Offshore investing

Japan: economic pessimism creates buying opportunities

EXECUTIVE SUMMARY: As bottom-up stock pickers, we believe that great investment opportunities can be found in even the most challenging conditions. Japan is a perfect example. Ben Preston and Trevor Black from our offshore partner, Orbis, explain why our holdings in Japan are not necessarily a reflection of our views on Japan. We agree that Japan's economic prospects are bleak but widespread pessimism is precisely what allows us to buy well-managed companies at bargain prices.

'What on earth are you thinking?' It seems as if clients have been asking us some version of that question about Japan for more than two decades.

When the Orbis Funds were launched in 1990, Japan was the investment destination of choice its stock market was near an all-time high and accounted for nearly 40% of the FTSE World Index. At the time, the Orbis Global Fund's exposure to Japan was precisely zero. Clients thought we were crazy to be missing out on such a great investment opportunity.

Today, Japanese stocks are hovering just 21% above the 27-year low that was set in March 2009 and they account for a mere 8% of the World Index. Orbis Global's allocation to Japan is 17% more than double the benchmark weighting. Once again, clients think our stance on Japan is crazy, this time for the exact opposite reason.

Deviating significantly from index weights is not unusual for us our unconstrained, contrarian approach to stock picking quite often produces portfolios that look radically different from their benchmarks (see Graph 1). But it is the reason behind those exposures that sometimes needs some explaining.

Intuitively it would seem that if we are significantly overweight in Japan we must be bullish on the economy. That is not true. More importantly, it is not the way we think about building portfolios. We do not allocate a certain percentage of capital to a country and then look for stocks to buy. Regardless of nationality, each individual investment idea must compete for clients' capital based on its own merit: the difference between price and our assessment of value.

We wholeheartedly agree that Japan faces enormous challenges in the years to come. To say nothing of the terrible devastation caused by the 11 March earthquake and tsunami, Japan is struggling with a declining population and a government with one of the worst debt burdens in the world at 200% of gross domestic product (GDP). We have no illusions about any of this.

EACH INDIVIDUAL INVESTMENT IDEA MUST COMPETE FOR CLIENTS' CAPITAL BASED ON ITS OWN MERIT: THE DIFFERENCE BETWEEN PRICE AND OUR ASSESSMENT OF VALUE

But that does not mean we cannot find compelling investment opportunities in the world's third-largest economy. In fact, we have identified a number of individual Japanese companies whose prospects we are very excited about, even if we are uncertain about the Japanese economy.

Japan's answer to Amazon.com?

Rakuten the 7th largest holding in Orbis Global is a perfect illustration. The company is an online shopping mall, somewhat akin to Amazon.com. Instead of carrying its own inventory, Rakuten simply provides a platform for independent merchants. Rakuten handles customer orders and collects payments through its website, but the merchandise is shipped directly from the sellers to customers. With 70 million members, which is more than half the population of Japan, and a network of 37 000 independent merchants, Rakuten is easily the largest e-commerce player in Japan.

Constrained vs unconstrained - exposure to Japan

While Japan's economy may be sluggish, online shopping is a rapidly growing industry with enormous potential. Online sales represent only 2-3% of total retail sales in Japan, compared to 7%-and-growing in the US and 10%-and-growing in the UK. As such, even though the total Japanese retail market is in decline, Rakuten can continue to grow by taking market share from traditional retailers. In a densely populated country like Japan, shopping online makes sense: it is convenient, efficient and offers significant cost savings compared to operating a physical store. Rakuten's core business is growing at 15-20% per annum and we believe it can sustain that growth rate for many years to come.

Growth is one thing, but can it hold off the competition? We think Rakuten has some important competitive advantages. The first is the huge benefit of scale. Customers come to Rakuten because it has the biggest range of merchants; merchants come because Rakuten gives them the biggest potential customer base. This 'network effect' is nearly impossible for a competitor to replicate and it will only become more powerful as Rakuten continues to grow.

At about 18 times next year's estimated earnings, Rakuten's valuation is very reasonable given its growth potential. By comparison, Amazon trades around three times that multiple.

Risky or just different?

Despite Rakuten's reasonable valuation and strong fundamentals, many investors would argue that filling 17% of your portfolio with Japanese companies is extremely risky. This school of thought argues that risk should be measured by 'tracking error' or the extent to which a portfolio is different from its benchmark (see Delphine Govender's article for a broader discussion on risk).

This has never made much sense to us. In fact, we would argue that investing along with the herd poses a far bigger risk. Sticking close to a benchmark usually means that you will end up buying high and selling low, which is the opposite of what we are trying to do.

That is precisely why we had no exposure to Japanese shares 21 years ago. As investors piled into Japanese stocks, the market became wildly overpriced trading at more than 80 times earnings at its peak. In that environment, we could not find any attractive stocks to buy and yet our position regarding Japan was considered extremely risky, because it was different.

Of course, with hindsight we all know that the real risk in 1990 was being in Japanese stocks, not out of them. While stock markets in the rest of the world have increased many times over since then, Japanese stocks remain down more than 70%.

Today the herd is running in the other direction away from Japan and we are again being told that our position is risky because it is different. We cannot help but see the irony; if a 17% allocation to Japan would have been considered too little when the market was at its peak, why is it now too much when the market is so much cheaper? Of course, this time around the herd may prove to be right. But that is not to say that taking a different view is 'risky' at least not according to our definition of risk.

To us, the only risk that matters is the risk of losing money - the permanent loss of capital. Not volatility. Not tracking error. Common sense tells us that paying too much for stocks, like so many investors did in Japan in 1990, is one of the easiest ways to lose money. The converse is not necessarily true - just because stocks are cheap does not mean you will make money, but it certainly tilts the risk-reward proposition in your favour. We continue to find stocks in Japan that trade well below our assessment of their intrinsic value. Quite often these are well-managed companies like Rakuten that have delivered significant growth in earnings and shareholder equity despite incredibly challenging economic conditions. If they could do it in the last decade, difficult as that was, why not also in the next?

Our intensive research process is designed to uncover attractive investment opportunities from all over the world, and often we find the greatest opportunities in markets that others choose to ignore. Just don't call us 'big on Japan'.

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