276. Japan’s resilience and debunking deglobalisation

14 September 2023 (pre-recorded 7 September 2023)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION]

Staci West (SW): Welcome back to the ‘Investing on the go’ podcast brought to you by FundCalibre. We’re considering all things Japan today as our guest provides valuable insights into Japan’s evolving economic landscape, its resilience, and the investment opportunities it offers.

I’m Staci West, and today I’m joined by Sam Perry, manager of the Pictet Japanese Equity Selection fund. Sam, thanks for joining us today.

Sam Perry (SP): A pleasure to be here.

[INTERVIEW]

SW: Now, I wanted to start with something that we’ve discussed on this podcast before, which is this widespread view that the world is de-globalising. Is this a view or trend that you are seeing in maybe from Asia and Japan? Do you think that we are in fact de-globalising?

SP: Actually, funny enough, no, no, I don’t. I think a lot of the idea that we are deglobalising is really kind of based in our recent history of Brexit and Trump. Where Trump, obviously with ‘America First’, was making all sorts of noises about trade wars. He was fantastically ineffectual in every sense there. I mean, the NAFTA 2 – the USMCA* – is almost a direct copy of NAFTA 1 with almost no difference. The KORUS** deal for Korean steel was going to be counted widely by Trump as being a magnificent achievement; all it did was allow GM & Ford to sell up to 50,000 cars in Korea; they’ve sold less than 10,000. So, it doesn’t really make a lot of difference.

And of course, Brexit, while it feels like it’s had a deglobalising impact, the whole premise of Brexit of course is greater globalisation, that we’ll be having bilateral trade deals absolutely everywhere. It hasn’t happened, but that was the plan.

Biden, on the other hand, while he’s not going for direct deglobalisation, has actually been much more impactful. So, the impacts we’ve had or seen on China and on the Chinese technology [sector], some responses from China as well, have actually had more of an impact than anything we saw in previous years. Despite the fact that you’re not having 25% tariffs being threatened on European autos, nonetheless, it feels like a lot more has happened. So, what’s the impact of that? It’s interesting, we can actually really see what the impact is in Japan. So, we’ve had conversations with, for instance, Hitachi. They’re effectively now fire-walling their elevators and escalators business, which is in China, from China; that’s going to be it now. And so, this is kind of something we’re seeing again and again, that you are getting, rather than reshoring – friendshoring. People see there’s a geopolitical issue with China, so they’re going, okay, well, we’re going to build our plant in India – or Thailand. But the really important thing is that the genie is well out of the bottle, so oil is going to come from wherever oil is, minerals are going to come from wherever minerals are.

When we’re looking at consumer electronics, for instance, there’s a reason that we’ve still got a lot of containers coming from the west coast of China – sorry – the east coast of China to the west coast of the US – it’s because that’s where the electronics are. Think about the iphone; can you build my phone in the US? Of course you can build my phone in the US – the extra cost would be maybe $50. I did this calculation a couple of years ago, but it’s probably still about that. So, why don’t we? Well, the reason is, it’s people. If you look at Pegatron [Corporation], their plant, which makes that a third of Apple’s phones about the same as are sold in the US; they have 77,000 people in their factory. And the head of Foxconn [Hon Hai Precision Industry Co., Ltd.], one of their competitors, they’ve reduced – to some extent – the number of people they have, but they’ve still got … iPhone city has 200,000 employees in it. And the head of technology automation of Foxconn said, well, the turnaround and the shelf life of phones are so short, we simply can’t automate it that much. It would be wildly cost ineffective to do that. So, you need people. So, in Pegatron, there’s 77,000 people; if you put that into the US you’d need a 100,000, 120,000 Americans, because of different shift hours and so forth. Where are you going to find 120,000 Americans to go to one factory? The biggest factory in the US, the Boeing one – it may not be the biggest now, but it certainly was with 30,000 people; the Pentagon, has 23,000 people in it. You can’t put 125,000 Americans into one factory, coming from a small pool of people. Foxconn has dormitories; you’re not going to have that in the US. So, are we likely to see a reshoring of Apple’s iPhones, from China to the US? No, we’re not.

Are we seeing a friendshoring? Yes, we are. So, we’ve got new factories opening up in India and so forth. It comes down to people, it comes down to transport, it comes down to logistics. Supply chains are the supply chains. So, I don’t think we’re going to see de-globalisation. We are seeing a shuffling of supply chains and we’re seeing that both, you know, we can see it more globally [and] we can see it very much on the individual companies we talk to in Japan.

SW: I don’t even want to think about the traffic in America, trying to get that many people to one factory <laugh>.

SP: I mean, there is actually one interesting comparison, and that is, you know, some of the big college football stadia, they take over a hundred thousand people. But like Foxconn’s dormitory town, everybody’s living there, they’re just walking there, they’re not trying to drive there. I think the biggest carpark in the world is supposed to be the one in Edmonton, which is some shopping mall, that’s only 30,000 cars. I mean, yeah, the traffic just doesn’t even begin to make sense.

SW: No, no it does not. <Laugh>. But I like the way that you rephrased a reshuffling because that makes a lot more sense and is slightly less worrying than thinking about de-globalising. As you said, the genie seems to be out of the bottle on that one, but it’s still a topic that’s thrown around very frequently.

SP: Yeah, I mean, another way again, I’m going to use a bit of an American comparison, but the theory is that the average American woman has seven pairs of jeans. They cost $20-$25 a piece if you, you know, buy them from Walmart. If you were to make a pair of jeans uniquely in America, so you’re going to use American denim, American fittings, and American seamstresses, your retail price would be more like $200. The actual cost of just the sewing is a big difference. So, you know, if you look at East Asia, then the cost per hour for a seamstress is say $25; cost per hour in South Asia is more like, sort of $15; cost per hour in Ohio – I can’t remember why I got an Ohio figure, but I did – and Ohio seamstress would be more like kind of $140. You just can’t do it. So, you mean your labour cost alone would be something like $50 for your American pair of jeans. You know, there’s a reason we outsource this stuff.

SW: Before we get too fixated on our kind of first topic that I wanted to talk about, let’s shift gears slightly to the economic environment in Japan. So, at odds with the rest of the world, it almost seems with interest rates are still negative, inflation at just over 2% which is welcome in a country that has had deflation for more than three decades; why is Japan so different and what does it mean for your Japanese companies?

SP: This is one those sides where I have to say, well, Japan is different because we didn’t start from here. Where we started with Japan was – we have to go back to the bubble. So, we have the bubble in late nineties, sorry, late eighties, the collapses into the early eighties, early nineties rather. You then have a series of policy missteps; the banks aren’t cleaned up; you have zombie loans everywhere; and effectively, you have a bad bank situation that could have happened in the West in 2008, but didn’t, largely because we could see what happened in Japan. So, 2008, you know, Bernanke*** and people all around the world, looked to actually liquidate these bad loans as fast as possible. In Japan in the nineties, the reverse happened; the zombie loans just stumbled on and on and on. And what the bad banks did is what bad banks always do, and that is they yank credit from healthy borrowers. So, at that point, the healthy borrowers are going, right, we can’t trust the banks, we’re just going to dash for cash – cash is king. Now, the problem with that is that if everybody’s going for cash and you are seeing that transactions in the economy are crunching down and slowing because nobody’s investing, nobody wants to buy anything, nobody wants to do anything – that just makes deflation worse and worse and worse.

Now, what that means, once you enter into deflation, you then have a new problem, and that is the cash is now going to give you a real return – so, there’s a return after the effects of inflation or deflation – for free. There’s no risk – it’s cash! So, this means that now you’re in a position of, well, why should I invest? It doesn’t make any sense. I may as well just sit there with a large pool of cash. And there’s certainly no point in getting in debt to invest in machinery or whatever, I’ll just stick with the cash. So, that was the position we were in, that’s the classic deflationary spiral that we saw actually in the 1930s as well.

So, let’s fast forward then to 2012/2013. Abe’s come into to power****. He puts [Haruhiko] Koroda in as Bank of Japan Governor and now Koroda launches, QQE – Qualitative and Quantitative Easing – deliberately targeting the idea that inflation is happening in the economy. Because if that happens, everything changes, because now cash is no longer giving you a real return, risk free – it’s a wasting asset. So, you need to get rid of it, you need to invest it, you need to actually get a return from it. So, all of a sudden, everything we saw in the last 10 years reverses, and now we have completely the opposite <inaudible>. We have a dash to re-leverage. We need to get the debt in and we need to use up this cash, we need to return it to ,inaudible>, we need to invest, we need to grow. So, now we are seeing a completely different situation from what we are seeing in Europe and the US where yes, they’ve got inflation, but that inflation is really very significant and we’ve seen rates go up and up and up and up and up and now people are looking at actually substantial real rates coming along. So, they really will feel the pinch. Whereas in Japan we’ve still got, as I say, very low interest rates. And we’re seeing inflation just pick up gently, which means we have a negative inflation, real inflation, sorry, negative real rates – and that means that the compulsion to invest is going to be quite hard because otherwise you won’t make a return. So, that’s why it’s a great thing for Japan and that’s a fantastic thing for the Japanese equity market.

SW: And the Japanese stock market has been one of the best performers of this year as well – returning almost 18% in yen terms, which is more than double the US stock market [SP: In dollars]. In dollars. Can these good times continue for investors?

SP: Yeah, well, I mean the reason I interjected with the dollar point is of course actually that in dollars, 16% is actually rather better than what we’re seeing in dollars from the yen. And similarly better than European stock markets and obviously a lot better than the UK stock market, which is down a smidge in dollar terms and up barely in sterling. And I think there we have to point to the impact of [the] Nasdaq, I mean that’s up really a third year to date. So, actually we’re not racing ahead in Japan, but on the other hand, we have a lot of tailwinds, which other people don’t have.

But the tailwind [I] just mentioned of this massive economic stimulus, which is effectively happening, not stimulus coming from the government, not stimulus coming from Bank of Japan, but just the actual overall shape of the economy is that strongly favouring investment and growth, which it never has done before. So, we had a Bank of Japan deputy governor talking about the green shoots are finally here and it’s been a long time coming. So, that’s one part.

The other part is that we’re getting an interesting dynamic happening here, but at the same time as you are getting this inflation pushing companies to invest more and get higher returns, you’re also getting strong pressure from the Tokyo Stock Exchange, from the Ministry of Finance and administration, for companies to make themselves more efficient and to push more money back to shareholders. So, that’s going to be a great dynamic as well. Because now, the easiest way for a company to increase its return on equity – so, look at the sort of the source capital between debt and equity, and then how much profit is it making as its return on equity? Well, one of the most impactful things they can do is just increase leverage, because then you should look at the return on equity effectively as being the return on your assets, so how much profit are you making from all your factories? And then consider how it’s financed, namely you deleverage. So, if you really want to increase your returns – returns on equity – very easily, just reduce your cash. It’s kind of as simple as that – you deleverage.

So, this is being, you know, you are getting a drive for this both from the overall economy and a drive for this from top down as well. You are also getting a drive for this from the bottom up, from us, from investors. Because we keep on banging on the door and saying, you know, you are sitting on a huge amount of cash, why aren’t you actually handing it back or doing something useful with it? And here again, we come to a matter of time and now it’s about management. The guys who were desperate to deleverage and hoard cash were the guys who were around in the chief executive’s chair, chief financial officer’s chair in the late 1990s. They’re retired. This is a cohort of chief executives who now pretty much don’t exist. So, we now have people with very different ideas about what should be happening, who now in the chairs of as chief executive and chief financial officer and chairmen, who are actually looking at the piled up amount of cash and going, yeah, we do need to get rid of this; we need to hand it back to people, I guess do something useful.

SW: You mentioned a few different points within Japanese companies themselves and how these companies are managed has undergone a lot of changes in recent years, some of which we’ve talked about before with more women being encouraged onto boards and companies being asked to give money back to shareholders in the form of dividends. And now I guess that these teams are also having to raise prices for the first time potentially ever, or deal with the rising costs of running these companies? So, how are the companies coping? Have there been some knock-on effects of these changes?

SP: I think we can describe it in a way as quiet delight. I mean companies we’ve been talking to who’ve said – they’ve been saying for years – and we said, what are you doing with your pricing? They say, well, we can lift prices in the US, that’s fine. And we can lift prices in Europe, that’s fine. And we’ve been able to lift prices here, there and everywhere, but not at home. We just simply can’t get price rises through. That’s a real drag. We’re having to increase efficiency, cut costs, but we just can’t push the prices at home. Whereas now they’re just turning around and saying, yes, we can increase prices in the US, we can increase prices in Europe, and we can increase prices at home. And these price increases are sticking. So, a conversation we had with a cardboard manufacturer recently – you know, they’re the guys who make this really heavy duty packaging for car parts and stuff, not thinking so much of Amazon parcel-type cardboard, but really heavy duty stuff – and they’ve been, you know, saying yeah, we’ve been able to get two price prices through. The Asahi Beer Group [Asahi Group Holdings, Ltd.], which has San Miguel, Peroni, Greenwich Meantime my local brewers – they’ve been able to lift prices at home as well, and this is kind of like the first time in forever.

When Ezaki Glico [Co. Ltd.], the ice cream manufacturer – and they have this one particular product which is, you know, everybody knows, it’s kind of the standard ice cream everybody thinks about from their childhood – he actually made a public apology that he had to raise prices for the first time in something like three decades. But yeah, the price increases are going through, they’re sticking and it’s becoming normalised and, you know, this is a truly extraordinary development for Japan. I mean, it’s certainly not something … that’s the first time I’ve seen it since I’ve been following the market for what, 26-7 years now.

SW: I mean, you’ve painted quite an optimistic rosy picture talking about Japan, which slightly contradicts something that I heard a few weeks ago, which was someone saying that Japan is one of the most inefficient equity markets. Do you think that this is true or is it just it’s under-resourced and researched, so it appears this way?

SP: Yeah yeah, well it’s definitely under-resourced and under-researched. So, the S&P 500, you know, pretty much a third of the total market has over 25 analyst recommendations. About over half the market has more than 20. Look at Japan and over two thirds have less than seven recommendations. Now, does that make it efficient or not? So, there’s the TOPIX 500***** compared to S&P 500, you know; same number of stocks – we’re talking the biggest stocks in the index – and that’s kind of our investment universe-type thing.

Does that make it more or less efficient? Well, you’ve got some deep and knotty problems there and namely, you know, what do we mean by efficiency? Classically, academically, we mean that information goes through the market pricing absolutely automatically, and very, very quickly, so there’s no chance of arbitraging on information – that’s kind of academically what it’s supposed to mean by efficiency. Even, however, even in a perfectly efficient market, then there’s still lots of scope to make money. I mean, think about it this way: if an analyst comes up and he’s an absolute genius and knows exactly what’s happening with Toyota for the next three years, he absolutely calls it perfectly; he’s the only analyst in town and he is shouting it from the rooftop. If nobody else is actually buying and selling Toyota, nothing happens, the price doesn’t change. Why? Because the market is [about] price discovery. It’s about trying … for us to sit there, weigh it up and think how much are we willing to pay for what we can see? Now, this still leaves us opportunity even with perfect efficiency because if you have everybody looking at Toyota and going, the analyst is right, short-term this is bad or good. Well, in the long term we may say, actually the reaction that these people are making on Toyota share price – let’s say it’s bad, so it’s dropping – you think, ah, well actually if we’re going to look out 10 years, we think this is good. So, that then gives us an opportunity.

So, I mean for us, we are pretty long-term investors and we like to try and … effectively our view on all the big stocks, you know, and all the stocks we follow is constantly evolving, constantly changing. We may not be doing very much inside the fund, but then when an opportunity does appear, we can then say, right, now we have our opportunity. It’s, you know, we’ve seen the market move a long way from our fair value, now we can actually move into this. So, at March 2020 when you had the Covid collapse in the markets, that gave us a fantastic opportunity to buy all sorts of stocks that we wouldn’t normally be able to buy because we thought they were too far away from fair value – sorry, too close to fair value or above fair value, and all of a sudden we have an opportunity. So, is it efficient? I don’t know. It’s certainly under-researched, but you know, whether or not it’s efficient doesn’t really matter for an active manager, it’s just a matter of timescales.

SW: Well that’s what I, you kind of took the words out of my mouth, being long-term then, is it more a matter of presenting opportunities individually as they come and less about, as you said, the inefficiency or efficiency of the market and more these individual stocks and the process that you are doing for the fund as the asset manager?

SP: Yeah, absolutely. I mean, we’re very much a bottom up fund. It’s very, very rare that something happens, which makes us think, you know, that we shall move the whole fund in this direction. That very, very rarely happens. So, usually it is, yes, it’s about, you know, where are the opportunities at the moment? It’s also why we don’t have much of a style bias because we don’t really mind whether we think the valuation opportunity comes because the market doesn’t understand the balance sheet of the company – so, classical value investing – or if it doesn’t understand, you know, what’s likely to happen in the future with its revenues – classical growth investing; we are just looking for where that valuation mismatch is. And sometimes, it’s a classic deep value type investment; the market simply doesn’t understand the balance sheet and isn’t valuing it right. And sometimes, because the market’s just got the growth prospect’s completely wrong, and that’s where the opportunity is. So yeah, it’s basically you sit there and you wait for the opportunities to happen and you wait for stocks to actually reflect what we believe is their fair value.

SW: Well, that brings me on nicely to my last question is that looking at your portfolio, you have a couple of car manufacturers in the top 10 and we spoke to another Japanese manager last year who had sold out of these types of companies because just felt that they were too far behind on the EV curve so to speak and didn’t see the opportunity. So, why do you have your conviction in the car manufacturer industry and can you just elaborate, give us an example about what you’re seeing?

SP: Well, this definitely brings us onto the idea of efficiency and markets and opportunities. Okay, so, the implication from your previous question about efficiency was that the US has a really efficient market. In which case we need to discuss Tesla, since we’re on cars. That’s got an $800bn dollar market cap, give or take even now, even after it’s dropped quite a lot – and it was at something like $1.5trn.

Okay, well let’s have a look at the big three Japanese manufacturers: you’ve got Toyota, Honda, and Nissan. Altogether that’s less than $400bn worth of market cap. If we chuck in the big three US [car companies], that gives you another $150bn. Chuck in the remaining European auto manufacturers of any given size – so Mercedes-Benz, BMW, Volkswagen, and Renault, and that’s going to give you another $200bn. So, you’re still less – putting all those guys together – you are still less than Tesla.

Now, the joke has always been, you know, which comes first: does Tesla learn how to make cars before the other manufacturers learn how to make batteries? Well, you know, this is the accusation that your previous correspondent clearly levied at Toyota and beyond. Fine, fine, they have a point, they definitely have a point. You know, the Japanese manufacturers have been slow off the mark, Nissan less so – obviously the Leaf^ was very early. But Toyota notoriously stuck with the nickel batteries for much longer than everybody else who moved on to lithium, stuck with hybrid for much longer.

Now, Toyota’s response is, well, we are making a powertrain for everywhere. So, if you are in, let’s say, South Africa, do you necessarily want full battery or actually, do you need to be able to carry some fuel with you? You know, the great thing about the internal combustion engine is that gasoline is an incredibly rich power source in terms of density of energy. And so, you might want a full ICE [Internal Combustion Engine] or you might want a hybrid, or you might want full battery. So they’re saying, well, we’re going to work for all of them. They have ways of producing enough efficiencies to make that kind of work on a production basis. So, the next generation architecture is something they’ve been pursuing for years.

But, at the end of the day, let’s hone in on that battery point; I mean, the world is large, the developed world is moving towards battery as the number one power source. And we have got information on that. So, you know, Toyota had this battery technology day, which I thought that, I’ve got to say absolutely blew me away.

So, their new kind of crossover SUV, BZ4X – catchy name – has a, let me think, 600 km … no, about 500 km range. So, that’s what, around 300ish miles, isn’t it? Their next generation battery, which is going to be launched in I think two years, is going to effectively double that up to 1000 km. So, this is assuming you’re sticking it into the same vehicle. You can then double that up again when you move to their second stage, solid-state battery, which is coming two years after that. So, then you’re going to be looking at 1500+ km range for the same vehicle.

Now, you know, this is pretty extraordinary, even more extraordinary that these solid-state batteries will move to full charge – you can take it from 10% to full charge inside of 10 minutes. Exactly how the infrastructure works that will be able to supply that sort of wattage, I’m not sure, but you know, this is the sort of technological development you’re seeing. So, have they been behind the curve? Yeah, they’ve been behind the curve, sure. That probably was a mistake they made, in terms of sticking with nickel for too long, sticking with the plugins and hybrids for too long. Do they have the technology? Yes, they do. So, have they learned how to make a battery? I really think they have.

SW: Well, that has been so fascinating, and I have definitely taken up enough of your time. So, thank you very much for talking through a whole spectrum of different topics and areas. I really do appreciate it, it was incredibly interesting.

SP: Well, thank you very much for having me on.

SW: Pictet Japanese Equity Selection is a high-conviction strategy which invests in large and medium-sized businesses for the long term and offers investors excellent exposure to a country in the world whose recovery may prove a success story in years to come. To learn more about the Pictet Japanese Equity Selection fund, visit FundCalibre.com – and don’t forget to subscribe to the ‘Investing on the go’ podcast, available wherever you get your podcasts.

*Source: The USMCA, which substituted the North America Free Trade Agreement (NAFTA) is a mutually beneficial win for North American workers, farmers, ranchers, and businesses. The Agreement creates more balanced, reciprocal trade supporting high-paying jobs for Americans and grow the North American economy.

**Source: The revised United States-Korea Free Trade Agreement, also known as KORUS, is supposed to boost US car sales.

*** Source: Ben Bernanke, former Chair of the Federal Reserve

**** Source: Shinzo Abe, former Prime Minister of Japan

*****Source: TOPIX 500 is the Tokyo Stock Price Index, owned by Tokyo Stock Exchange which measures the performance of the 500 most liquid stocks of the TOPIX Index

^Source: Nissan’s first EV, launched in 2010