A Value Investor’s Haven: Japan [Part 1] by SG Value Investor, The Value Edge
As value investors, we have constantly been searching for that fifty cents for a dollar. Scrutinizing balance sheets, searching for companies trading at a minimum of 33% discount to NCAV coupled with minimal debt. With the case of Japan, there are an abundance of such stocks, where companies can be trading even at 50% discount to NCAV with zero debt.
For many people, Japan is a enigma. After a 20-year bear market, coupled with a decade of deflation, there is huge consensus that Japan is a value trap. Despite the fact of so many cheap stocks, it is extremely difficult to profit from them.
When a common stocks sells persistently below its liquidating value, then either the price is too low, or the company should be liquidated. Two corollaries may be deduced from this principle:
Corollary I. Such a price should impel the stockholders to raise the question whether it is in their interest to continue the business.
Corollary II. Such a price should impel the management to take all proper steps to correct the obvious disparity between market quotation and intrinsic value, including a reconsideration of its own policies and a frank justification to the stockholders of its decision to continue the business.
Benjamin Graham, Security Analysis 1934 edition
What does it mean for investors?
- Trust the mechanism. As investors, by predicting the future of the company implies that we know more than the business managers themselves. It is within the nature of business owners to know how best to manage the company, especially where many of these companies have been founded in the 1800s or 1900s. Hence, using a “net-nets” strategy, cast aside all skepticism and go back to the basics of analysing companies. Trust the mechanism whereby majority of these companies would revert back to the mean based on the law of large numbers. You would probably lose your money on 20% of the picks, but the amount earned from the other 80% far covers the losses. Unless we see a shift in the fundamental of human beings, I do not see a reason why the mechanism would no longer work.
- There are no winners. For companies trading at a discount to NCAV, it is pointless trying to search for one with characteristics such as consistent growth in earnings or 10-years of positive EPS etc. These companies are labelled as “net-nets” for a reason. They aren’t winners. This is one reason why I find many avoid using a “net-net” strategy for the sole reason of being unable to stomach such volatile earnings.
- Picking losers over winners. Now, in the event that you do find a winner, discard it. Research has shown that the performance of “net-nets” with a negative EPS has shown far better performance than “net-nets” with positive EPS. The logic is as long as these former companies manages to bring EPS back into the positive region, the share price would just rise significantly. While for the latter companies, such significant increase in share price would only be seen when they manage to show huge increase in EPS, which to be honest is much harder than just posting positive results.
To summarise, the above-mentioned mentality is one that a value investor adopting a “net-net” strategy should have. In my next part, I would be sharing on the characteristics of the Japanese market.