Valuing Japan's Reform
44% of Japanese companies trade at <1x P/B, but they’re almost all microcaps
By: Verdad Research
Early last year, the Tokyo Stock Exchange started its “capital efficiency” initiative by instructing all public companies trading at less than 1x price-to-book (P/B) to publish a reform plan to raise their valuations. While the Exchange later clarified they also wanted other companies to publish improvement plans, the emphasis on these valuation laggards in the plan’s initial rollout was perhaps, in our opinion, because they are the lowest-hanging fruit for boosting Japan’s overall valuations—and the most reformable.
The problem the exchange identified is that Japanese equity valuations are, well, we think embarrassingly low. Today, the median stock in Japan trades at 1.1x P/B. This is less than 25% of the valuation of the S&P 500 index (4.5x P/B).
A whopping 44% of listed companies fall below 1.0x P/B.
We don’t know if this directive will achieve its intended goal. But let’s assume for a moment that the directive is a success and that, magically, on average the roughly half of Japanese companies trading below 1.0x P/B traded up to par. What would the implications be for investors in Japan, and how could we maximize our profits?
Let’s start by looking at how the four Japan ETFs offered by BlackRock, the world’s largest asset manager, could be impacted—a decent case study for understanding how the vast majority of foreign investors in Japan invest in the country.
Below is a chart of the four ETFs along with the size and valuation characteristics of their holdings.
Figure 1: BlackRock Japan ETFs - Size and Valuation Characteristics
Source: Generated using BlackRock published holdings and weights dated 1/19/24. Valuation data from Compustat on the same date. "% Appreciation” is hypothetical and is the weighted average multiple expansion from stocks currently below 1x P/B to 1x P/B while stocks at or above 1x P/B are assumed to appreciate 0%.
Despite 44% of Japanese stocks trading below 1x P/B, these funds seem to have quite limited exposure to these stocks, so the hypothetical price appreciation if value stocks trade up to 1x P/B on average looks quite limited, ranging from 7% to 16%.
Roughly 60-80% of every dollar invested in these vehicles is not in stocks below 1x P/B.
We believe the primary reason for this skew is that the indices these funds track are free-float capitalization-weighted indices and thus focus their dollars on large, liquid stocks. But almost the entirety of the opportunity in Japanese stocks trading at <1x P/B is in small and illiquid stocks. To illustrate this, consider the table below.
Figure 2: Japanese Aggregate Market Cap and Stocks Below 1x P/B
Source: Compustat. Dec 31, 2023. All Japanese stocks >$25M in market capitalization. Excludes REITs and financials.
Now let’s say you wanted to own a portfolio that would nearly double if the reform were successful at getting cheap stocks to trade up to 1x on average. Here’s what that portfolio would look like. You could buy every company at <0.63x book that’s tradable at >$50M in market cap to get a median and weighted-average portfolio multiple of exactly 0.5x.
You’d then own 456 stocks, but the median market cap would be $148M and the median trading volume would be just under $400K, so you’d only be able to put about $200M dollars to work based on the limitation of not underweighting the most thinly traded 25% of that portfolio (underweighting the smallest stocks here would drive up your weighted-average purchase multiple).
This is difficult trading, but it is something that could be achieved by a specialist, in our opinion.
To us, this portfolio of smaller companies makes even more sense in the context of a reform catalyst, given that smaller stocks have systematically lower free floats than the largest stocks in the market. The largest 20% of Japanese value stocks have free floats that average over 80% while smaller value stocks average around 60%. If you are trying to target stocks that are most likely to adopt reforms that will raise their P/B multiple, it could make more sense to weight into and not away from the lower-float stocks (cross-holdings and 1980s-era business tie-ups that reduce company floats are one of the prime targets for reform potential, in our opinion).
Overall, investors who think they are gaining meaningful exposure to this potential catalyst via cap-weighted retail vehicles should be aware of just how little they are actually getting.
There has already been a sharp repricing in the subset of large and liquid stocks that trade at <1x P/B, driving disproportionate relative multiple expansion in one corner of the market in 2023.
Within deep-value stocks at the start of 2023 (<0.5x P/B) the P/B multiple of the largest 40% of them (over $250M) ran up 30% by the end of last year. By contrast, the rest of deep-value stocks only ran up about half as much in price, by our calculation. The same was true for less steeply discounted value stocks as well. Large, liquid value stocks had about twice as much multiple expansion last year, no matter how we cut it.
Perhaps funds flow first where they easily can and eventually follow fundamental financial results and fundamental reforms. But this does not appear to be the result of differing fundamentals among the large deep-value names.
Below we show the relative selection opportunity, multiple expansion over the last twelve months, and various profitability and growth metrics for smaller and larger deep-value stocks. Here we use the current universe at the start of 2024 to give some idea of what’s out there today.
Figure 3: Selection Opportunity, Price Change, and Quality Metrics of All Deep-Value Stocks Today
Source: Compustat. All Japanese stocks >$25M in market capitalization. Excludes REITs and financials. Deep value is defined as the cheapest 20% of the market here. The $1B size cutoff used here approximates the largest 20% of all stocks in Japan (those over $912M now). Characteristics shown are for the median stock in each group.
There are only 45 stocks over $1B today that are deep value, versus 566 smaller stocks at equivalent prices. After prices ran up twice as quickly for these large caps last year, the remaining stocks look a bit like the liquid leftovers within Japanese deep value stocks, in our opinion.
For these reasons, should this catalyst continue to play out, we believe there is potentially much more room to run for deep-value stocks across the board, and especially for those outside the reach and weighting of most of the existing fund industry infrastructure.
You’ll notice we didn’t dedicate any space here to discussing views on the extent to which the reform measures will influence company behavior. There’s certainly no shortage of attention-grabbing tweets, sensationalistic headlines, and thoughtful qualitative deep dives into the topic over the last year. The reason we skipped that is certainly not for lack of trying to formulate reasonable views on the matter.
Over the last year, before, during, and after the formal announcements, we spent countless one-on-one meetings in Japan directly asking deep-value Japanese companies about the likely impact of the reforms, how much pressure they are feeling, and what they consider feasible reform measures would be for them and their peers. In short, based on these interactions, we think the reform initiatives of last year should have at least some impact, and our best guess is a lot more nuanced than much of the recent media coverage of the topic. We’d be delighted to chat more about the topic with readers interested in that subject.
Here, we focused instead on what we think are the measurable and relatively indisputable exposure facts investors might not be aware of but would need to understand should they wish to bet on Japan at least in part for corporate reform. Otherwise, using the tools that are out there for catalyst investors might prove to be a bit more like trying to eat soup with a knife, in this case.