Why Buffett Bought Japanese Stocks
And how smaller investors might do even better in Japan
Warren Buffett recently announced he had invested ~$5bn in five Japanese trade companies, a value investment in a country that trades at a steep discount to the United States. The companies Buffett purchased trade at a 35% discount to the broader Japanese TOPIX index and a whopping 79% discount to the S&P 500 on a price-to-book basis.
Figure 1: Valuations of Buffett’s Investments vs. TOPIX vs. S&P 500
Source: Capital IQ
Why is Buffett investing in Japan today? We bet it has something to do with the massive valuation disconnect shown above: Japan is one of the few value investments available in today’s global developed markets. Large caps in the United States have gotten dramatically more expensive compared to Japan in the last 10 years.
Figure 2: S&P 500 vs. TOPIX Valuations
Source: Capital IQ
It seems logical that Buffett would shift exposure to the Japanese market at this point in history. He was constrained by the sky-high valuations in large-cap US stocks and found value in the less-appreciated stocks across the Pacific.
The stocks Buffett bought are cheap even by Japanese standards and wildly cheap relative to the S&P 500 or even Buffett’s heavily Apple-centric stock portfolio. The dividend yield on these companies is about 3x the S&P 500 and 2x the TOPIX.
Figure 3: What Buffett Bought
Source: Capital IQ. Pricing as of August 15, 2020.
Scanning his list of purchases, it’s also notable that Buffett chose to buy highly leveraged companies, with these companies trading on average with over 8x net debt to EBITDA, which is extremely high, even by private equity standards. But with these companies paying basically zero interest, and with Japan having almost no corporate bankruptcies of publicly listed firms in the last 20 years, this isn’t the risk many investors might perceive it to be. In fact, as a way of disciplining capital allocation, debt is actually quite an effective tool.
In short, this looks like a classic Buffett move of “finding companies that trade at a discount, pay healthy dividends and might offer less risk than is commonly perceived” as the WSJ reported.
But that description could well fit the entire Japanese market when looked at from the perspective of a US value investor. And while the stocks Buffett bought are cheap relative to the TOPIX and the S&P 500, we do not believe they are cheap relative to our specialty: Japanese small caps.
Buffett chose to invest his $5B in only one industry in Japan: trading companies. Trading companies are diversified conglomerates with multiple, often loosely related, business lines. Within this industry, he seemed to have a relatively simple criteria: size. He bought the five largest companies in the industry. It would have been difficult to invest $5bn in any other five Japanese trading companies without taking them over, as only 13 of the 84 Japanese trading companies have market capitalizations over $1B. And whereas the trading companies Buffett bought trade at 0.8x revenue, 0.9x book value, and 11.9x EBITDA, the median trading company trades at only 0.2x revenue, half of book value, and 5.8x EBITDA at the median stock. The only catch is that the median market cap of these companies is $200M, meaning it would be impossible to deploy the amount of capital Buffett wanted to put into Japan.
The relationship between market cap and valuation is powerful in Japan. Value investment strategies in Japan face severe capacity constraints. Only 109 out of 2,914 listed stocks (3.7%) in Japan have greater than $10bn in market cap, and those stocks trade at 3.1x book value on average, by our calculation. Buffett made deep-value investments relative to this pool of Japanese mega-caps. The stocks outside of that tiny pool are significantly cheaper. Below we show Buffett’s holdings compared to the whole Japanese market of 3,000 stocks.
Figure 4: Buffett Holdings vs. All Japanese Companies
Source: Capital IQ. Pricing as of Sept 2, 2020. All TSE listed 2,914 stocks after excluding REITS and financials.
Buffett bought stocks that trade below the median valuation in Japan, a hard thing to do with a minimum $1B in each stock. But he could have built a portfolio that was much, much cheaper, even within his chosen sector of trading companies had he deployed less money.
Buffett famously remarked that it’s much easier to make big returns on smaller amounts of money. "If I was running $1 million today, or $10 million for that matter, I'd be fully invested. Anyone who says that size does not hurt investment performance is selling,” he said. “It's a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million.”
We believe this is nowhere more true than in Japan, where the vast majority of stocks have very small market capitalizations, very limited trading volume, yet trade at prices unheard of in the United States in decades.
Buffett’s Japan trade is a brilliant value move. But with less money, we feel he could have done even better.