The Dangers of Net-Net Strategy & After Thoughts by Tee Leng, ValueEdge
Many of you readers should know by now our strong inclination in using a net-net strategy. Recently, I came across this article which I found pretty interesting, which got me thinking about certain points, which will be discussed below.
James Grant: I invested in Japanese value stocks, and had occasions to regret over and over on the reluctance of the Japanese to admit error and re-price. Companies that deserved bankruptcy would often not be allowed to meet their just deserts, but were carried on the back of banks that themselves had no true claim to solvency but were supported by the government. Capitalism is not just about success–that is the easy part. It is also about failure, recognizing it, dealing with it, liquidating it, properly pricing it. The Japanese have been unable to do that, and this characteristic was on display in the 1920s as well, so I take this to be a salient Japanese trait.
You were a great believer in Japanese equities. What happened?
With my friend Alex Porter, I was a general partner in Nippon Partners from 1998 through the end of 2010. We invested in Japanese value stocks. We closed it in December of 2010, because we weren’t making money, and it was immensely frustrating. Japanese corporate managers, by and large, don’t own equity. They have a platonic interest in the stock price. In the absence of a lively market for corporate control, there is no check on management doing nothing. In 1998 we began investing in companies whose shares are trading well below their pro-rata share of net cash on the balance sheets. In this country, in 1974, 1975, there were a lot of companies like that they did rather well in the 1970s and the 1980s. But in Japan, many (companies like these) remained at these compelling valuations for year upon year upon year. You get tired. The last straw was when one of our companies was selling at a huge discount to everything, and announced that it would undertake a capital investment larger than its stock-market capitalisation.
Barrons, 11th September 2011
James Grant has indeed shown how such cheap stocks could just be value traps with an inefficient management running the business. Furthermore, the case of great fund managers faring poorly in the case of a net-net strategy in Japan would be Mohnish Pabrai who exited all positions with a realized gain of 2.2% including dividends, or 1.4% annualised.
- Poor Management. I have read many arguments regarding the weak shareholder rights within Japan and a culture that regards the corporations as ‘social institutions’ that consider the needs and aim to provide stable employment for their workers. While I am unable to fault such an argument, how do we truly define poor management? During bad economic times and profits tumbling, the Japanese are willing to slash bonuses and take a lower pay home if necessary (Read: Asian Business and Management: Theory, Practice and Perspectives). Furthermore, last year with Nintendo’s poor financial results, the President Satoru Iwata was willing to take a 50% pay reduction and game designer Miyamoto taking a 30% pay cut. Whereas, we see top management within U.S. taking huge bonuses amidst the Global Financial Crisis. Hence, how do we truly define poor management?
- Conviction. While I admit I do not understand what James Grant/Mohnish Pabrai were thinking at that point of time, I felt if they had greater conviction in the strategy and held it on awhile longer they would have enjoyed the huge run up in stock prices in Japan during recent years. Many a times, our conviction would be tested over a 3, 5 or even 10 year period. Furthermore, value investing in itself is not something widely appreciated. Hence, it can be a very lonely sport where the majority out there would not be agreeing with your investment thesis. This would be when our conviction is put to the test. Would we yield to outside pressure, or will we stand firm to our beliefs? I believe one great investor who exemplifies a strong sense of conviction would be Seth Klarman who stood his ground despite under performing the S&P500 for 10-years straight.