Stockwatch: why did Warren Buffett really buy Japanese trading stocks?

by Edmond Jackson from interactive investor |

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Some say this is a case of value investing, but our companies analyst thinks currency risk is the real reason.

The knee-jerk reaction is that Warren Buffett’s declaring 5% stakes across five of the major Japanese trading houses is just his hallmark ‘value investing’.

But, as I shall explain in this piece, that would strictly be a throw-back to the Benjamin Graham style of investing he said he had learned to move on from. 

Moreover, I suspect a real motivation, especially since he recruited a chief investment officer, is to re-balance Berkshire Hathaway (NYSE:BRK.B)overwhelming US dollar exposure, the Japanese yen being a prime candidate. 

This is something British investors might learn from as we face a potential triple whammy of Covid-19 disruption dragging on, tax rises and a hard Brexit. 

Conglomerates are a curiosity

Coinciding with his 90th birthday, Buffett’s investment holding company has selected Itochu Corp (8001.T), Marubeni Corp (8002.T), Mitsubishi Corp (8058.T), Mitsui & Co (8031.T) and Sumitomo Corp (8053.T)

These are long-established companies going back to the late 19th or early 20th century, highly diversified across industries and services - classic conglomerates.

This type of business model has a proven stable history in Asia, whereas in the West it often features aggressive debt-fuelled takeovers and accounting tricks to manipulate earnings per share. 

Investors learned from bitter experience, first in the 1960s and then 1980s, that this kind of listed company can impress then implode.

Then in the late 1980’s Warren Buffett began to get wider attention, practising the financial moral high-ground. He restructured former textile manufacturer, Berkshire Hathaway, to buy insurance companies and then use the cash they generated to buy whole businesses and US listed company shares. 

He frequently bemoaned how, as a ‘value’ purchase, Berkshire took a lot of sorting out.

Yet its modern cash-generating prowess means that by mid-2020 Berkshire had $147 billion £110.7 billion) cash reserves at mid-2020, a whopping 44% of its market value. Unless Buffett is very bearish, it needs deploying, and this latest move constitutes only $6.25 billion equivalent.

Modest ratings, possibly for good reasons 

These Japanese stocks are priced modestly for earnings – especially versus those US-listed – and offer meaningful yields. The exception (see table) being Sumitomo, with a trailing price-to-earnings ratio in the mid-30s.

There is talk this week of how they also trade on a discount to net assets, but no consensus. Another lesson from Western conglomerate fads was liability for write-downs, which is why complexity became suspect and ‘focus’ in vogue. 

An efficient market theorist might say this mostly explaims why these Japanese conglomerate stocks trade at a discount, as indeed Berkshire Hathaway appears to nowadays. Markets have become increasingly international, with investors applying similar standards. 

More positively, Asia-Pacific being a dynamic region, such Japanese stocks offer a good level of diversification than specific industry risks of those more focused. 

Anticipating long-term mean reversion of values

I draw a parallel between Buffett and Tony Dye, a once high-profile city fund manager. Twenty years or so ago, he warned how tech-stocks were becoming ridiculously overvalued and he held onto industry laggards, deploying fresh money their way. 

He was sacked for under-performance but had the last laugh when the tech bubble burst in 2000. The essential point is ‘mean reversion’, i.e. that although markets can go crazily up or down in the medium term, eventually they will balance out against classic valuation criteria.

That is currently lost amid colossal stimulus measures, often said to be distorting the markets, although Japan is the most egregious.

Its fiscal stimulus in response to Covid-19 may be as high as 40% of gross domestic product (GDP), versus 15% for the US or 9% for the UK. 

France has just ramped up its stimulus programme to a comparatively measly 4% of GDP, albeit the biggest in the European Union. Japan’s stimulus appears likely to continue at very high rates given inflation was just 0.1% higher in May, like-for-like, and consumer spending is yet to significantly improve.

Japanese Trading Houses: key investment metrics          
           
  Ticker Price Mkt Cap PE Fwd Yield
  JPX Yen Yen trn x %
           
Itochu 8001.T 2,800 4.2 9.1 3.2
           
Marubeni 8002.T 646 1.1 n/a 2.4
           
Mitsubishi 8058.T 2,617 3.9 9.6 5.2
           
Mitsui 8031.T 1,950 3.3 10.2 4.2
           
Sumitomo 8053.T 1,383 1.7 34.2 5

Japan and the yen are logical choices for Berkshire 

It is probably the only Asia-Pacific market where it can buy equity in size. Moreover, the US has a constructive relationship with Japan, compared with frictions versus China. 

The yen is already perceived as a safe haven currency, offering a hedge in the short-term.

This could come in handy if, say, November’s US presidential election results in a constitutional crisis of Trump refusing to accept any Democrat victory. 

Medium-term, the US economy could weaken again if Covid-19 disruptions drag on, and then longer-term whether (like in the UK) taxes have to rise to pay for all the support schemes. 

Obviously, Japan may similarly be stoking up trouble although it has struggled to see any meaningful inflation for decades. 

Versus currency advantages for a portfolio investor, bear in mind these Japanese trading companies are significantly manufacturing/export-driven, hence undermined by a strong domestic currency. The yen has also appreciated the most already against Japan’s largest Asian export markets. 

Consensus is for a slow economic recovery 

Economists’ main caution however relates to weak economic demand – especially from the US – weighing on Japan’s exporters and manufacturers. 

Entering the pandemic, the Japanese economy was already mired in recession. GDP had contracted both in the final quarter of 2019 after a consumption tax was introduced, then the first three months of 2020. 

More positively, global advertiser WPP (LSE:WPP) has said it reckons the second quarter was the trough, advertising often being a leading indicator of economic recovery. 

In terms of coping with the virus, Japan’s experience with the SARS and MERS outbreaks plus its people’s greater willingness to wear masks, bodes well. Japanese people get on with life instead of arguing. 

Overall, whether you buy into investment funds or shares like these, you are taking a view on the Japanese economy. It is hardly unusual how the most prominent buyer of corporate Japan has proved an investor most patient.

The spoiler: conglomerates finding each other

A cynical view would be: Berkshire Hathaway and the Japanese trading houses are all similar dinosaurs. They are unwieldy to innovate compared with modern businesses such as China’s Xiaomi, the world’s fourth-largest technology company in just 10 years.

Can you imagine Elon Musk tagging space travel onto Tesla (NASDAQ:TSLA)? Cutting-edge business has moved on, and shares in conglomerates will stay at a discount to assets similarly as most investment company shares relative to underlying portfolios.

It is hardly surprising how, confused at being surpassed, Berkshire Hathaway and the Japanese trading houses have met up. Does Berkshire’s initially buying into US airline stocks (which Buffett used to ridicule in past annual reports) then dumping at Covid-19 lows, show they really know what they are doing?

Currency and mean reversion remain key

My conclusion is Japanese equities are useful to diversify currency risk, also (drawing on the post-2000 experience) to capitalise on a possible market rebalancing from extremes of tech-stock valuations currently. 

Diversified trading houses are similar to investment funds although if Buffett’s reputation remains positive then it could be a trigger for international fund managers to accumulate these stocks. Mind how their comparatively attractive yields globally, are not altogether secure if events conspire against Japanese exporters. 

All-considered, taking a five-year view: ‘Buy’

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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