Japan Value Report

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A sample of our monthly research. When the Great Earthquake struck in Japan, we opportunistically looked at potential investment opportunities arising from this tragedy.

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Japan Value Report

  1. 1. Value-oriented Equity Investment Ideas for Sophisticated Investors A Monthly Publication of BeyondProxy LLC  Subscribe at manualofideas.com “If our efforts can further the goals of our members by giving them a discernible edge over other market participants, we have succeeded.”Investing In The Tradition ofGraham, Buffett, Klarman Year IV, Volume IV May 2, 2011 THE JAPAN ISSUE When asked how he became so successful, Buffett answered: “We read hundreds and hundreds ► Context: Japan, the country and the economy of annual reports every year.” ► 20 Japanese companies profiled and analyzedTop Ideas In This Report ► Proprietary selection of top investment candidatesKonami(Tokyo: 9766, NYSE: KNM) ……. 50 ► Plus: Exclusive interview with Scott CallonRicoh(Tokyo: 7752, OTC: RICOY) …… 90 ► Plus: Exclusive interview with Mark O’FrielToyota Motor(Tokyo: 7203, NYSE: TM) …….. 106 ► Plus: Superinvestor holdings updateAlso Inside ► Plus: Favorite screens for value investorsEditorial Commentary ………………. 4Superinvestor Update ………………. 7 Companies mentioned in this issue includeInterview with Scott Callon ………… 8 Advantest, Aeon, Aisin Seiki, Asahi Breweries, Asahi Glass, Asahi Kasei,Interview with Mark O’Friel ………. 12 Astellas Pharma, Bridgestone, Canon, Central Jap. Railway, Chubu Electric, Chugai Pharma, Chuo Mitsui, Dai Nippon Printing, Dai-ichi Life,Japan, the Country and Economy … 17 Daiichi Sankyo, Daikin Industries, Daiwa Securities, Denso,Screening for Japanese Ideas …….. 24 East Japan Railway, Eisai, Fanuc, Fast Retailing, FUJIFILM, Fujitsu,Profiles of 20 Japanese Companies 30 Hitachi, Honda Motor, Hoya, ITOCHU, Japan Tobacco, JFE Holdings,Selected Statistics on Japan ………110 JS Group, JX Holdings, Kansai Electric, Kao, KDDI, Keyence, Kirin,Screens for Value Investors ……… 115 Kobe Steel, Komatsu, Konami, Kubota, Kyocera, Kyushu Electric, Marubeni, Mitsubishi, Mitsubishi Chemical, Mitsubishi Electric,This Month’s Top Web Links …….. 124 Mitsubishi Estate, Mitsubishi Heavy, Mitsubishi UFJ Financial, Mitsui + Co., Mitsui Fudosan, Mizuho Financial, MS + AD Insurance,About The Manual of Ideas Nikon, Nippon Steel, Nissan Motor, Nitto Denko, NKSJ, Nomura, NTT,Our goal is to bring you investment NTT Data, NTT DoCoMo, ORIX, Osaka Gas, Otsuka, Panasonic, Resona,ideas that are compelling on the Ricoh, SANYO Electric, Secom, Seven + i Holdings, Sharp,basis of value versus price. In ourquest for value, we analyze the top Shin-Etsu Chemical, SMC, Softbank, Sony, Sony Financial, Sumitomo,holdings of top fund managers. We Sumitomo Chemical, Sumitomo Electric, Sumitomo Metal,also use a proprietary methodologyto identify stocks that are not widely Sumitomo Mining, Sumitomo Mitsui, Sumitomo Realty, Suzuki Motor,followed by institutional investors. T+D Holdings, Takeda Pharma, TDK, Terumo, Tohoku Electric,Our research team has extensive Tokio Marine, Tokyo Electric, Tokyo Electron, Tokyo Gas,experience in industry and security Toray Industries, Toshiba, Toyota Industries, Toyota Motor,analysis, equity valuation, andinvestment management. We bring a West Japan Railway, Yahoo Japan, and more.“buy side” mindset to the ideageneration process, cutting acrossindustries and market capitalization (analyzed companies are underlined)ranges in our search for compellingequity investment opportunities.Copyright Warning: It is a violation of federal copyright law to reproduce all or part of this publication for any purpose without the prior written consent ofBeyondProxy LLC. Email support@manualofideas.com if you wish to have multiple copies sent to you. © 2008-2011 by BeyondProxy LLC. All rights reserved.
  2. 2. Value-oriented Equity Investment Ideas for Sophisticated Investors Table of Contents EDITORIAL COMMENTARY ......................................................................... 4  SUPERINVESTOR HOLDINGS UPDATE ..................................................... 7  EXCLUSIVE INTERVIEW WITH SCOTT CALLON ....................................... 8  EXCLUSIVE INTERVIEW WITH MARK O’FRIEL ....................................... 12  SOME CONTEXT: JAPAN, THE COUNTRY AND THE ECONOMY .......... 17  SCREENING FOR JAPANESE INVESTMENT OPPORTUNITIES............. 24  TOP 100 TOKYO STOCK EXCHANGE COMPANIES, BY MARKET VALUE ......................................... 24  PROFITABLE COMPANIES WITH 5-YEAR ROE > 5%, TRADING AT < 1X BOOK ............................... 26  PROFITABLE COMPANIES WITH 5-YEAR ROA > 5% .................................................................... 28  CHEAPEST BASED ON TANGIBLE BOOK TO MARKET VALUE ......................................................... 29  PROFILES OF 20 JAPANESE INVESTMENT CANDIDATES ................... 30  ADVANTEST (TOKYO: 6857, NYSE: ATE) .................................................................................. 30  CANON (TOKYO: 7751, NYSE: CAJ) ......................................................................................... 34  FUJIFILM (TOKYO: 4901, OTC: FUJIY) ...................................................................................... 38  FUJITSU (TOKYO: 6702, OTC: FJTSY) ...................................................................................... 42  HITACHI (TOKYO: 6501, NYSE: HIT) ......................................................................................... 46  KONAMI (TOKYO: 9766, NYSE: KNM) ....................................................................................... 50  KUBOTA (TOKYO: 6326, NYSE: KUB) ....................................................................................... 54  KYOCERA (TOKYO: 6971, NYSE: KYO) ..................................................................................... 58  MITSUBISHI UFJ FINANCIAL (TOKYO: 8306, NYSE: MTU) .......................................................... 62  MITSUI (TOKYO: 8031, OTC: MITSY) ........................................................................................ 66  NOMURA HOLDINGS (TOKYO: 8604, NYSE: NMR) ..................................................................... 70  NIPPON TELEPHONE AND TELEGRAPH (TOKYO: 9432, NYSE: NTT)............................................ 74  NTT DOCOMO (TOKYO: 9437, NYSE: DCM) ............................................................................ 78  ORIX (TOKYO: 8591, NYSE: IX) ............................................................................................... 82  PANASONIC (TOKYO: 6752, NYSE: PC) .................................................................................... 86  RICOH (TOKYO: 7752, OTC: RICOY) ........................................................................................ 90  SHARP (TOKYO: 6753, OTC: SHCAY) ...................................................................................... 94  SONY (TOKYO: 6758, NYSE: SNE) ........................................................................................... 98  TDK (TOKYO: 6762, OTC: TTDKY) ........................................................................................ 102  TOYOTA MOTOR (TOKYO: 7203, NYSE: TM) ........................................................................... 106  APPENDIX: SELECTED STATISTICS ON JAPAN .................................. 110  FAVORITE STOCK SCREENS FOR VALUE INVESTORS ...................... 115  “MAGIC FORMULA,” BASED ON TRAILING OPERATING INCOME ................................................... 115  “MAGIC FORMULA,” BASED ON THIS YEAR’S EPS ESTIMATES ................................................... 116  “MAGIC FORMULA,” BASED ON NEXT YEAR’S EPS ESTIMATES .................................................. 117  CONTRARIAN: BIGGEST YTD LOSERS (DELEVERAGED & PROFITABLE)....................................... 118  VALUE WITH CATALYST: CHEAP REPURCHASERS OF STOCK ..................................................... 119  PROFITABLE DIVIDEND PAYORS WITH DECENT BALANCE SHEETS ............................................. 120  DEEP VALUE: LOTS OF REVENUE, LOW ENTERPRISE VALUE ..................................................... 121  DEEP VALUE: NEGLECTED GROSS PROFITEERS ....................................................................... 122  ACTIVIST TARGETS: POTENTIAL SALES, LIQUIDATIONS OR RECAPS ........................................... 123  THIS MONTH’S TOP 10 WEB LINKS ....................................................... 124 © 2008-2011 by BeyondProxy LLC. All rights reserved. SUBSCRIBE TODAY! www.manualofideas.com May 2, 2011 – Page 3 of 126
  3. 3. Value-oriented Equity Investment Ideas for Sophisticated Investors Editorial Commentary Japan has been on our radar screen for quite some time. The aftermath of this year’s Great East Japan Earthquake has given us the impetus to look at this market in more detail — and to try to identify some bargains among Japanese mid- and large- cap stocks. These companies are quite accessible to non Japan-based investors, as they trade on one or more stock exchanges in addition to the Tokyo Stock Exchange. When an already cheap market becomes even cheaper due to an exogenous shock, value investors are bound to take notice. While the human toll of the Great East Japan Earthquake has been devastating, we have confidence in the ability of the Japanese people to rebound from disaster. Japan has gone through many trying periods in history, repeatedly emerging with a newfound zeal to grow and prosper. Most of the issues that have kept investors away from Japan over the years remain today. Japanese companies still have not embraced a goal of achieving strong returns on equity. Corporate boards remain entrenched, and value-unlocking strategic actions remain an exception. On the positive side, many Japanese companies are highly competitive on a global scale and have built truly global brands — Canon (CAJ), Sony (SNE) and Toyota Motor (TM) are just a few. Executive compensation at Japanese companies remains reasonable, contrasting sharply with the experience of major U.S. corporations. Finally, Japanese companies’ balance sheets tend to be among the strongest in the world, with many large companies owning substantial excess assets. The latter can be seen as a positive or a negative, but the fact is that much improvement is possible at Japan Inc. Excess assets could be rationalized over time, while returns on equity have ample room for improvement. Contrast this with Corporate America, where profit margins have almost nowhere to go but down.  Here are a few lessons from our research into Japanese companies: Lesson #1: There is not a “Japanese” company. However, there is Canon that derives ~80% of revenue from outside Japan; there is Advantest that is set to become the largest global producer of semiconductor test equipment pending the acquisition of Verigy; and there is Toyota that created the world’s first mass-produced hybrid car. These firms are leaders in their industries and defy being labeled “Japanese.” Lesson #2: Company-specific factors remain paramount for valuation. Companies like Kubota and Mitsui are benefiting from the same trends that Caterpillar and Glencore are taking advantage of. They also face similar risks, which likely outweigh the risk associated with a Japan-based headquarters. Lesson #3: Governance is not all bad. In our research, we’ve mostly come across committed and experienced managers who are not overpaid or incentivized to bet the house every day they walk through the doors. Another often overlooked fact about Japan’s corporate governance is that it is a shareholder-meeting system, not a board-level governance regime. Shareholders have strong legal rights and can call a shareholder meeting at will. If shareholders want to dismiss the board or double the dividend, with enough votes it can be done, even against the board’s wishes. Lesson #4: The “Mitsubishi UFJ” factor. The Japanese mega bank, with customer deposits representing two thirds of total assets, has avoided the fate of some of its Western peers during the 2008/09 financial crisis. Indeed, it has taken© 2008-2011 by BeyondProxy LLC. All rights reserved. SUBSCRIBE TODAY! www.manualofideas.com May 2, 2011 – Page 4 of 126
  4. 4. Value-oriented Equity Investment Ideas for Sophisticated Investors advantage of weaker rivals to buy up assets, including community banks in the U.S. as well as a stake in Morgan Stanley. Supported by strong balance sheets, many Japan-based companies are similarly expanding their business. On the other hand, quite a few Western firms have taken on debt to buy back shares at the top of the market, ruining investors in the process. So much for “efficient” capital structures. Lesson #5: Key issue is long-term competitiveness, not how “Western” the management culture is. It is underappreciated how well-invested Japan-based companies are and how much they spend on R&D to advance their competitive moat. This, however, is one of the key determinants of long-term shareholder value. On this account, it is interesting to observe how former household consumer electronics companies such as Fujifilm and TDK have stumbled and are attempting to reinvent themselves. Similarly, Sony investors would probably prefer if Howard Stringer could win some product battles against the likes of Apple than if he were to split the role of CEO and chairman or sell the financial services business.  We are pleased to bring you two exclusive interviews this month, each of which sheds light on the peculiarities of the Japanese equity market as well as the way to identifying compelling investments in Japan. Scott Callon and Mark O’Friel have decades-long experience and impressive track records in Japan. We think you’ll enjoy the conversations a great deal.  We highlight three intriguing Japanese investment opportunities: Konami (Tokyo: 9766, NYSE: KNM, $19.50 per share; MV $2.6 billion) $45 $40 $35 $30 $25 $20 $15 $10 $5 $0 Apr 03 Apr 04 Apr 05 Apr 06 Apr 07 Apr 08 Apr 09 Apr 10 Apr 11 Under the direction of CEO and founder Kagemasa Kozuki, Konami has expanded from an arcade games producer in the 1970s to one of the world’s major gaming companies, with a strong franchise in video game software publishing. Despite conglomerate tendencies, including a loss-making foray into fitness clubs, Kozuki remains incentivized to create long-term value as the largest shareholder with 28%. Recent valuation is attractive relative to the earning power inherent in Konami’s businesses.© 2008-2011 by BeyondProxy LLC. All rights reserved. SUBSCRIBE TODAY! www.manualofideas.com May 2, 2011 – Page 5 of 126
  5. 5. Value-oriented Equity Investment Ideas for Sophisticated Investors Ricoh (Tokyo: 7752, OTC: RICOY, $58 per share; MV $8.4 billion) $140 $120 $100 $80 $60 $40 $20 $0 Mar 02 Apr 03 Apr 04 Apr 05 Apr 06 Apr 07 Apr 08 Apr 09 Apr 10 Apr 11 Office printer and copier manufacturer Ricoh derives high-margin, annuity-like income from equipment maintenance, rentals and consumables, which represent nearly half of revenue. This offsets the more volatile product sales and leads to relatively stable free cash flow generation. Ricoh’s modest valuation fails to reflect this, as shares trade at 1.1x tangible book and a 10+% FCF yield based on average free cash flow during FY06-10. The balance sheet is stronger than it may appear as cash and finance receivables offset the gross debt balance. Despite product commoditization risks, the risk-reward is attractive. Toyota Motor (Tokyo: 7203, NYSE: TM, $80 per share; MV $125 billion) $160 $140 $120 $100 $80 $60 $40 $20 $0 Apr 02 Apr 03 Apr 04 Apr 05 Apr 06 Apr 07 Apr 08 Apr 09 Apr 10 Apr 11 Car industry pioneer Toyota is struggling following multiple “shocks” including the financial crisis of 2008/09, the massive U.S. vehicle recall in 2010, and most recently, due to production issues related to the Japanese earthquake. While it may take time, an eventual reversion to average profitability should reward long-term shareholders. Trading at tangible book, the shares offer an attractive risk-reward as Toyota is likely to deliver normalized ROEs of 10+%, in-line with historical experience. Sincerely, John Mihaljevic, CFA and The Manual of Ideas research team© 2008-2011 by BeyondProxy LLC. All rights reserved. SUBSCRIBE TODAY! www.manualofideas.com May 2, 2011 – Page 6 of 126
  6. 6. Value-oriented Equity Investment Ideas for Sophisticated InvestorsSuperinvestor Holdings UpdateWe recently profiled the holdings of 50+ top investment managers, based on their Schedule 13F-HR filings with theSecurities and Exchange Commission. On this page, we provide an update on the latest disclosed purchase and sale activityby the same group of investors. This information is based primarily on Schedule 13G or 13D filings and Form 3 or 4 filings.Increases in Superinvestor Holdings  Latest Market Stock Price ($) Shares Owned Holdings Trade/ Filing Value Latest Filing ∆ since Latest ∆ since as % of Filing Type Investor Company / Ticker ($mn) Date Date Filing (mn) 12/31/10 Company 4/8/11 4 Second Curve Primus Guaranty / PRS 186 4.89 5.01 -2% 6.5 0% 17% 3/21/11 13D Pershing Sq. Alexander & Baldwin / ALEX 2,190 52.65 41.57 27% 3.6 new 9% 3/18/11 13G Glenview Meritor / MTOR 1,600 17.00 17.85 -5% 5.4 33% 6% 3/15/11 4 Icahn Hain Celestial / HAIN 1,310 30.43 28.67 6% 7.1 n/a 17% 2/23/11 13G Scout Domino’s Pizza / DPZ 1,080 17.97 16.49 9% 3.0 21% 5% 2/16/11 4 Ancient Art ZipRealty / ZIPR 56 2.75 2.71 1% 2.2 0% 11% 2/14/11 13G Lone Pine Ctrip.com / CTRP 5,290 36.86 40.65 -9% 7.9 83% 5%Source: SEC filings, The Manual of Ideas compilation and analysis.Decreases in Superinvestor Holdings  Latest Market Stock Price ($) Shares Owned Holdings Trade/ Filing Value Latest Filing ∆ since Latest ∆ since as % of Filing Type Investor Company / Ticker ($mn) Date Date Filing (mn) 12/31/10 Company 4/19/11 4 Second Curve Mercantile Bank / MBWM 78 9.06 9.50 -5% 0.9 n/a 10% 4/8/11 4 Breeden Zale / ZLC 116 3.61 3.99 -10% 7.5 -17% 23% 4/5/11 4 Second Curve CompuCredit / CCRT 151 4.22 6.83 -38% 3.5 -19% 10% 4/4/11 13D Third Point Nabi Pharma / NABI 242 5.76 5.78 0% 3.5 -8% 8% 4/1/11 13D Southeastern Pioneer Natural / PXD 11,660 100.10 103.81 -4% 5.0 -61% 4% 3/29/11 13D Southeastern Telephone & Data / TDS 3,510 33.72 32.81 3% 9.6 -17% 9% 3/28/11 13G Bares Hallmark Financial / HALL 170 8.46 8.08 5% 1.9 -20% 10% 3/1/11 13D Breeden Hillenbrand / HI 1,330 21.50 21.47 0% 3.1 -25% 5%Source: SEC filings, The Manual of Ideas compilation and analysis.The Manual of Ideas follows portfolio moves by Bill Ackman, Pershing Square; Lee Ainsle, Maverick; Chuck Akre, Akre Capital; Zeke Ashton, Centaur Capital;Brian Bares, Bares Capital; Bruce Berkowitz, Fairholme; Richard Breeden, Breeden Capital; Tom Brown, Second Curve; Warren Buffett, Berkshire Hathaway;Francis Chou, Chou Associates; Chase Coleman, Tiger Global; James Crichton, Scout; Ian Cumming and Joe Steinberg, Leucadia; Boykin Curry, Eagle; DavidEinhorn, Greenlight; Phil Falcone, Harbinger; Alan Fournier, Pennant; Glenn Fuhrman and John Phelan, MSD Capital; Jeffrey Gates, Gates Capital; Tom Gayner,Markel Gayner; Kian Ghazi, Hawkshaw; Ed Gilhuly and Scott Stuart, Sageview; Glenn Greenberg, Brave Warrior; John Griffin, Blue Ridge; Howard Guberman,Gruss; Andreas Halvorsen, Viking Global; Mason Hawkins, Southeastern; Lance Helfert and Paul Orfalea, West Coast; Chris Hohn, Children’s Investment Fund;Carl Icahn, Icahn; Rehan Jaffer, H Partners; Seth Klarman, Baupost; John Kleinheinz, Kleinheinz Capital; Eddie Lampert, ESL Investments; Quincy Lee, Teton;Dan Loeb, Third Point; Steve Mandel, Lone Pine; Sandy Nairn, Edinburgh Partners; Mohnish Pabrai, Pabrai Funds; John Paulson, Paulson & Co.; Boone Pickens,BP Capital; Mark Rachesky, MHR; Lisa Rapuano, Lane Five; Larry Robbins, Glenview; Bob Rodriguez and Steven Romick, First Pacific; Wilbur Ross, WL Ross;Ken Shubin Stein, Spencer; Chris Shumway, Shumway Capital; David Tepper, Appaloosa; Peter Thiel, Clarium; Prem Watsa, Fairfax; Wally Weitz, Weitz Funds;and David Winters, Wintergreen.© 2008-2011 by BeyondProxy LLC. All rights reserved. SUBSCRIBE TODAY! www.manualofideas.com May 2, 2011 – Page 7 of 126
  7. 7. Value-oriented Equity Investment Ideas for Sophisticated Investors Exclusive Interview with Scott Callon We are pleased to bring you the following interview with Scott Callon, Partner and CEO of Ichigo Asset Management, Ltd. A brief biography follows: On behalf of Ichigo, currently serving as Chairman and Representative Statutory Executive Officer of Ichigo Group Holdings Co., Ltd. (2337), a Japanese real estate asset manager listed on JASDAQ (ichigo-holdings.co.jp). Previously, Managing Director, Head of Equities, and member of the Executive Committee of Morgan Stanley Japan; Chairman of the Foreign Securities Council of the Japan Securities Dealers Association (JSDA); and Chief Executive Officer of PCA Asset Management of the UK Prudential Group. A.B., Woodrow Wilson School, Princeton University, 1986 (Phi Beta Kappa and summa cum laude (highest honors)), and Ph.D. in Political Science from Stanford University. Author of Divided Sun: MITI and the Breakdown of Japanese High-Tech Industrial Policy, 1975-1993, winner of the Arisawa Prize. (“Callon’s findings are extraordinary... It is essential for anyone trying to get a little closer to the core of what makes Japan tick.” Japan Times). Has lived in Japan for twenty-two years; fluent in spoken and written Japanese. Chartered Financial Analyst (CFA). The Manual of Ideas: Tell us about the genesis of your firm. What goals did you have at the outset, and what operating principles have guided you since then? Scott Callon: We started the firm in early 2006, so it has been five years now. Our goal was and continues to be to serve our investors by investing wisely and judiciously on behalf of their enduring missions (we invest primarily for endowments and foundations), to partner with great companies and management “Japanese valuations are teams, and to support positive change in Japan. We are high-commitment value truly unique: it is the only investors. We believe that valuation ultimately is the single most important market in the world where determinant of investment merit and ultimately returns. We seek to be you can buy consistently shareholders of outstanding companies that have demonstrated their excellence profitable companies at a over many years and yet trade at substantial discounts to their fundamental discount to their tangible value. asset value.” We are Japan specialists and invest only in Japan. Japanese valuations are truly unique: it is the only market in the world where you can buy consistently profitable companies at a discount to their tangible asset value. We strive to invest with respect and humility – it is an enormous challenge to run a public company and the management teams of our portfolio companies have our deepest respect. We seek to focus our portfolio on the best return opportunities available and have only about ten major positions. We are not in the diversification business – we expect to be only a small part of our clients’ highly diversified portfolios and thus we concentrate only on what [we] consider to be our very best investment ideas.© 2008-2011 by BeyondProxy LLC. All rights reserved. SUBSCRIBE TODAY! www.manualofideas.com May 2, 2011 – Page 8 of 126
  8. 8. Value-oriented Equity Investment Ideas for Sophisticated Investors MOI: You have received much publicity for successfully standing up for shareholder democracy in Japan in the case of Osaka Steel’s proposed merger with Tokyo Kohtetsu in 2006. How has this event shaped your investment approach since then? What lessons have you learned? Callon: We think Tokyo Kohtetsu is Japan’s best small steel company. We thought that back in 2006 and still think that today. We have never sold a share. With all due respect to the proposed buyer, which was a larger, also extraordinarily successful steel maker, we and a large number of other shareholders had a strong desire to remain as shareholders of Tokyo Kohtetsu. Unfortunately, we could not reach agreement on what the Tokyo Kohtetsu shareholders hoped for as an acquisition price, so we and nearly three-quarters of the individual shareholders chose not to vote for the acquisition, which proved to be the first successful shareholder-led proxy in Japanese history. For us, the first key lesson was that Japanese shareholders are willing to stand up for their rights. The second was that we as a firm needed to work harder at building deeper relationships with our portfolio company management teams to reach agreement on the way forward. In 2006, we had just started out as a firm, had not yet built the depth of relationship with Tokyo Kohtetsu that we typically aim to achieve, and quite frankly were taken by surprise at the merger announcement. The outcome may have been in its own way history- making, but it also strengthened Ichigo’s commitment to building and maintaining close relationships and alignment with our portfolio companies. MOI: Help us understand your investment approach more broadly. What are the key criteria you employ when making an investment decision? Callon: Again, we’re value guys. We do not try to guess what the market is thinking or will be thinking, we do not track flows of funds, etc. That is not to say that we think those particular approaches to investment are wrong – it is just not what we do. There is lots of room in the capital markets for a variety of approaches and the markets are stronger for having diversification in investment approaches. However, in our case, we are valuation fundamentalists. We seek to buy companies that are trading around or below tangible book value, who typically have dominant market positions in specialized markets (smaller market “We think Tokyo Kohtetsu is size and specialization invites less new entry), conservative balance sheets, and Japan’s best small steel high returns on net operating assets – in short, companies with great operating company. We thought that and financial performance over time and through multiple economic cycles. Our back in 2006 and still think basic framework is to think of corporate value as made up of two fundamental that today. We have never components: asset value and operating value. Asset value tends to be simpler to sold a share.” understand (although usually requires a translation from book value to market value), and we generate a view on operating value using conservative views of the future and relatively high assumptions about cost of capital. MOI: What role, if any, do macroeconomic factors play in your investment strategy? Are you worried about how Japan’s high debt, aging population or other macro variables may affect real equity returns in the long-run? Callon: We are entirely company-focused. Operating cashflows, assets required to generate those cashflows, etc. are what is fundamental to us. Having said that, macro factors clearly feed into company operating performance. If the population is shrinking, then retail sales are also likely to shrink. We own a couple of great retailers, and we have forecast very little in the way of future© 2008-2011 by BeyondProxy LLC. All rights reserved. SUBSCRIBE TODAY! www.manualofideas.com May 2, 2011 – Page 9 of 126
  9. 9. Value-oriented Equity Investment Ideas for Sophisticated Investors growth from them. However, if you have a market cap that is 60-70% made up of cash holdings, a dominant market position which translates into significant positive cash flow, and a price-to-book ratio well below one, you can build in a large amount of macro deterioration and still be confident of generating a reasonable return. In fact, what we tend to find is that the negative demographic headwinds have been overly-priced in, that the negative scenarios baked into certain companies’ stock prices are wildly more extreme than what is actually happening. MOI: For investors that may be new to Japanese equities, are there any Japan- specific “checklists” that you would recommend going through before investing? Callon: Not really. We think the fundamental principles of sound investing apply the same in Japan as they do anywhere else in the world. MOI: Many investors, most notably Warren Buffett and Jim Rogers, have expressed a view that the Japanese stock market may present buying opportunities following the sell-off related to the March earthquake? Do you share this view, and, if so, do you think the opportunity may extend beyond retracing recent share price declines? In other words, could this catastrophe accelerate changes at the corporate or government level that could lead to more sustained value creation for shareholders of Japanese companies? Callon: We do share the view that there have been some significant buying opportunities post-quake. Alongside the deeply saddening human loss, the disaster has impacted Japanese companies on three levels: 1) Direct physical damage (destruction of corporate assets such as factories, loss of employees, etc.); 2) Secondary sectoral spillover effects, either negative or positive (supply chain disruptions, electricity shortages, substitution effects as production shifts “Japan’s ROE challenge is away from suppliers in Tohoku to other regions, heightened demand for goodsreally about the E, not the R. such as construction materials, alternative fuels, bottled drinks, etc.); and 3)Japanese companies’ returns Macro effects, again both negative and positive, including a dampening in are very similar to those of discretionary consumption as the Japanese people mourn, loosened monetarypeers in the US and Europe, policy to lessen the initial supply and demand shocks to the economy, massiveso the R part of the equation infrastructure spending to rebuild Tohoku, etc. What is striking is that for a is fine. The driver of low number companies the sum of these three impacts has been quite moderate ROEs is thus the relative to how much their shares have been sold off. denominator, E: Japanese Although this is not something that we have attempted to price into our firms frequently have very company-level valuations, we do think it possible that the aftermath could prove large amounts of retained to be a catalyst for positive and accelerated change.earnings, often in the form of cash, so the returns are MOI: While Warren Buffett has recently sounded optimistic on Japan, it remains telling that he has not made any significant investments in Japan. As far diluted across a massive back as in 1998, Buffett commented in a speech to University of Florida equity base.” students that one reason for his lack of interest in Japanese companies are their low returns on equity. Despite low ROEs remaining a characteristic of the Japanese equity market in general, can you point to any exceptions to this “rule”? Are there any developments that may lead to improving ROEs in the future? Callon: Japan’s ROE challenge is really about the E, not the R. Japanese companies’ returns are very similar to those of peers in the US and Europe, so the R part of the equation is fine. The driver of low ROEs is thus the© 2008-2011 by BeyondProxy LLC. All rights reserved. SUBSCRIBE TODAY! www.manualofideas.com May 2, 2011 – Page 10 of 126
  10. 10. Value-oriented Equity Investment Ideas for Sophisticated Investors denominator, E: Japanese firms frequently have very large amounts of retained earnings, often in the form of cash, so the returns are diluted across a massive equity base. On the one hand, this is enormously comforting: Japanese balance sheets are about as bullet-proof as they come and cash has real value. However, the large equity bases do dramatically reduce ROEs, so from a shareholder’s perspective, this is a negative. The good news is that more Japanese companies are working towards higher capital efficiency and increasing shareholder distributions via both higher dividends and share repurchase, but this is clearly going to happen over time. We actually prefer to discuss this issue with management teams in terms of EPS, rather than ROE. Growing EPS is clearly in everybody’s interest, and EPS can “The sell-side is a business, be grown both via increasing total earnings and reducing share count, so we and Japanese equities have think a balanced approach of both managing for earnings growth and buying underperformed for so long back shares when they are inexpensive is appropriate. that the sell-side has MOI: How do you generate investment ideas?retreated (along with a good Callon: We invest only in Japanese small caps, so we need to build ourchunk of the buy-side), so our understanding of our portfolio companies directly. The sell-side is a business, investment universe has no and Japanese equities have underperformed for so long that the sell-side has research coverage to speak retreated (along with a good chunk of the buy-side), so our investment universe of. If one is investing in has no research coverage to speak of. If one is investing in Toyota, there are Toyota, there are plenty of plenty of folks out there expressing a view, but our universe is under-researched, folks out there expressing a under-known, and under-owned. view, but our universe is under-researched, under- MOI: What is the single biggest mistake that keeps investors from reaching their goals? known, and under-owned.” Callon: Hmm. Not sure. I do think it is important to be extraordinarily prudent about downside risk, to test worst-case scenarios and make sure one is protected under those scenarios. In our case, we don’t use leverage and prefer to have cash on hand. Both of these decisions potentially constitute a drag on returns, but they also radically diminish risk during extreme negative market environments. MOI: Are there any books you would recommend to non-Japanese investors looking to learn about Japan? Callon: Gillian Tett, Saving the Sun: How Wall Street Mavericks Shook Up Japan’s Financial World and Made Billions. John Dower, Embracing Defeat: Japan in the Wake of World War II. Junichiro Tanizaki, The Makioka Sisters.© 2008-2011 by BeyondProxy LLC. All rights reserved. SUBSCRIBE TODAY! www.manualofideas.com May 2, 2011 – Page 11 of 126
  11. 11. Value-oriented Equity Investment Ideas for Sophisticated Investors Exclusive Interview with Mark O’Friel We are pleased to share with you our recent conversation with Mark O’Friel, the managing partner of MOF Capital, an alternative investment fund focused on investments in Japan and China. Prior to starting MOF Capital, Mark was with Steel Partners Japan as managing director and head of the Tokyo office in 2008 and 2009. Previously, he jointly led Morgan Stanley’s U.S. proprietary trading business in North America from 2002-05. Mark formerly directed Morgan Stanley’s Equity Division in Japan, acting as senior equity risk manager and a member of the firm’s Global Equity Operating Committee from 1996-2002. Under his leadership, Morgan Stanley achieved leading market share in the Japanese equity market and received Institutional Investor’s top ranking for equity research in Japan. Mark served on the committees of the Tokyo Stock Exchange that wrote the regulations and guidelines for program trading, options trading and new technologies. He also represented Morgan Stanley on the board of the Osaka Stock Exchange. He began his Morgan Stanley career as an equity derivatives and program trader, introducing some of the first quantitative trading strategies in the Japanese market. Mark began his career in Japan as a market strategist for Sanyo Securities. He serves on the board of the Kennedy Child Study Center in New York City. He is a member of the Leadership Council of the Harvard School of Public Health. He is active with the Harvard School of Public Health China Initiative, which partners with the Chinese Ministry of Health to advance health and social development in China, Room to Read, Math for America and Harvard College. He is a graduate of Harvard College. The Manual of Ideas: Mark, thank you for taking the time to discuss Japan at this pivotal moment in the country’s recent history. Mark O’Friel: Thank you for the opportunity to speak with you about Japan. The country has just experienced a tragedy that goes beyond words, with 25,000 “Despite high levels of people dead or missing. The pictures of the earthquake and ensuing tsunami government debt, the damage are heart rendering. The resilience that the Japanese of Tohoku have government actually has shown in the face of this event is a profound statement to the strength of the quite a bit of leeway. Ten- national character. The best of Japan is on display throughout the country. year JGBs have remained What is overlooked in the reports and pictures of the disaster is in fact how quite strong.” well prepared Japan was and how the damage was minimized. The earthquake itself, despite its unprecedented size, caused relatively little damage. Even near the epicenter, collapsed buildings and deaths were few. This is after the main earthquake of 9.0 and over 800 aftershocks greater than 4.5. The before and after satellite pictures now available on the web are testimony to the power of nature. The pictures now and the pictures one, five and ten years from now will be testimony to the speed and efficiency of how Japan can rebuild physical infrastructure. Japan has a long history of rebuilding, from the aftermath of World War II to the Kobe earthquake. Despite high levels of government debt, the government actually has quite a bit of leeway. Ten-year JGBs have remained quite strong.© 2008-2011 by BeyondProxy LLC. All rights reserved. SUBSCRIBE TODAY! www.manualofideas.com May 2, 2011 – Page 12 of 126
  12. 12. Value-oriented Equity Investment Ideas for Sophisticated Investors The earthquake and its aftermath will not be a catalyst for change in Japan. The government, corporate Japan and its population will seek to draw on the traditional strengths of discipline, perseverance, hard work and self sacrifice. MOI: You have spent the major part of your career in Japan. Tell us a little about your background and what motivated you to work in Japan. O’Friel: Japan had already become an economic power when I began my career, but it was just beginning on the path of deregulation of its financial service sector. The early eighties was also the first phase of the globalization of U.S. financial firms. Investment banks were just opening or expanding what had been small outposts overseas. Given my interest in Japan, it seemed interesting for me to take the opportunity to spend one or two years just out of college overseas and then come back to the U.S. Two years ended up being twenty. I first worked at a Japanese investment bank. At that time I lived in a company dorm and experienced firsthand the Japanese style of management. This was at the beginning of the equity and real estate stock bubble. I moved to Morgan Stanley where I was “present at the creation” of international derivatives markets. We were among the first traders of the Hang Seng, the SIMEX and the Osaka 50 futures contracts. Morgan Stanley facilitated the first program trades and the first electronic trades on the Tokyo stock exchange. As markets grew and became more sophisticated we helped introduce options, over the counter options and algorithmic trading to Japan. Morgan Stanley also had one of the leading prime brokerage businesses in Asia. We were able to deal with many of the leading hedge funds as they increased their exposure to Japanese shares. After running the Morgan Stanley Equity department in Tokyo, I moved to the buy side. First running an internal hedge fund for Morgan, then with Steel Partners Japan and now on my own. MOI: How has your view of corporate Japan evolved over the years? O’Friel: As I mentioned above, my first exposure to corporate Japan was working at a Japanese company. Those were the heady years just after the“Japanese managers are less publishing of Japan as Number One, a book by Ezra Vogel, my mentor atlikely to own a large amount Harvard. At that company, I learned the difference between management theoryof shares in their companies. and execution. They were an affiliate of Nomura Securities and tried to use the same business plan. However they did not have the human resources, capital or Thus, the interests of scale to execute the plan.managers are less likely to be directly aligned with It was obvious to me, a naïve observer fresh out of school, that there really shareholders, especially was no “corporate Japan,” just as there is no “corporate America.” There are short-term shareholders.” good companies and there are bad companies. That being said, there are some management philosophies that are more prominent in Japanese companies. In general the Japanese have a broader view of who the stakeholders are in corporations. There is a sense of responsibility to workers, vendors, clients and regions that is stronger than at most U.S. firms. Japanese managers are also less likely to own a large amount of shares in their companies. Thus, the interests of managers are less likely to be directly aligned with shareholders, especially short-term shareholders. This was true when I first came to Japan and is true now. The result is, although management is much more focused on the interests© 2008-2011 by BeyondProxy LLC. All rights reserved. SUBSCRIBE TODAY! www.manualofideas.com May 2, 2011 – Page 13 of 126
  13. 13. Value-oriented Equity Investment Ideas for Sophisticated Investors of shareholders, there is still little interest in financial engineering for the short term benefit of stock prices. MOI: Given the mixed track record of activist funds in Japan, is it justified investing in Japan using an activist approach? O’Friel: I would highlight the distinction that you made in your question. There is a difference between the success of activism used as part of the investment process and the success of particular activist funds, especially given the small sample size of such funds. Activist funds can act as a bridge between what the majority of shareholders want. Often large shareholders remain silent and prefer to “vote with their feet” by selling shares. However, there are fund managers who have complemented their success in Japan by behaving in an activist fashion, that is, working with management to implement change. These shareholders might not be noisy, but they have frequent and meaningful meetings with managers and directors of corporates. Japanese companies have always been innovative and willing to learn from the outside. Corporate finance departments and CEOs are willing to listen to shareholders. Gaiastu is a well recognized term in Japanese vocabulary that describes using the threat of foreign pressure to implement change. The improvements in balance sheets of corporate Japan over the last decade can be attributed to some degree to shareholder pressure. MOI: How would you assess the state of corporate governance in Japan? For investors looking to invest in Japanese equities, are there any governance related checklists that you would recommend? O’Friel: Corporate governance can be defined as monitoring the behavior of corporations so that efficient operations can be maintained, and assuring that the benefits accrue fairly among shareholders, management and other stakeholders. Legal shareholder rights in Japan are comparatively strong. Majority votes of shareholders can enforce change. The issue is that there are often more than a majority of shareholders that have no interest in the level of corporate governance and little interest in monitoring management. The first checklist point is the makeup of shareholders. Some items to check are the level of the institutional ownership, the number and relationship of “In [terms of executive cross shareholdings and the amount of insider or management ownership. compensation], Japanese The second item to check is the board membership. There has been somecorporations are far superior movement to improve the governance of corporate boards. The TSE has to companies in the West.” introduced some guidelines. Corporate boards in Japan are often large and have few independent directors. An analysis of the number and relationship of board members will give you an idea of the level of independence. A third item is executive compensation. In this area, Japanese corporations are far superior to companies in the West. There are few cases of management enriching themselves to the disadvantage of shareholders or employees. MOI: Many investors, most notably Warren Buffett and Jim Rogers, have expressed the view that the Japanese stock market may present buying opportunities following the selloff related to the March earthquake. Do you share this view?© 2008-2011 by BeyondProxy LLC. All rights reserved. SUBSCRIBE TODAY! www.manualofideas.com May 2, 2011 – Page 14 of 126
  14. 14. Value-oriented Equity Investment Ideas for Sophisticated Investors O’Friel: One of the reasons that the stock market rebounded so sharply after the immediate selloff was the vote of confidence by Buffett and other foreign investors. They realized that the damage of the earthquake and tsunami, while devastating in its human toll, was not huge in its infrastructure and economic ramifications. The three prefectures most directly affected by the quake (Miyagi, Iwate and Fukushima) account for only 4% of the population and GDP of Japan. However, damage to facilities did effect national supply chains and distribution. Then came the news of the damage and leaks at the Fukushima nuclear facilities. This has created more uncertainty in the medium term. 3% of the electrical capacity of Japan is now offline. This has begun to affect production outside of the areas directly impacted by the quake. In addition, both private consumption and consumer confidence in Japan will be eroded as the impact of blackouts continues. The loss of consumption on the private side will have to be measured against the rise in reconstruction demand. There will be gains in government consumption and public investment. While it is undeniable that the rebuilding process in Japan will be fast and efficient, it is vital that the repairs to the nuclear facility proceed without interruption and that the government is transparent about the damage and the impact of any dispersion of radiation. MOI: Will the recent catastrophe accelerate changes at the corporate or government level that could lead to more sustained value creation for shareholders in Japan? O’Friel: The general public has increased its demand for transparency from the government and from TEPCO. This might inspire the creation of an independent nuclear regulatory agency. The crisis has also highlighted the cozy relationship between regulators and the regulated in the power industry. We must keep in mind that tragedy often inspires countries to search for their core strengths. I think the Japanese nation, its people and its corporations will look to their core to help the rebuilding. They will look to the values of solidarity, patience and discipline. There is no indication that these noble traits, however useful they are to surviving and overcoming this disaster, will lead to fewer or better regulations or different views of corporate governance. “The three prefectures most MOI: While Buffett has recently sounded optimistic about Japan, he has notdirectly affected by the quake made any significant investments there. Are there any developments that may (Miyagi, Iwate and lead to improving returns on equity in the future?Fukushima) account for only O’Friel: The particular way of valuing Japanese companies has been the subject 4% of the population and of debate throughout the course of my career. Many of the valuation metrics GDP of Japan. However, have come into line with global norms. Once, brokers and companies struggleddamage to facilities did effect to justify P/E ratios of 60x to 100x as something that was unique to Japan. P/E national supply chains and ratios are now at levels in the low teens, which compare favorably to other distribution.” international markets. Price to book, especially for mid-cap and small-cap stocks, is low. There are many with price-to-book ratios below one. MOI: What are some of your key investment criteria? O’Friel: I have three simple criteria. First, the investment business is all about trust and values. If the management of an investment target is trustworthy and© 2008-2011 by BeyondProxy LLC. All rights reserved. SUBSCRIBE TODAY! www.manualofideas.com May 2, 2011 – Page 15 of 126
  15. 15. Value-oriented Equity Investment Ideas for Sophisticated Investors shares common values with the investor, then the opportunity is worth closer inspection. Otherwise, it is best to stay away, short or, if given the capacity, replace management. Second, valuation is the primary determinant of long-term returns. Being right on the concept and right on the price are two very different things. Finally, patience is important. If one is patient, it is easier to be a contrarian and to wait for the fat pitch. MOI: What is the single biggest mistake that keeps investors from reaching their goals? O’Friel: Research has shown that the single biggest error is overconfidence.“…valuation is the primary Investing is hard, with elements of skill, hard work and luck. An investor who determinant of long-term attributes every success to skill is susceptible to overreaching. Despite thereturns. Being right on the outward veneer of successful managers, most are rather modest in reference to concept and right on the their own skills. They know what they do not know. They respect the market.price are two very different things.” MOI: What books would you recommend to non-Japanese investors looking to learn about Japan? O’Friel: Any of the John Dower books, from War Without Mercy to Embracing Defeat, tell the story of how Japan rebuilds from disaster and will give readers a clue as to how Japan will respond to the recent earthquake. Ronald Dore’s Stock Market Capitalism: Welfare Capitalism challenges the preconception that there is one way of global capitalism. It highlights similarities between traits seen in Germany and Japan. It is especially relevant given the 2008 shocks to the “Anglo-American” system.© 2008-2011 by BeyondProxy LLC. All rights reserved. SUBSCRIBE TODAY! www.manualofideas.com May 2, 2011 – Page 16 of 126
  16. 16. Value-oriented Equity Investment Ideas for Sophisticated InvestorsSome Context: Japan, The Country and The EconomyPOPULATION SIZE – JAPAN IS DWARFED BY THE U.S. AND SEVERAL EMERGING COUNTRIES th Japan is ranked 9 in terms of population size, but its rank may slip in the coming decades.Source: Japan Statistical Yearbook 2011, The Manual of Ideas.POPULATION GROWTH HAS TURNED NEGATIVE The decline in youth is worrisome for Japan’s long-term economic and social outlook.Source: Japan Statistical Yearbook 2011, Chapter 2: Population and Households, The Manual of Ideas.© 2008-2011 by BeyondProxy LLC. All rights reserved. SUBSCRIBE TODAY! www.manualofideas.com May 2, 2011 – Page 17 of 126
  17. 17. Value-oriented Equity Investment Ideas for Sophisticated InvestorsJAPAN’S POPULATION PYRAMID HAS BECOME TOP-HEAVY…Source: “Statistical Handbook of Japan 2010” by Statistics Bureau, Japan; The Manual of Ideas.…AND WILL LIKELY BECOME EVEN MORE TOP-HEAVY OVER TIME Increased immigration or a higher birth rate are likely necessary for Japan’s long-term viability as an economic power.Source: Japan Statistical Yearbook 2011, Chapter 2: Population and Households, The Manual of Ideas.© 2008-2011 by BeyondProxy LLC. All rights reserved. SUBSCRIBE TODAY! www.manualofideas.com May 2, 2011 – Page 18 of 126
  18. 18. Value-oriented Equity Investment Ideas for Sophisticated InvestorsDISTRIBUTION OF ESTABLISHMENTS AND EMPLOYEES IN JAPAN Corporations, both large and small, dominate the employment picture.Source: Japan Statistical Yearbook 2011, The Manual of Ideas.GDP BY COUNTRY – JAPAN REMAINS AN ECONOMIC POWERHOUSE * Japan’s economic significance dwarfs what might be expected when considering the country’s population size ranking. That said, China recently surpassed Japan in terms of GDP.* Based on 2008 data. Source: Japan Statistical Yearbook 2011, The Manual of Ideas.JAPANESE GDP HAS STAGNATED FOR MORE THAN A DECADE The Japanese economy has made little progress against a backdrop of multi-year deflationary pressures.Source: Japan Statistical Yearbook 2011, The Manual of Ideas.© 2008-2011 by BeyondProxy LLC. All rights reserved. SUBSCRIBE TODAY! www.manualofideas.com May 2, 2011 – Page 19 of 126
  19. 19. Value-oriented Equity Investment Ideas for Sophisticated InvestorsNOT SURPRISINGLY, SALES AND PROFITS HAVE ALSO STAGNATED The financial crisis has affected the profits of “Japan Inc.” in an unprecedented way.Source: Japan Statistical Yearbook 2011, The Manual of Ideas.TRADE INCREASED THROUGH 2008, BUT EXPERIENCED A SHARP SETBACK AS A RESULT OF THE FINANCIAL CRISIS Japan has consistently maintained its status as a leading exporter and generator of trade surpluses. The latter have shrunk in recent years, as imports have become more important to the country.Source: Japan Statistical Yearbook 2011, The Manual of Ideas.© 2008-2011 by BeyondProxy LLC. All rights reserved. SUBSCRIBE TODAY! www.manualofideas.com May 2, 2011 – Page 20 of 126
  20. 20. Value-oriented Equity Investment Ideas for Sophisticated InvestorsNEARLY ONE-HALF OF REVENUE FROM BOND ISSUANCE, WHILE NEARLY A QUARTER OF BUDGET GOES TO DEBT SERVICE Japan relies heavily on debt issuance to fund the annual budget. Social security and debt service represent large burdens on Japan’s budget. Offsetting these needs is a relatively low allocation to defense.Source: Japan Statistical Yearbook 2011, The Manual of Ideas.“NON-PRODUCTIVE” SPENDING (RETIREES AND DEBT SERVICE) HAS BEEN INCREASING OVER TIME Japan’s has radically reduced land preservation and development expenditures in order to fund other priorities.Source: Japan Statistical Yearbook 2011, The Manual of Ideas.© 2008-2011 by BeyondProxy LLC. All rights reserved. SUBSCRIBE TODAY! www.manualofideas.com May 2, 2011 – Page 21 of 126
  21. 21. Value-oriented Equity Investment Ideas for Sophisticated InvestorsJAPAN’S GOVERNMENT DEBT-TO-GDP RATIO STANDS OUT AMONG DEVELOPED COUNTRIES Japan’s debt-to-GDP ratio may have passed the “point of no return”.Source: Japan Statistical Yearbook 2011, The Manual of Ideas.UNEMPLOYMENT HAS INCREASED BUT REMAINS QUITE LOW Japan’s unemployment rate fell to remarkable lows prior to the crisis.Source: Japan Statistical Yearbook 2011, The Manual of Ideas.© 2008-2011 by BeyondProxy LLC. All rights reserved. SUBSCRIBE TODAY! www.manualofideas.com May 2, 2011 – Page 22 of 126

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