Mitsubishi Corporation: A Japanese Trading Company - [Business Breakdowns, EP.156]

0:03This is Business Breakdowns. Business Breakdowns is a series of conversations with investors and operators diving deep into a single business. For each business, we explore its history, its business model, its competitive advantages, and what makes it tick. We believe every business has lessons and secrets that investors and operators can learn from. and we are here to bring them to you. To find more episodes of Breakdowns, check out joincolossus .com. All opinions expressed by hosts and podcast guests are solely their own opinions. Hosts, podcast guests, their employers or affiliates may maintain positions in the securities discussed in this podcast.

0:45This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. I'm Zach Buss, and today we are breaking down the Mitsubishi Corporation. I'm joined by Krishna Mohanraj, a portfolio manager at Diamond Hill Capital Management. When I first connected with Krishna, I cautioned him that tackling a Japanese conglomerate with operations that span energy, retail, manufacturing, mining, automotive, and food, amongst others, would present a tall task. In Japan, the business model of a trading company is prominent. The Big Five trading companies caught the attention of global investors in 2020 when Berkshire Hathaway disclosed a major stake in all of them.

1:27Mitsubishi, Mitsui, Itochu, Marobini, and Sumitomo. Today's Berkshire stake is nearly 10%. In this episode, we discuss how the rich history of trading houses is steeped in Japanese culture and how each differs from one another. We discuss the evolution of stakeholder priorities and how capital allocation policies have changed in the Japanese capital markets. And we spent some time exploring some of the operating companies specific to Mitsubishi. We hope that this episode serves as a strong introduction to the business model of Mitsubishi Corporation. All right, Krishna, thank you for coming on to talk about Mitsubishi, an audacious goal to break down a Japanese trading house.

2:12So at the onset, I wish you luck. But maybe just to start to set the table, give us a high level appreciation for what this business is how big it is and how you think about the world that they operate in. Zach, thanks for having me. Excited to be here, especially talking about Mitsubishi Corp. The fascinating thing is for all its size and reach, it's a company that's not very well understood. It's a huge enterprise, about $135 billion in enterprise value, about $150 billion in revenues last year. Very global. They have their hands on so many different aspects of global GDP. Super long history, going back to the late 1800s, prestigious as an employer in Japan even today.

2:59But despite all that, it's not that widely followed, not much is written about it in the public domain. It's certainly an odd entity. It doesn't neatly fit into your typical pure play, obvious mode, high returns on capital type business, but fascinating in its own right. So it's really fun to unpack this. Most of us have heard of the Mitsubishi name, especially in the context of cars, electronics, etc. There are actually a family of companies that bear the Mitsubishi name. Mitsubishi Corp is one of them. It's a trading house. They call them Sogo Sochas. There are seven of them now. At one point, there were a lot more.

3:37But over time and through various crises, including the fallout of the Japanese bubble in the 80s, that number has shrunk to seven. So besides Mitsubishi, you have Itochu, Mitsui, Marubeni, Sumitomo Sojits, and Toyota Tushu. Obviously, they come with a lot of history, both before and especially after the Second World War, when they contributed greatly to the rebuilding of Japan. So what is inside Mitsubishi? While historically it was a trading company, today you should think of Mitsubishi more as a collection of ownership interests in different businesses. Now, some of them are trading companies, but many are operating companies.

4:18They organize themselves under 10 different business groups. But I'm going to simplify it a little bit. If you go by rough profit mix, it's easy to think of Mitsubishi in two halves, as roughly half in resource assets and the other half in non -resource assets. within resources you have assets in metallurgical coal copper iron ore lng nickel most of these are high quality assets so you're talking bma which is the largest seaborn metallurgical coal mine in australia they have a 50 stake in it along with bhp the escondida copper mine in chile which is the largest copper mine in the world the coiaveco copper mine in peru in which they had a 40 % ownership along with Anglo -American.

5:08These are the kinds that they own, typically long -life, high -quality assets. And these are all partnerships or JVs with all the major miners that you know of, BHP, Rio Tinto, Anglo -American, Glencore, all of them. So that's one half. The other half, that's non -resources. On this half, you have a mixed bag of assets. You've got about 15 % in auto distribution in Southeast Asia. That's basically your full auto value chain, production, sales, aftermarket, auto finance, in partnership with Isuzu and Mitsubishi Motors. And Mitsubishi Corp owns stakes in both of them. Then you got about 10 % in food in a few different assets.

5:50You have the Lawson's Convenience Chain, which is a popular chain in Japan, a small stake in KFC Japan. They own the third largest salmon producer in the world called CERMAC, and then several smaller businesses in grain trading, food distribution, et cetera. Then you got 10 % in utilities, which are predominantly North America and Europe. And finally, the remaining is a mixed bag, industrial materials, chemicals, industrial infra, urban development, really a mixed bag of industrial businesses. No doubt that it's a complex collection of assets. How do we see it? Here you have a well -managed business, strong global presence and talent pool, diversified, ultra -conservative balance sheet.

6:34And finally, here's the important part, in a clear path toward improving capital efficiency and improving shareholder returns. And you have all that at an attractive price. That's the investment case. Okay. So this is a pretty basic story, which is good. I think if you consider what they have now, what they own, the partnerships, the JVs, presumably there's a particularly rich history in order to get to where we are today, to this rather high quality amalgamation of assets, which uniquely work together. So how did Mitsubishi get to be what it is today? The history of Mitsubishi and the trading houses in general, it's very much a part of Japanese industrial history.

7:17There's really so much detail and nuance here. So I'm going to shoot for the CliffsNotes version. And I'll start with the punchline. the adaptability of the firm. Mitsubishi has been through a lot of change and has simply adapted and changed firm. As you study this history, you will see basically their ability to rethink what it means to be a Japanese corporate citizen, what it means to be Japanic, if you will, at each point in time, over 150 years and counting. So we have to start all the way back in the 1850s Japan, the country's forced out of literally 300 years of isolation when they see the American Navy outside their hubbers.

8:00So Commodore Perry ships show up in 1853, 54. Japanese realize that they're one step away from being colonized. And because they know what happened to their neighbors, the Chinese, priority number one, if they want to escape that fate, was to build a Western -style army and navy. Now, that's easier said than done. They realized that they have to learn from the West. So they began sending their students to the U .S. as early as 1860. They learned from what happened in the West. They realized that military strength can only come from having a strong industrial base. And to build that strong industrial base, they realized they needed the help of private entrepreneurs.

8:39here is when you start to see the beginnings, the origin of the strong collaboration between business and government in Japan, a theme that will continue over the decades, a theme that continues still today. And that's the backdrop for the founding of Mitsubishi. That is the backdrop when a young entrepreneur, Yataro Iwasaki, finds the opportunity to bootstrap this company using a single government contract. So it's 1874. Japan is preparing to launch its first modern military expedition against Taiwan. It's sort of a test and an exhibition of what they're capable of, but it's starting to look like it'll be a profound embarrassment.

9:20They have an army, but no navy. And the government was relying on a steamship company called YJK that they had built in partnership with some wealthy families to transport its army to Taiwan. But YJK gets cold feet and declines to support the government in this mission. Enter Mr. Iwasaki. He had just listened to the top of a small shipping firm. He wins this government contract, mostly because the government is desperate. And using this one contract as a base, he renames the firm, calls it Mitsubishi Steamship Company. Mitsubishi literally means three diamond shapes or three water chestnuts, which is the crest of Mitsubishi that we all know.

9:59and he builds this into the premier shipping company in Japan at that time. Within a year or so, he takes on the US and British rivals in shipping, gets into a price war with them, and forces them to abandon the key Yokohama -Shanghai shipping rule. And that's huge because just a few years earlier, the Japanese were completely dependent on the US and British ships for commercial shipping lanes. So that is the origin. And from then on, you see these powerful families take off. They're called zaibatsus. As the government realizes you need scale to build industry, they start selectively favoring a few wealthy families.

10:37Zaibatsu really means family wealth. And you end up with four big families. So there's Mitsui, Mitsubishi, Sumitomo, and Yasuda. And I think they become so dominant at one point, that's 60 % of the market cap in their stock exchange. And they continue to prosper. You get the First World War. Of course, the Europeans are out of business. So these Japanese companies benefit even more. And then all the way to the Second World War, given that link with the government, and given the fact that the government is becoming increasingly militarized, they play a big role in the war. Mitsubishi in particular, Japan's biggest battleships, the infamous Zero Fighter plane, Mitsubishi plays a big role.

11:16A lot of it is not very good history at that time. And not surprisingly, you wouldn't find these firms wanting to talk about that period much. So that's the first half of the history, the pre -war history. The second half is completely different. It's a completely different world. The US occupation is here. A big focus now is actually dismantling these Zaybatsos. So we're going the opposite direction. Because they were such a big part in the war machine, the US wanted to eliminate Japan's ability to re -arm. So they break them up, but that doesn't last for long. So cynically, you could say it's because typical American interventions after wars and places they know little about never seem to work.

11:55You could also say it's because the Japanese government understands very well the need to rebuild. They have a prior roadmap of success with the Zaibatsus. So they selectively, again, encourage scale in the industry. And they do that pretty much by circumventing the anti -monopoly laws that were set up by the U .S. So Mitsubishi is now already broken up into 170 pieces. But somehow the pride, the networks, the membership and allegiance with the family name is still not broken up. So very quickly, and this is super surprising, within a couple of years, Mitsubishi is back. It is just in a different form.

12:36The new structure, they call it kiretsus. It is simply the absence of the family. So it's no longer family related. It's more of a horizontal relationship structure. the government does not mandate the structure. That's important to remember. But what it does is it sets the ground for the structure to evolve. So if you think about the next five, six decades, these kiretsus play an important role in the rebuilding of Japan. And through, I guess you could say, the growth in Japan, the bubble in Japan, and the subsequent recession. If you go through a decade by decade, just in Mitsubishi's case, in the 50s, you have a re -establishment of Mitsubishi.

13:14You see the building of global networks to become a supplier to manufacturers. 60s, you see high growth. You see them expanding into downstream distribution and exports. 70s, oil shocks, the need to procure oil assets. They become large -scale project organizations. Investments in Saudi Arabia. In general, the beginning of foreign investments, that's when it happens. 80s, you have high -end bubble years, but basic materials are struggling. So a time of restructuring, rethinking. 90s, complete bust, recession, more restructuring. 2000s, again, you've got a boom in commodities from China. They benefit from that.

13:56And then 2010s, rescaling, realigning. And we'll talk about this later. Over the last decade, it's been increasing focus on capital efficiency. So that brings us to present day. I know that's a long history. That's pretty much 150 years of rethinking what it means to be Mitsubishi. And then maybe it's just a follow -up on that question, just given the rich history here. Is there a specific angle that differentiates the trading houses today, or are they all different and competing on the basis of allocating capital, but operate principally in similar industry? I would say they're all fairly similar in style.

14:38In fact, the thesis for Mitsubishi is very similar to the thesis for pretty much any of the other trading houses. You know very well that Buffett has taken a stake in all five of the large ones. They're all seeing improved capital allocation. They're all making better decisions overall. The difference is primarily in the mix of businesses they own first. And then second, the areas where they're investing for the future. So the future mix of businesses. And third, maybe I could say clarity around capital allocation priorities. Now, of course, each one is complex. So I'll share some color on how we think about each one of them, but this is going to be very brief and high level.

15:20First, Mitsui, great reputation in the resource industry. Versus Mitsubishi, the biggest difference, I would say, would be Mitsui's iron ore exposure, which is by far their largest individual segment. Now, we prefer Metcol over Iron ore, simply because the supply -demand dynamics appear way more positive for Metcol than for Iron ore. The seaborn Iron ore market is very much dependent on China. Versus with Metcol, the seaborn market is a lot more diversified. Really, at the end of the day, you're asking, where do you get a more diversified commodity exposure? So that's Mitsubishi. Second, Itochu, very well, Ron, has the highest ROE of the group.

16:02We think very highly of the management team, outside -the -box thinkers. Versus Mitsubishi, two key differences. One, China exposure. Itochu also has a large iron ore business. That's China. and it also has a major stake in CITIC, which is a Chinese -owned conglomerate. Two, exposure to the Japanese consumer. Itochu has higher exposure and it's well -placed if the yen strengthens, but you also have to contend with the demographic headwinds as you obviously have a greater percentage of earnings coming from within Japan. So that's Itochu. Third, Marubeni, a bit smaller, has made great progress over the years within its business.

16:44Like Mitsubishi, Marubini also has meaningful Metcol business in addition to iron ore, copper, and LNG. I think the biggest difference here is the ag exposure. Marubini owns a large US ag business, Helena. So you get exposure to the price vagaries of corn, soybean, etc. So that's Marubini. Finally, Sumitomo. Long history, it was one of the original Zaibatsu's. In general, Sumitomo is a little bit more oriented towards heavy industry. So you get steel products, ship aircraft leasing, infrastructure, et cetera. So that's the different groups in a nutshell. I would say at the end of the day, this is a fascinating group of companies to know and follow.

17:26It really comes down to the exposures you would want over the long run and how each one of them would fit in a portfolio. That's helpful context. And I guess this is a business, as you alluded to, that they almost tried to break up. And despite that, it couldn't help but find itself back together. What is the secret to this business and the way that it's grown so successfully? Yeah, I think the first thing to say is the global network and the relationships. If you look at some of the relationships they have, they go back decades. I'll give you an example. Recently, we saw that they were selling some shares in the Ayala Corporation.

18:06Ayala is a conglomerate in the Philippines. publicly traded itself, has a long history, deeply embedded in corporate Philippines. So first off, you're happy that this isn't in line with our thesis, that they are reducing non -core stakes and possibly returning more capital. But as you dig in into this partnership, you realize that this is a relationship that's 45 years old. The partnership goes across multiple sectors in the Philippines, everything from automobile production, real estate, technology, water, power, infra. Now think about doing business in a place like the Philippines and think about how much of an advantage it is to have a really long -term partnership with a deeply connected local player like that.

18:49Even after the stock sale, I think they will own roughly 300 million worth of Viola stock. So it's not that they're getting out, but even if they are, at this point, given the long history in that partnership, it's not about the stock ownership anymore. This story plays out with Mitsubishi all over the world, because over decades, their DNA is about providing, procuring, building for Japan. And that has meant forming relationships and being able to invest in these networks for the very long term. It's not surprising given their origins as a trading house. I mean, the nature of a trading house is to build value via networks.

19:28The more well -connected people in the network, the more valuable that network is. I'll give an example. If you just think of it as a commodity, you know, historically, Mitsubishi would go into different countries to find raw materials. Eventually, they would start producing a surplus, as you can expect in a cyclical business. And then they'll have to start finding networks to offload that surplus. So after doing this for decades, you become really well -aversed at working with suppliers and buyers of raw materials all over the world. And you know that your word is super important, your reputation is super important.

20:03Long -term thinking in those relationships is institutionalized within Mitsubishi. In fact, the most recent annual report, it goes back to the 1870s, legacy is valued. Also, not surprising that they are willing to make multi -decade investments in long -life assets. Think about it, some of the largest copper mines in the world, massive LNG projects, they're forced to take the long view. And the corollary to that is they end up with a very, very good reputation. So A, reputation as excellent long -term players. If you speak with mining companies in Latin America, Australia, you'll constantly hear consistent praise for them as long -term partners.

20:44We, within Japan, they're highly prestigious as an employer. Just anecdotally, there are multiple Japanese blogs that publish annual rankings of the most desirable employers. I believe they're like number two this year, number one last year. Not that the exact ranking matters. Point being, they're able to attract the best Japanese talent. So overall, it's a powerful collection of moats built over a very long period of time. And so more recently, Warren Buffett and Berkshire Hathaway have provided what I'll call validation capital to the Japanese trading houses. I believe he owns just under 10 % of most of them, or Mitsubishi in particular.

21:28Can you talk a little bit about how Berkshire's investment coincided with the market value appreciation we've seen in these equities and whether that was coincidence or happenstance? How do you think about their impact on how the world views these assets? When I read Buffett's most recent letter, what surprised me really was how positive he sounded on the management. And this is just my view, and this is purely speculation. When he made the initial investment, that was almost four or five years ago now, it seemed like it was purely and arbitrage. He could borrow essentially at zero cost in yen and finance the purchase of effectively a slice of global GDP, well -managed in a sort of no -fuss, almost Berkshire -style manner.

22:15That was all it was. And also, if you think about it, Berkshire's size, there are so few places that he can deploy large amounts of capital for the very long term. So it didn't strike me that this is the kind of idea that as an independent investor or a retail investor, or even an investor in any other structure would want to follow. But then last year, he and Greg Abel went and met with the managements. And we think that's for the first time. And he seems much, much more enthused about the management teams. The stake has, of course, gone up over the time. Like you mentioned, it's now 9 % in each of them.

22:52And he had very positive things to say on shareholder friendliness, you know, reasonable approach to compensation, unwillingness to issue stock and return capital to shareholders. From our perspective, we have to think a bit differently because we don't get the benefit of the cheap end funding. It's still a case -by -case, bottom -up stock picking decision. But having said that, not a bad fellow shareholder to have. And you can't deny the benefit to Mitsubishi to having such a liquid partner on hand. If you're worried about cyclicality in some of their resource assets, what better partner to have than Berkshire?

23:28And to your question on the market moves, you have to also look at the changes in capital allocation that are happening, the actual numbers more than just the talk. I feel the Buffett vote of confidence is important, but it's equally important that the market is seeing capital return for the first time from these companies. And Mitsubishi in particular, it's astonishing the amount of change that's happened over the last 10 years, and it feels like the market is giving credit to it. If you look at 2012, investments net of disposals was about 840 billion yen on an equity base of roughly 5 trillion yen.

24:08So that's about 17 % net investments net of disposals. Last year, investments itself was down to 125 billion yen. So that's almost one eighth or one seventh. On an equity base, that was almost double of what it was 2012. So as a percentage of equity, that net investment numbers come down to 2 % from 17%. In effect, you've seen a significant drop in net investments. And not surprisingly, this has led to a significant reduction in net debt, significant improvement in ROE. So while the capital return has picked up in the last couple of years, the process of improving capital efficiency has been going on for a while now.

24:47So our views is that the market is slowly beginning to accept that this is a changing situation. I guess on that particular point, I know that Japanese corporates broadly have been effectively instructed to improve upon capital allocation and return on capital and how to think about driving shareholder returns. What is it that has changed culturally around Japanese businesses and their orientation towards their shareholders? It's a fascinating question. In fact, one of the learnings for us here is the importance of not just keeping an eye, especially, I mean, when you're investing in international markets, it's important not just to keep an eye on the cultural dynamic, but also how that dynamic is changing over time.

25:34In corporate Japan, change has to come from within and has to have a collectivist flavor. It's a collectivist culture asking for change in the name of shareholder returns and stock price going up is not going to work. Over the last 20 years or so, you've seen this story play out. Western investors have tried many times to play an activist role. For the most part, the results have been poor because an outsider coming in and telling Japanese management to change, and especially with the logic of increasing share price performance, it was the exact opposite trigger in that culture. What you needed really was a gradual change from within.

26:14And the cause always has to be articulated as a positive for Japanese society, not just increasing share price. So to your point, if you really go through the details of what has happened since 2013, in 2013, you have base structural reform. One of the arrows is economic. 2014, they followed it up with the ITO review, which was one of the documents. For the first time, it had this quote in it. It said, increasing capital efficiency in the broadest sense is crucial from the perspective of Japan's survival. Imagine that. That review tied capital efficiency in the Japanese system to Japan's survival.

26:58That was, in our mind, the starting point of change. But even from there, change was very slow. It was consistent, but slow. So from then on, you started seeing internal changes year after year. You got the stewardship code, the corporate governance code, lots of incremental changes there. Market was not willing to buy it because you've seen the market has disappointed before. All the way up to last year, when the TSE basically started naming and shaming companies, it initiated this dynamic of peer pressure and the need to be a good Japanese corporate citizen was now equated with being capital efficient.