuracy.

The question facing investors is what to do when multiple narratives comport with the available facts. How do we choose among them, how do we evaluate different, potentially valid narratives? In the next few weeks, we will show how rigorous quantitative analysis can help systematically choose between competing narratives - and inform a more systematic, rather than narrative-driven, approach to investing.

Investing is a game of meta-analysis, not analysis. And meta-analysis requires weighing the competing potentially true interpretations and evaluating whether the price of the stock reflects an appropriate humility about the future or too strongly reflects the power of one narrative. The more extreme a valuation, the more confidence the market is expressing in the likelihood of a particular outcome prevailing over competing alternatives.  An abundance of flawed and excessively simplistic negative narratives makes Japan fertile field for the savvy investor.
 

I

ISK, Ltd. manufactures and sells organic and inorganic chemicals in Japan and internationally. It operates through three segments: Inorganic Chemicals, Organic Chemicals, and Other Businesses. ISK, Ltd. was founded in 1920 and is headquartered in Osaka, Japan.

Japanese companies aren’t swayed by the prevailing orthodoxy of American business: All that matters is shareholder return. Japanese corporates balance stability for employees and the community with short-term profitability to maximize sustainable growth. Employees are rarely ever fired and managers tend to be promoted from within. But the same positives that make Japan a great country for employees and managers has made the country’s stock market less than attractive for speculators. The stock market — which has done so much to bolster income inequality in America — has stayed mostly flat, a constant disappointment for the casino capitalists.

And what reason is there for stock market expansion? The economy has been an unmitigated disaster for 20 years. The population is old and getting older, population growth is negative, monetary and fiscal stimulus plans have failed over and over again. Government debt is at 225% of GDP and the deficit is increasing, not decreasing. The currency is volatile, rising and falling at just the wrong times and adding unnecessary risk to the portfolio. Better to stay out of Japan entirely than add unnecessary complication to your portfolio by seeking out exposure to the walking dead economy of this island nation. There’s no reason to even look at individual Japanese names.
 

II

Japanese is full of cheap small-cap stocks. But most of them are value traps. Maybe some Tokyo stock trades at 4x EBITDA today or 0.5x book tomorrow, but let’s be honest: There aren’t any catalysts in sight that are going to make portfolio managers start buying most of these unloved dogs. Every time you think you’ve found a cheap stock in Japan, it gets cheaper. Show me a Japanese stock with a crazy low valuation and I’ll show you a dozen others. Even if you wanted to play the cheap Japanese stock game, do it in a basket and hope for the best. The idea that anyone is going to differentiate between these unloved junk stocks is laughable. For one thing that would require a dramatic increase in Japanese speaking investors, and how many Japanese investors did you meet at HBS?

Take a look at the price chart for one of these types of ultra-cheap, low volume, commodity type Japanese names, ISK. Classic value trap — stock has languished at current levels since 2009. No reason to think it’s going to revalue anytime soon. Not when the Japanese economy is virtually stagnant, Abenomics has basically failed, and there’s so much concern about the Chinese economy stalling. The stock hasn’t moved since 2009, why expect a revaluation now?
 

III

To earn a return above the cost of capital, a company needs some sort of comparative advantage, a monopoly on something that gives the company the ability to extract excess rents. To profitably compound capital, investors need to find great franchises with wide moats that will sustain above-average returns on invested capital over long time periods.

ISK does not meet a single one of these thresholds. The company makes titanium dioxide (Ti02), which isn’t even a particularly complex commodity. There’s not much difference between ISK’s Ti02 and any other company’s Ti02 except price, and price should be driven down to marginal cost. The companies best positioned to compete on price should be in countries with cheap labor and cheap feedstock (e.g., not an island nation with super high wages). There are few profitable reinvestment opportunities in a business tied to GDP growth, when Japanese GDP growth is basically zero. Competitive pressures will further decrease margins, and investor capital will be eroded by an efficient market that has no love for inefficient commodity businesses in high-cost, slow-growth countries. Investors looking for opportunity in Japan should seek out businesses with competitive advantages that trade at reasonable prices, not just jump at a cheap company that deserves to be cheap.
 

IV

ISK is the Exxon Valdez of Japan. In 2006, the Japanese government discovered that it had dumped about 100,000 tons of Feroshilt, a material made from sulfuric acid waste, into reclaimed land in Kameyama over 12 months starting in 2002, despite knowing that it was an industrial waste product that contained such toxins as hexavalent chromium and fluorine. The company put into place a ¥40B reserve (about $400M) to pay for the cleanup, taking out a significant debt load in order to finance this extraordinary cash drag. As the company began investigating this environmental crime, executives uncovered further problems. In September 2007, the company found more illegal dumping of industrial waste. In January 2008, the company announced that it had failed to report emissions violations. And in March 2008 an internal investigation revealed seven further cases of inappropriate activities.

The company may still be alive and publicly traded, but would you really want your money in a company whose corporate culture had led to such a scandal? Japanese investors won’t touch such a bad brand, and stocks need more investors for prices to go up. There are lots of stocks out there to consider, no reason to add one with such a dark past to the list of worthy candidates.
 

V

ISK trades at 4.5x EBITDA with a 45%+ LTM free cash flow yield. The company has significantly reduced outstanding liabilities. In 2013, the company had net debt of ¥66B and a reserve for the environmental cleanup of ¥8B. Today, ISK has only about ¥30B of net debt and has completely finished the cleanup of the environmental scandal. Despite being less leveraged and having paid off all remaining liabilities from the scandal, the stock is down, not up. This is despite a dramatic rally in the equities of other Ti02 producers since the beginning of this year — the result of a massive shuttering of Chinese capacity and the first price increases for Ti02 in years.

Quantitative evidence suggests that buying Japanese companies that trade at these value multiples with this level of leverage relative to enterprise value is an excellent strategy, and ISK is one of the best ranking stocks on these metrics in Japan. Add to that the recovery in the company’s key end-market and the completion of the environmental cleanup and you’ve got two reasons (in addition to a beautiful quantitative profile) why this Japanese leveraged small value stock should provide significantly above-market returns.

ISK is priced like a bankruptcy risk, with the stock price down sharply over the past year. Yet the company’s underlying financial health has improved and there are reasons for optimism about the company’s end-markets. The company has finally put the environmental scandal in the rearview mirror, providing an opportunity for trading multiples to drift closer to international peers that trade at over 10x EBITDA. The company’s debt load acts as a forcing mechanism for management’s capital allocation decisions, meaning no uncertainty about where cash is going to be deployed (a rare case in corporate Japan). While not without risk, there is a high probability that ISK will exceed the extremely low expectations baked into the stock price and that investors will earn a return in excess of the company’s healthy free cash flow yield to equity.