Zero Hedge has an article Uncovering Liquidation Value… In Japan? discussing SocGen’s Dylan Grice’s Are Japanese equities worth more dead than alive. The title is a nod to Benjamin Graham’s landmark 1932 Forbes article, Inflated Treasuries and Deflated Stockholders, where he discussed the large number of companies in the US then trading at a discount to liquidation value:
…a great number of American businesses are quoted in the market for much less than their liquidating value; that in the best judgment of Wall Street, these businesses are worth more dead than alive. For most industrial companies should bring, in orderly liquidation, at least as much as their quick assets alone.
Grice writes:
In the space of a generation, Japan has gone from the world economy’s thrusting up-and-coming superpower to its slowing silver-haired retiree. Accordingly, the Japanese market attracts a low valuation. The chart [below] shows FTSE Japan’s equity price to book ratio and enterprise price to book ratio, since equity P/B ratios alone can be distorted by leverage. Both metrics show Japan to be trading at a low premium to book compared to its recent history. So it’s certainly cheap. But does it offer value? The answer can be seen in the chart above, which shows corporate Japan’s RoEs and RoAs over recent decades to have averaged a mere 6.8% and 3.8% respectively. This is hardly the sort of earnings power which should command any premium over book value at all. Indeed, to my mind the question is one of how big a discount the market should trade at relative to book.
The fundamental problem in 1932 America, according to Graham, was that investors weren’t paying attention to the assets owned by the company, instead focussing exclusively on “earning power” and therefore “reported earnings – which might only be temporary or even deceptive – and in a complete eclipse of what had always been regarded as a vital factor in security values, namely the company’s working capital position.” Graham proposed that investors should become not only “balance sheet conscious,” but “ownership conscious:”
If they realized their rights as business owners, we would not have before us the insane spectacle of treasuries bloated with cash and their proprietors in a wild scramble to give away their interest on any terms they can get. Perhaps the corporation itself buys back the shares they throw on the market, and by a final touch of irony, we see the stockholders’ pitifully inadequate payment made to themwith their own cash.
In his article, Grice makes a parallel argument about valuations based on earnings in Japan now:
Regular readers will know I favour a Residual Income approach to valuation. It’s not perfect, and it’s still a work in process, but anchoring estimates of intrinsic value on the earnings power of company assets (relative to a required rate of return, which I set at an exacting 10%) helps avoid value traps. Things don?t necessarily come up as offering value just because they’re on low multiples. The left chart below shows Japan’s ratio of Intrinsic Value to Price (IVP ratio, where a higher number indicates higher value) to be only 0.6, suggesting that in an absolute sense, Japan is intrinsically worth only about 60% of its current market value.
Grice arrives at the same conclusion about Japan as Graham did in 1932 about the US:
But here the tension between “going concern” valuation and “liquidation” valuation becomes important. Let’s just imagine the unimaginable for a second, and that my IVP ratios are correct. Japan currently trades on a P/B ratio of 1.5x, but if it is only worth 60% of that, its “fair value” P/B ratio (assuming we value it as a going concern) would be around 0.9x. Of course, that would only be true on average. Nearly all stocks would trade either above or below that level. And of those trading below, some would trade slightly below, others significantly below. And of those which traded significantly below, some might be expected to flirt with liquidation values which called into question whether or not the “going concern” valuation was appropriate. Indeed, this is exactly what is beginning to happen.
It seems that there are quite a few stocks trading at a discount to net current asset value in Japan:
Grice likes the net current asset value strategy in Japan (sort of):
Not only are these assets cheap but, unlike the overall market, they probably offer value as well. My Factset backtest suggests such stocks trading below liquidation value have averaged a monthly return of 1.5% since the mid 1990s, compared to -0.2% for the Topix. There is no such thing as a toxic asset, only a toxic price. It may well be that these companies have no future, that they shouldn’t be valued as going concerns and that they are worth more dead than alive. If so, they are already trading at a value lower than would be fetched in a fire sale. But what if the outlook isn’t so gloomy? If these assets aren’t actually complete duds, we could be looking at some real bargains…
…
So should we be filling our boots with companies trading below liquidation value? Not necessarily. But I would say the burden of proof has shifted. Why wouldn’t you want to own assets that have been generating shareholder wealth yet which trade at below their liquidation values?
It is interesting that this article echoes another SocGen article, this one a September 2008 report by James Montier called Graham’s net-nets: outdated or outstanding? in which Montier looked at Graham sub-liquidation stocks globally. Of the 175 stocks identified around the world, Montier found that over half were in Japan.
Now all we have to do is figure out how to invest in Japan.
Greenbackd 
[…] Fer it: Net current asset value stocks have performed remarkably well throughout the investing world and over time. In support of this argument I cite generally Graham’s experience, Oppenheimer’s Ben Graham’s Net Current Asset Values: A Performance Update paper, Testing Ben Graham’s Net Current Asset Value Strategy in London, a paper from the business school of the University of Salford in the UK, and, more specifically, Bildersee, Cheh and Zutshi’s The performance of Japanese common stocks in relation to their net current asset values, James Montier’s Graham’s net-nets: outdated or outstanding?, and Dylan Grice’s Are Japanese equities worth more dead than alive. […]
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[…] 10, 2010 by greenbackd In his Are Japanese equities worth more dead than alive?, SocGen’s Dylan Grice conducted some research into the performance of sub-liquidation value […]
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[…] 9, 2010 by greenbackd Since last week’s Japanese liquidation value: 1932 US redux post, I’ve been attempting to determine whether the historical performance of Japanese […]
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[…] but obviously a difficult period through 1987 and not an exact facsimile of Graham’s strategy. An astute reader notes that ”…the test period for that study is not the best. It includes Japan’s best […]
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Interesting article, i like the ideas of Grice ( and J. Montier, really sorry that James left SG). Japan Valuation and currencies situation saved me in 08-09 turmoil. Valuations are low, that’s what we knew for a while and you are discussing here about a market going down for more than 20 years and we know all the circumstances. I keep it with JME (J.M. Eveillard) buying cheap world class business and some small and mid cap bus. on valuation base there. It really makes a lot of fun, sometimes when investing there, i feel like the first human being on a unknown planet. 25 years ago, everybody was talking to me about beautiful investment opport. in Japan – companies were mentioned to me i had never heard about before (but you had to own it, valuations….why !??????). What difference 2 decades make – now sometimes the same people telling me i should stay away its to uncertain (future is always uncertain). Why, is it to expensive? No, it is unbelievable it is to c h e a p but outside the herd it is cold and uncomfortable. But wearing the right quality and valuations it is really a nice area.
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Very good article!
For those interested check out Interactive Brokers, you might be able to trade Japanese equities. They seem to offer many different instruments to trade/invest.
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FYI for the other readers: Third Avenue Value Fund (TAVFX) owns a lot of Japanese NCAVs. It’s an easy way to participate.
But a problem in Japan is weak shareholder rights, which weaken the link between price and value. For example, changes of control are very rare.
In the past 20 years, many US investors have chased these things and eventually given up, because they do not easily converge to underlying value.
Of course, this tactic probably is still useful defensively, even if they remain undervalued.
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I’m a little chary of the “Japan has weak shareholder rights” narrative. A 1993 paper analyzed the performance of Japanese net nets between 1975 and 1988:
Bildersee, J. B., Cheh, J. J. and Zutshi, A. (1993). “The performance of Japanese common stocks in relation to their net current asset values.” Japan and the World Economy 5: 197-215.
Here are the paper’s findings described in another paper:
Not a great return, but obviously a difficult period through 1987 and not an exact facsimile of Graham’s strategy. It would be interesting to see an update.
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I want this to be true, because it is logical, matches public market behavior in the US, and opens up so many apparent bargains.
But the test period for that study is not the best. It includes Japan’s best analog to America’s Roaring Twenties. The Nikkei peaked on 12/29/89, and never recovered.
Many of the “assets” on public companies’ books at that time were real estate bubble-related. At the peak in 1989, the aggregate market price for all private real estate in the city of Tokyo was purportedly greater than that of the entire state of California. You can see how the sudden runup in real estate during the bubble could cause asset-heavy companies to outperform the market.
So a better crucible for Japanese NCAVs might be the deflationary period, say beginning 1/1/90, which is more analogous to the US in 1932.
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What brokers are you guys using? I use Fidelity and they allow me to trade Japanese stocks for $8 a pop.
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Unfortunately I don’t have a million dollars or place over 120 trades a year which Fidelity requires to get the international trading.
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Also, what do you use to screen Japanese stocks? Does Fidelity’s screener tool for for international exchanges? I thought it was limited to the US exchanges and foreign stocks that trade as ADRs.
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Great post, read this over at Zero Hedge and have been thinking about it for a few days. I noticed this back in the summer as well, at that time about 1/3 of Japanese small caps were trading below NCAV. I have been trying to figure out an effective way to play this, at the time I went with closed end fund JOF but the fund lagged while the number of companies trading below NCAV dwindled.
If I remember correctly most of the companies trading below NCAV are smaller companies. Without being able to buy directly a US investor is limited to ETFs or funds. I don’t know of any Japan small cap value funds, so that leaves us with ETFs. The problem with an ETF is it’s market weighted so the companies we want to buy have the smallest weighting in the index. Buying a ETF might get some of the mean reversion effect but not all.
The second problem is for an investor without access to a Bloomberg or FactSet terminal is it’s very difficult to screen for these companies. If I was able to screen I’d consider investing directly through Fidelity or E*Trade.
Any ideas on how to invest or screen would be helpful!
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Are equity P/B ratios distorted by leverage or are overly leveraged companies appropriately punished by the ratio for their capital structure? I would argue the latter.
Secondly, I would argue the low RoE and RoA need to be interpreted in context. As the first graph nicely shows, Japan are currently benefiting from the unseen benefit of a recession, the reduction of debt. In said recession, bottom lines are not falsely inflated by the credit expansion that causes the bubble. In a sense they are misleadingly depressed by the reduction in consumption necessary to retire debt.
I would however agree entirely with your conclusion. If the US is at the end of its bubble and Japan at the opposite end of its economic cycle, Japan is the place to be investing.
Have you thought of starting a new blog: Yenbackd?
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