Tohoku aftermath: seeing the positives amid the gloom

CIO Insights 1Q2011

It lies in the very nature of contrarian-minded analysts like us to be cautious when common opinion is in high spirits and to be constructive when consensus fears the worst. True to this mindset, given our significant exposure in Japanese equities we would like to focus this discussion on (1) what structural advantages our Japanese businesses possess to overcome the current hardship and (2) how the virtues of our price­ sensitive equity selection process – in Japan and else-where – become apparent during crises like this one.

On the first topic, there are a number of aspects about corporate Japan which we view positively but which in Western corporate theory are commonly seen as impediments for value creation. One such factor is the generally conservative balance sheets with which Japanese businesses tend to operate: most of them hold significant cash balances and other liquid assets (currently by far the highest in the world) while keeping indebtedness at very modest levels. Needless to say, liquidity and solvency are critical to survive economic shocks brought about by natural or man-made disasters. Another structural benefit in our judgment relates to the widely-criticized cross-share-holdings and strategic tie­ups among firms. These types of interrelationships aid in troubled times to gain flexibility when it comes to issues such as managing working capital (e.g., paying bills, collecting receivables), arranging credit facilities on short notice, or proactively dealing with bottlenecks created by interruptions in the supply chain. And finally, Japanese businesses are often organized as conglomerates or at least pursue diversified business models in terms of products, markets and/ or required resources. As we have argued in the past, we like such multi-pronged approaches because they once again add managerial options and raise the chances to soften the blow to the consolidated entity when sudden disruptions hit one aspect or area of the firm.

On the second issue, one of the pronounced characteristics of the Fund’s portfolio composition is the heavy tilt towards mission-critical products and services such as utilities and telecommunications, transport and logistics, engineering services, capital goods, materials, packaging, basic food, and land. On the flip side, the Fund has very limited exposure to businesses that earn their money in satisfying the niceties of life, such as fashion and luxury goods, electronic gadgetry, entertainment and most leisure-related activities.

Society in general and the investment community in particular typically comes to truly appreciate only during post-disaster periods just how essential the former are to the workings of a modern economy while the latter are relegated to the back burner. But to be sure, the Fund is not structured this way by grand design, recalling that we are strictly valuation- based as opposed to theme-based investors. Rather, the portfolio comes about in this form because we find that we can usually buy these “must have” businesses at far more attractive prices relative to their intrinsic value than the “nice-to-have” ones.

We surmise that this – for our comprehension somewhat paradoxical – situation may occur because in benign, i.e., disaster-free economic environments, the former tend to be too boring, too low growth and too cyclical in nature for most investors, while the latter tend to fetch a certain vanity, excitement and recognition premium. Whatever the ultimate dynamics for such investor preferences may be, they work to the advantage of dedicated value investors like us.

Sincerely,