The Siren Call of Japan's Cash Hoarders
Conventional financial wisdom is full of intuitive theories and maxims. These theories often underpin investment strategies. One such theory popular among value investors is an emphasis on “fortress balance sheets.” Many value investors argue that investing in cheap companies with low debt and healthy cash balances can lead to superior returns.
In the past, we have found little evidence to support this intuitive theory. This week we would like to share evidence from the Japanese market reinforcing our skepticism.
Below is the average annual performance above the market median of all Japanese listed companies since 2000 by the cross section of value and leverage.
Figure 1: Return above Market Median, Value (TEV/EBITDA) vs Leverage (Net Debt/TEV) among All Japanese Companies (2000–2016)
Source: Verdad Research, CapitalIQ.
On the top half of the above table, we observe that levered value investing seems to have significantly outperformed value investing with fortress balance sheets in Japan. Firms with high net debt valued below 5x EBITDA returned 8.7% more than those with net cash balances in the same valuation range. This outperformance seems to have been quite persistent, with levered deep value outperforming net-cash deep value in 82% of the last 17 years tested. Why is this so?
One reason is that leverage can amplify returns and is extremely sensitive to purchase multiples, as we have written about many times in the past. Buying expensive leveraged firms at greater than 10x EBITDA can be a bad idea, as we have replicated in US public and private markets.
Another interesting reason for the outperformance of levered value may be unique to the Japanese context: the prevalence of poor capital allocation in that country. As Michael Mauboussin at Credit Suisse has documented, Japanese firms significantly underperform their US and European counterparts in almost all shareholder returns metrics. They return significantly less cash to shareholders in the form of dividends and repurchases and instead tend to hoard cash on the balance sheet.
We have noticed that the more cash heavy a Japanese firm is, the more it tends to continue to direct earnings to the balance sheet rather than to shareholders in the future. Below we show the average percent of revenue that was placed on the balance sheet during the last year for all Japanese equities, broken down by their capital structure.
Figure 2: % Revenue Used to Build Cash among All Japanese Companies
Source: Verdad Research, CapitalIQ. High Cash is < -30% ND/TEV, High Leverage is > 30% ND/TEV
Japanese value firms with fortress balance sheets allocated about two to four times more of their revenue to the balance sheet than leveraged Japanese value firms. “Wasting assets” is a term normally used in bankruptcy and liquidation proceedings of distressed firms in the United States. In Japan, however, the term might instead be more appropriate for the fortress balance sheet firms. We believe leverage is the most reliable strategy for solving the poor capital allocation phenomenon in Japan that so many activist strategies have tried to remedy.
A third reason for the outperformance of levered value in the Japanese context might be the significantly reduced bankruptcy risk in that country. Value investors who prefer fortress balance sheets will often argue that even if cash-heavy companies do not outperform in the average year, they might preserve investor value during bad economic times when leveraged companies are stressed. If this were so, we might expect to see significant underperformance from levered value during the worst years. In Japan, the evidence does not support this expectation. Below is the average annual outperformance above the market median for high-leverage deep value vs net-cash deep value for each year. During the financial crisis (portfolios formed June 2007 and June 2008 below), high-leverage deep value only underperformed in one of those years, and not by much.
Figure 3: Return above Market Median, Net-Cash Deep Value vs High-Leverage Deep Value among All Japanese Companies (2000–2016)
Source: Verdad Research, CapitalIQ. Net Cash is < 0% ND/TEV, High Leverage is > 30% ND/TEV
We cannot understand why value investors continue to prefer fortress balance sheets, especially in a macroeconomic environment with dramatically reduced bankruptcy rates and significantly worse capital allocation such as Japan. To our knowledge, we are the only active value investors who target levered firms in the US and certainly in Japan. We combine leverage with value along with other proven quality indicators and risk-mitigation factors to offer investors a portfolio we believe has the highest odds of outperformance of any active strategy in Japan.