Wednesday, October 05, 2011

When Around the Bend the Yen Descends...

In May of 2007, when almost everything seemed Hunky-Dory, the sober-minded BCA forecast EURJPY of >180. In a note of reply to this extrapolation of this prevailing trend into the future, I took a stab as to which side of the distribution the fat-tail might be hiding. With certainty, we now know where it was (Cass-1, BCA-Nil). Since The Reckoning began in earnest [and risk-off] pushed USDJPY below par, many have tried their hand shorting JPY. Armageddonist Kyle Bass (somewhat wrongly one might point out) forecast its demise several years ago in a lengthy piece arguing that JPY is essentially guano (my word not his though upon reflection I realize I've erred in my wordchoice as guano IS extremely valauble). And swaggering big-picture dudes talking their books at Drobny's pow-wows, have featured short JPY trades more or less continuously since 2009, with each episode leading to the formation of a nascent trend, though each subsequently ending with a head-on into the electronic herd and other mysterious flow.

JPY now sits at 76 and some bits versus USD, and circa 103 basis the European unit. This is NOT a post forecasting the imminent demise of the Yen. My hide too lies besides Friends of Drobny, reckoning that the end of Q1 was the denoument, though I still think it will pay sufficiently in the next 12mo, despite being egg-faced on the timing. But that is not the point of this post.

What I encourage you to do is put your imagination caps on for a few minutes. Not that you need them to inspect the collateral damage of a currency appreciating up towards 50% vs. the worlds other two largest units. Of course during the past two decades Japan has followed the US and Europe in hollowing its base, setting up shop first abroad in its largest market, then all over southeast asia and subsequently in China and beyond. The global manufacturing enterprises thus created can absorb some of the shock. And they do hedge their FX too, providing additional triage. But as in the mid-1990s squeeze, Japanese enterprises' product prices abroad have not moved with the currency, as manufacturers have chosen to stomach lower margins in order to retain markets, customers and volumes rather than cede them to competitors. This is one of the primary reasons trade gaps are sticky. And it is not necessarily irrational, particularly if one believes the curse of an over-valued exchange rate to be temporary.

Investors have observed the carnage and voted with their feet. Many large exporters have dived beneath their 2008 crisis-lows, plumbing price and valuation depths not seen for a deacde (or more). Their brethren that haven't sunk so low are chasing their coat-tails. It is, to use a technical term, ugly. And as usual, there is circularity since banks remain large shareholders, and despite their clean-er balance sheets (clean meaning not laden with US Housing, and peripheral Euro sovereign exposure), experience stress upon capital ratios with each new lurch down in the broader indices.

The pessimist (and the quant, and the fundamental screener) looks and sees uncompetitive enterprises, and all the red flags associated with declining sales and margin erosion. Five-year histo sales growth of MINUS 15 to 20%. Same in operating profits (or worse). Some reflects reality for zombie co's remain and continue to produce in comical Shaun Of The Dead fashion. However, under the circumstances, the numbers of these JPY-sensitives actually demonstrate some superhuman adaptive skills. They have managed (so far) to avoid being fatally torpedoed by the currency, and in the main, keeping the declines in operating profits to almost-tenable levels. Their income statements, when viewed in dollars or Euros, of course tell another picture. In this imaginary land, historical top-line growth for companies this size and breadth have been respectable - even ignoring The New Normal. One must imagine the sensitivity of their OPs to fanatasize about what lies below, though any of the brokers will share their forecasts as will the companies themselves (if you chance the latter). But a USDJPY at par would unarguably bring a polished lustre (and apparent top-line revenue growth) to what are presently tarnished in diminished local currency value translations. The circularity works through the system. Bank capital re-inflates, reducing stress, and encouraging an expansion of lending. The Government's balance sheet, too smartens as currency losses on the trillion or so of their US T-Bonds diminish and their USD coupon receipts contributes to government coffers. Worker bonuses rise, consumption edges higher and consequentially, suicides drop. Maybe even whaling might finally be abandoned!! (I exaggerate on this last point.)

Rose-tinted glasses...yes, perhaps. But the grimmest view of JPY-sensitives by investors are also seeing a distorted view of the world (Stevie Wonder's Sunglasses?!!?) since the JPY is no SGD CHF NOK SEK or CAD. It is JPY and it is, irresepctive of its levitation, Bat-Shit. The current prevailing view is one that myopically assumes the status quo remains, and makes no judgement upon where the fat-tail is NOW, and what those impacts (whenever the fat-tail shows itself) will be.

Japanese companies are already some of the cheapest in the world. Admittedly, sometimes for good reason (hostile to shareholders, poor governance, truly dismal prospects). When regressed against peers along value and growth axes, they are the cheapest, but also with the lowest growth. It is, I submit, worth more closely examining the idea that the apparent lame-duck growth (shrinkage, more accurately, in local JPY terms) has more to do with the extemes of the JPY rather than the ossification one encounters in the type of value traps enroute to ignominy. In precisely the same way fair-weather friends make themselves scarce at the first signs of trouble, or the young, beautiful gold-digger abandons her balding sugar-daddy when SEC investigation bankruptcy is on the horizon, so have investors fled from otherwise sound (and cheap!!) enterprises, in the process driving them to multiples of diminished cash-flow expectations or, even better, free cash-flow expectations that would have made Graham or Dodd or both salivate. And these enterprises are not shells of their former selves, hollowed-out by predators and asset-strippers, but companies that continue to invest robust proportions of revenues in R&D, and remain on the leading-edge of their respective markets.

It is true that many Japanese companies remain hostile to foreign investors, pay hommage to a wider constituency than that narrow-defined by shareholders, and are undoubtedly poor communicators. To their credit, their corporate GINI's would make American executive management blush; they can, and are willing and able to make longer-run ivnestment decisions that American mgmt can only dream of; and they have spent the last two decades relentlessly (and deftly) avoided being cast upon the Scylla of vaulting energy prices and the Charybdis of an elephantizing exchange rate. What doesn't kill you makes you stronger - not in the proverbial sense, but, as my youngest too-often exclaims "For Real!". One needn't recount here, after two deacdes of being squeezed vise-like, the output unit of GDP per input barrel of oil and labour which by comparison will only conjure images of profligate lard-ass Yanks driving Lincoln Continentals, and Cadillacs of the type that causes Jeremy Clarkson to spit venom and derision. Yes, maybe the Japanese don't do finance like GS or MS, nor do they do activism like Warren Lichtenstein or Nelson Peltz, having had their near-death brush with Zaitech. But then again, maybe NOT emulating US IBs and their financial shenannigans is not such a bad thing, all considered. At the corporate level, they are, at this stage, more likely to be financially STD-free, despite their less-than-salubrious past.

I find myself getting bulled-up as I write this, but THAT is not the point, nor my conclusion. The allure may merely be in relation to the rest of the trolls, who are not as far along in their metastases. The point is that when the world is driving by looking out the rear window and extrapolating the recent past ad infinitum into the future, discounting or ignoring causes, at the expense of reasonably weighing the probabilities of alternate future realities, one can ascertain on which side of the distribution the fat-tail resides. And that, to me, seems where we are at the moment. And I have put my imagination-hat on and think the visions neither far-fetched, nor even that far off.


Anonymous said...

So for those of us who are thoughtful, patient investors who have only worked in the US and Europe, but will go anywhere for a cheap stock even if it takes years to work - where does one start in Japan? Impossible w/out being on the ground w. a translator?

My few experiences in Tokyo amount to lots of culture shock in boardrooms and meetings and the realiziation I didn't even know where to begin.

Anonymous said...

I've always made the sirens reference w/ respect to Graham and Dodd and Japanese companies for what its worth.

Which of us doesn't get hot an bothered at discounts to tangible book?

Rich said...

I find it interesting to look at the trade balances of China and Japan. The trade deficit with China has narrowed over the past few years, so they are nearly even the last I looked. I’m no expert, but I’d guess that the Japanese manufacturers are selling the high tech parts into China for manufacture of the finished product in China.

The Japanese firms are likely doing what they’ve always done – heavy capital spending to generate depreciation expense to keep taxes low, which also keeps Japanese nationals working. What’s better now is that the Chinese get the heat for the trade imbalances when the high value added Japanese parts have a Made in China stamp placed on the end product.

Anonymous said...
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Anonymous said...

what is interesting to me is that having spent the better part of the past month in japan (after not having visited the country for 20+ years), i found prices very reasonable relative to other global centers of commerce (e.g., SF, Rio, London, HK, NYC).

that's not to say that japan is cheap. it isn't. but i went expecting to find prices exorbitant, but instead i merely found it expense. it felt in line with other major cities around the world.

while i wouldn't be surprised to see the Y/$ rate go back to 100, i doubt it goes as low as 125. imo brazil, quite frankly, is much more over-valued than japan. at least in japan, you have first rate infrastructure (narita aside) and a low gini coefficient.

as far as the *stocks* go, i'll echo the comments of the first person commentator. i happened to spent time with the board member of a well regarded domestic life insurance company who told me that his company would like to move into the *banking* business in australia. when i asked him why, the answer wasn't "it's a oligoply with cartel pricing and we think we can leverage our nascent online japanese bank enter and disrupt the market". instead the answer was "the australian dollar is very strong and interest rates are higher in australia than japan."

yikes. i know they don't ring a bell at the top, but no one ever said anything about a gong. i wanted to walk out of the meeting and short the A$ right then and there. i would have shorted the company i met with as well, except for the fact that every single financial institution in japan is basically a warrant on future inflation. and i *definitely* do not want to be short deflation in a world of massive government budget deficits and growing social inequality.

Anonymous said...

I like your piece but please make it a tad more simple minus all the SAT words...but I agree with your view tho!

Anonymous said...

Anon @ 2:21 - how about you do yourself a mental favor and learn the words for yourself?

C - where do the small caps fit into this? they got clobbered to nearly unthinkable valuations post-quake but they don't export. are these companies a value trap since they combine the worst of Japanese corporate inefficiency with the worst of Japanese bureaucracy?

Saxy Orienteer said...

I would be interested in knowing if better/more disclosure from Japanese micro/small caps would drive stronger interest from investors. Planning a system that would allow better information flow.