CIO Insights 3Q2024

On the last day of July, in a small but telling move the Bank of Japan raised its short-term policy interest rate, from zero to 25 basis points. It also hinted at further increases as macroeconomic conditions improve. The market seems to have been taken off guard by the news, triggering a sharp rise in the yen. This in turn forced speculators to unwind borrowings in the currency which they had previously used as a cheap funding source to finance the purchase of supposedly higher-yielding assets. The first-order casualty was the Japanese stock market, with equities selling off hard and indiscriminately.

The incident illustrates a classic case where short-term market dynamics (Ben Graham’s “voting machine”) can play into the hands of thoughtful long-term investors (his “weighing machine”). The fact that the market went down immediately after the Bank of Japan’s announcement was not inherently “bad,” as intuitively interpreted by many observers. Stock prices did not fall because the economic realities of Japanese firms suddenly turned for the worse. They did so, firstly, because a rising yen plays against the positions held by carry-traders and, secondly, because the algorithm-based trading programs that dominate market activity these days overwhelmingly engage in trend-following and hence reinforce a prevalent price direction. Another peculiarity is that share dealing in Japan has always been dominated by foreigners, as local companies and institutional investors are mostly buy and hold investors. We surmise that many foreign “investors” in Japan tend to be momentum-driven “asset allocation tourists” with a short-term view. Thus, they are probably quick to sell if their trades do not act well.

The investment case for our Japanese equities has not been altered by these moves in Japanese interest rates and currency. First, a higher policy rate is in fact good news and a direct response to the solid trajectory characterized by positive wage-price dynamics, something the country has finally achieved after trying in vain for more than three decades. It is true that tighter monetary conditions raise the price of money and hence the hurdle rate for discounting the future cash flows firms generate. (Incidentally, though, long-dated Japanese government bond yields fell on the news, resulting in a flatter yield curve). Crucially, the prudent investor presumably has already incorporated in his or her valuation case that the price of money, even in Japan, will not be essentially zero forever. Thus, the relevant long-term equity discount rate used for present value calculation purposes should not have been materially impacted by the hike in the short-term rate.

Another argument commonly made is that yen appreciation is hurting exporters and owners of foreign assets due to the transactional and translational effect it has on their books. This may be a shorter-term concern especially for passive equity allocators because the largest, most well-known Japanese companies that constitute the big indices are heavily driven by foreign revenue and/or assets. For long-term investors this is less of a worry as companies with a competitive product offering typically cope well with strong home currencies. For evidence, if we look at countries with historically very strong local currencies, such as Switzerland and the very Japan, we find that their leading exporters have been able to adjust and keep excelling over time. Having said that, the majority of Japanese companies we are currently invested in generate / hold most of their revenues / assets domestically. We have had more exposure to exporters in the past, but our selling discipline led us to dispose of several of them before the recent market turbulences as their prices rose to our conservative estimates of intrinsic value.

Corporate Japan has made great strides in recent years since corporate reforms took hold in the mid-2010s under “Abenomics.” Neither higher domestic interest rates nor a strong yen can derail this progress. Japanese managers are now properly incentivized and firmly attuned to raise return on capital employed by improving operating efficiencies as well as return of capital in the form of higher shareholder payouts—and that’s what ultimately matters to deep value investors.

Sincerely,

Gregor Trachsel
Chief Investment Officer SG Value Partners AG