Toby Rodes - Unlocking Value in Japan (EP.407)

28:26What's really interesting is Japan has tried to educate their own domestic investor complex to be better custodians of capital. And they looked to the UK, a kinder and gentler market than the US, and they saw the UK stewardship code. They latched upon this shortly following the rise of Prime Minister Abe, who said, we need to have at least one independent director in all Japanese companies. That was a revolution in 2013. And out came the stewardship code from the FSA. And this code was trying to teach the language to domestic investors that it's not a taboo to ask for higher return, higher dividends, better balance sheets.

29:09It took 10 years for this conversation to take form. I've got a lot of theories around that, but my strongest assertion here is that no one was rewarded for taking that risk. It was really the emergence of the foreign manager with strong research capabilities, largely backed by U .S. university endowments that led the ultimate upgrade and the transmission of the stewardship code into reality. And what we found is where a lot of these outside firms have pushed, domestic institutions are following. So this is why this time is different. We're seeing very constructive voting finally coming from the domestic investing complex.

29:56It's transformational. How does the regulatory body or regulatory bodies go about some type of enforcement of the stewardship code? Japan is different. They make domestic investors disclose how they're voting. They embarrass them. It takes MITI to embarrass the managers of these companies. They have to threaten unsolicited takeover bids. It takes the TSE to literally publish a list of companies that are not publishing a cost of capital and proof that the management team is managing the business with a cost of capital mindset. So there is no immediate one center to this. It is a collaboration between various parts.

30:41And you'd think that it would be the investors that grab this bull and take it by the horns, but they wait until all the other institutional stakeholders and participants and regulators give them the green light before they take action. So I'd love to turn to how you were taking advantage of this. So let's start with Konami. The name, what does it mean? So Konami is the linchpin. It's the linchpin in a fan. So a fan in Japan is the symbol of prosperity. And the more the fan is opened, the more prosperity is being shared. And this is a well -understood symbol in Japan. And by being the kaname, the pin, the whalebone that literally holds this fan together, our role is to protect the cost of equity.

31:26We think the cost of equity is the kaname of the economy. With the proper protection of the cost of equity central to every balance sheet, you get capital to start flowing again. So this message is the reason we think in our dialogue and our engagement with companies comes with a high degree of spreading prosperity, joint value creation. We're going to take a quick break in the action to tell you about SRS Aquium. Want to make sure your M &A processes aren't stuck in the past? Partner with a company that's been defining the future of dealmaking for nearly two decades instead. When it comes to M &A innovation, SRS Aquium has reshaped the way that deals get done, streamlining processes for maximum efficiency and minimum headaches.

32:14Professional shareholder representation, online M &A payments, digital stockholder solicitation, SRS Aquium pioneered each and continues to set the bar for game -changing innovation. So leave the days of disjointed deal management behind and define your future with SRS Aquium, the smartest way to run a deal. Learn more at srsaquium .com. That's S -R -S -A -C -Q -U -I -O -M .com. And now, back to the show. How do you think about what works in generating returns? Value works, but you have to be very careful. Value works for two reasons. One, in Japan, this has been a growth -starved economy for a long time.

33:06When there is a growth company, it tends to get overvalued. Traditionally, the boundaries of growth are hit and the company disappoints. So value works because you start with low expectations and any positive surprise is asymmetric return. The other thing about Japan is it's easier for me to love what the herd hates, that I find it easy to embrace and understand why the collective wisdom of the market in Japan is often wrong because they do not understand when leadership is embarking upon a journey of change. When I first started investing in Hitachi, one of Japan's large cap darlings, it was 2008.

33:49The share price was 236 yen. A new manager came in and sat in front of me, Nakanishi -san, and he said, I've read through the notes. You've kindly met with Hitachi for five years. And every year, you've given us a laundry list of things we need to do. I've read it. I'm here to tell you that we have failed. Our share price is back to 1973 levels. I'm going to do what you've told us to do. The meeting lasted 30 minutes. And in that 30 minutes, I realized that this company was serious about change. We backstopped a follow -on offering and the stock has been on a tear for the last 12, 13 years. Japanese people laughed at me.

34:29They were horrified. So it's very easy to find huge, long -run, secular stories that Japanese people are very late to understanding. How do you avoid value traps? It's the biggest risk in Japan. There's no shortage of cheapness. By most counts, still half of listed Japan trades at less than one time priced a book. It's hard to argue with what that means. Our analysis of a market where half trades less than one -time price to book means half of the listed market is still defaulting on their cost of equity. So how do you find the diamonds in that rock pile? We do it with a quant screen because by our analysis, still roughly 60, 70 % of listed Japan, roughly 3 ,000 companies remain totally uncovered by the street.

35:18Our quant screen is based upon three primary quality factors. One is to reduce the risk of high fixed cost businesses. We want companies that can keep margins high through now a 15 -year look back. The second is probably the most important, and we call it management rate of return. What we're doing is we're adjusting the asset side of the balance sheet, and we're only looking at assets used to produce a sale. You're looking at the muscle of the balance sheet, and you're forgiving the fat. Let's face it, Japanese balance sheets still carry a lot of fat. But because of that fat, the muscle can get ignored.

35:53And we focus on the muscle and we turn it into an adjusted ROA by taking operating profits after tax. And then we hold it to a 10, 15 -year look back of generating consistent 10 % adjusted ROA. You don't do that by accident. You have to have very productive assets to be able to do that. The last thing we do is look at incremental returns on CapEx. Here, we're using a longitudinal study that shows not only good management, but operating in a good industry. So once we mesh these three attributes of quality, we know that this company has tremendous product focus and they operate in a good industry.

36:31And by and large, they've got certainly better than average management. Then we just ask that we're able to get those stocks on less than five and a half times EBITDA. And lo and behold, there are still 300 of these companies in Japan. When you've run those screens and you've got your shopping list of 300, how do you think about confirming that what you saw in the numbers is something that will translate to a business that is going through change? That's where the quant turns into fundamental work. The middle step is we take those 300 names and rank order them by a pretty naive but punitive DCF.

37:08So with that, we organize our research and on any given quarter, we're visiting 30 or 40 new companies. Our first meeting is literally for the first 45 minutes to say, we are here because we think you're a high quality business. And we spend the first 40 minutes confirming that our numbers are right. And nine times out of 10, the numbers don't lie. This is a high quality business. And then we finish in that first meeting and we say, but you're too cheap. Here's where it gets really interesting. The person on the other side of the table might say, yeah, I know that. But the old man in the corner.

37:38He lived through the bubble. He had a highly levered balance sheet. And he said, never again. Can you help us tell the story of why balance sheets matter and why we should be using cheaper capital against higher quality assets? That's where we find kindred spirits and partnership. And we're a solution for these sorts of companies. The other example, and this is hard earned and maybe a trade secret that I'm willing to share, is the person smiles politely and says, I know we're a listed company, but we're not really a listed company. Being listed and managing it with cash on the balance sheet is our way of handing the company off to the next generation.

38:15And if we can do that at 0 .6 price to book, we save 40 cents on the dollar in terms of the inheritance tax. You can bang on the door, you can kick, you can scream, but our shareholder structure is such that you're not going to really change us. So we're a porcupine. Do you really want a quill in your nose? Maybe you should go somewhere else. So you have to be very careful about being dazzled by cheapness. When you're assessing that management's willingness to improve the stock price through those meetings, and you've got these two extreme buckets of, yes, please help us and go away. How much does the understanding of the local culture help you interpret what that message is?

38:57It's hard work. And even Japanese people miss it at times. It's not an overstatement to say that sometimes not even Japanese people know what Japanese people are saying. And sometimes my job is to pretend I don't understand what they're saying. This is the dynamic. And I'll walk you through a few examples. We hear a company that understands that they've got a good business. It's not a run and hide, try and dodge taxes type of business, but maybe they're a slow moving company in a slow moving industry. And they've just never really thought about shareholder return. They've got a big anchor shareholder that owns 35%, a negative control element.

39:33And they know that basically they don't have to listen to shareholders. So they've gotten in the bad habit of not doing it. This type of company has, in the process of ignoring shareholders, has also ignored animal spirits and aggression. And when we show up, we say, do you realize that there's a shift happening in your industry? You've got 25 % global market share. Now is the time for aggression. It might It sounds strange to you, but we're not here to ask you for a big buyback and a large dividend. We want you to go all in on investing in next generation fuels in your Himeji plant. We want you to capture market share in ammonia, methanol, hydrogen, next generation fuels in the shipping industry.

40:14Huh. We've never thought about that, says the company. We wait until our customers tell us they're ready for what we're ready to ship. We've got all the technology, but we're a supplier. They said, this is the moment where you drive the change. This has taken two or three years, but this type of partnership has allowed us to put people on the board of this company. This company flies and spends seven hours with us in Boston and whiteboards around what new service offerings, how to reposition themselves, how to rearticulate their equity story to the market. They finally realized the power of the equity market.

40:51So that's the positive. The negative is the same negative controlling shareholder role, but we find a fact pattern of self -dealing or bad behavior of insiders, a complete failure of the board. And I want to be clear, we do go in hard on some of these companies. We exercise all of our rights as shareholders. We bring shareholder proposals. We bring derivative lawsuits against the board in cases of obvious self -dealing. And what we find is that these two strands of our strategy are complementary, that in both instances were principle -based, that we're looking for properly functioning boards to deliver companies composed of the highest return assets with the lowest cost of capital.

41:35And when we're in the public driving good companies to be better because they've got insiders that are trapping value, that helps us with our story and credibility with companies that realize that we can partner with them to drive change, that no matter what, we're looking for the best outcome for the company. When you're going to construct your portfolio, adding names in on the margin, how do you assess the trade -off between valuation and your ability to engage with the management team to help them drive operational improvements? First and foremost, we're a value fund. That's the discipline that I was taught at GMO, and we continue it to this day.

42:16By adding those quality elements to our screen, we think we've given ourselves a huge head start by avoiding those value traps. These companies are not value traps from an operational and product standpoint, But for various quirks, they might be trapping value. So the first step is we always try and figure out the degrees of freedom of management. If we're going to ask for something, can these guys actually deliver it? Is there some hidden constraint that we don't know about? Have we done enough research to really understand what's holding these guys back? This is the cultural element again, because Japan is a proof of work culture.

42:52They won't tell you, hi, here's the pressure point. This is why I can't do it. You got to find it. This might harken back to my time working as the back office of the U .S. trade representative, but I was locked in a windowless room reading Japanese documents for two years. I love reading Japanese documents. The great thing about Japanese documents is they're very comprehensive. People accuse Japanese companies of having awful disclosure. And it's true. It's awful disclosure in English. It's great disclosure if you read Japanese. And we find all of our fact patterns and points of engagement in public information.

43:28How did you decide how many companies to own in the portfolio? That's been an evolutionary step. And one confession is in our five -year existence, we started as an equally weighted value portfolio and thought that the factor would drive the return. And in our mind, where quality meets value, Japan has shown that it compounds at about 12%. In the first year or two, the best companies in our portfolio with open shareholder roles got bought. We enjoyed the market for control expressing itself in our portfolio and five companies got bids. And we thought, hurrah, we've bottled lightning. What we didn't realize is that the remainder of our portfolio were the tough walnuts.

44:09The easy nuts had been cracked. So through that, we had to parse and let go of the nuts that we could never crack and then find the ones that we could. And then we had to refresh using our output to find higher and better uses of capital. That was a lesson learned in 2021, 2022 through COVID. And thankfully, I was able to bring this highly talented team on from Japan. A key addition was Nao Makino. I found him at Columbia Business School, young, hard -charging veteran of markets at a young age of 33. And between us, we jokingly call ourselves Batman and Robin. He helps me understand the fact pattern I see and translate that culturally into conviction.

44:51So today, our portfolio is really 15 names with the top five or six names representing 50 % of our portfolio. That's where our engagement has led us to events where we know through the mosaic that action is on the horizon. So we think our conviction is really uniquely informed and uniquely positioned. When you talk about cheap, if you look at summary evaluation metrics of your portfolio, what does that look like today? So I told you five of our top names are 50 % of our portfolio. We're still with 50 % of our weight, sub four times EBITDA, about three and a half times EBITDA, nine times earnings, 3 % dividend yield.

45:31Market multiples in Japan are seven, eight, maybe depending on where you look and maybe market cap adjust, 12 times EBITDA. So we're anywhere from a half to a third of market multiples. Our free cash flow yield is 40, 50 % higher than the market. Our ROEs are 30, 40 % higher. So we are twice as nice, if not more, at half the price. How do you think about holding periods? Engagements take time. The conviction that we enjoy today, that 50 % in five names is the product of three, four years of very hard work. Conviction is a three or four year process. So holding periods are anywhere from five to seven years.

46:11And I'm going to throw a bit of a curveball in that one of our main really headlines for why this time is different in Japan is there is a market for control. And we feel in certain of our lead engagements, there are sufficient trust elements to our relationship where bringing capital to privatize the company is not out of the question. We're starting to see this, that the public market investor, through the duration of that investment and through doing the hard work of partnering with management, has developed the credibility to make the case for privatizing the company. And that's something that we would like to explore.

46:50So when you talk about holding periods, well, infinite might be one answer. How do you think about cell discipline? So our bi -discipline is hard -coded. if it doesn't pass our screen, we're not looking at it. But our sell discipline is much more deep diligence -based. What do we really think this company is worth? And then we add a layer to that and we say, what do we think private equity is willing to pay for it? We're trying to put a premium for control in our valuation. So our valuations and holding periods tend to be both longer and reasonably aggressive, we are the first stage of unlocking that value in giving management confidence to understand that better ownership equals better outcomes for employees, for all stakeholders, and that what used to be considered hostility is now maybe a better way of delivering on the function of a company.

47:45If your conviction that now is the time doesn't play out and you look back a premortem over the next five years, what are some of the risks you see of what could cause this to not work? So the big element here, and it's playing out, is that this market for control is too painful for Japan to bear. Let's be clear, there's a tit for tat going on. Nippon Steel is showing up and trying to buy US steel. The flip side is a Canadian peer of one of Japan's giants, Seven and I. If you've been to Japan and you've been to a 7 -Eleven in Japan, you know it's a fundamentally different company than a 7 -Eleven in the US.

48:22It's a tremendous service offering. And the Canadian entity issued what is, quote unquote, a friendly bid for what is a almost sacred part of Japanese life. We're already starting to see Seven and I turn to the government and say, aren't we national security? Shouldn't we be able to thwart a aggressive takeover bid? We're all watching this closely. And the answer is Seven and I has had run -ins with Third Point. It's had run -ins with Value Act. And now it's got a run -in with someone who's not just a financial operator, but an operator of convenience stores saying we can run them better. We see this as constructive and positive.

49:01We don't think that Japan is going to run and hide, but watch this. This is where the thesis is playing out and where the friction point is. I would suggest that where we're operating, though, still offers another path in that the average size of our companies are distinctly middle market and nothing that we're bidding on or areas we're operating on is quote unquote essential and would fall under the national champion need for protection. And just as imagine someone showing up and trying to bid for Boeing or someone trying to bid for another national champion in any other market, these things are complicated.

49:38Japan isn't going to offer everything up for sale, but the bad capital allocators, the companies that have defaulted on their cost of equity, we're being told that that's game on. How does the rise in interest rates, cost of debt, and increased cost of equity affect the outcomes of these businesses? The second risk is a stronger yen. The yen is obviously the first derivative of interest rate differentials. And perhaps we'll talk about the carry trade and some of the convulsions we've seen recently. Our portfolio is built for these events. What I mean by that is the yen carry trade and the yen strengthening is something we're prepared for.

50:17We don't have a portfolio predicated solely upon weak yen. We think that risk is primarily high valuation in almost any environment, whether it's strong yen, weak yen, slow economy, higher interest rates. We've incorporated all that history in our screen and our 10 -year look back, and all of our companies have survived all of these exogenous shocks. So our portfolio is built for even things like the normalization of Japanese interest rates. We think it's positive because what it does is it finally puts a price tag on the cost of debt. And it means that what was being offered for free, you're now going to have to pay for.

50:55And anytime you put a price tag on decision making, people start to act. So we think that rising interest rates in Japan is just the sign of the Japanese economy finally normalizing. How do Japanese companies and the markets respond to something like the yen carry trade and the noise around it? So it's a challenge. The yen in 2023, and I think I'm quoting this right, went from 107 yen to 161 yen to the dollar. How do you manage forecasts in a world where your currency is moving that aggressively? And what does that mean? It means Japanese companies have been very conservative on thinking about the positive impulse from the weekend.

51:38It used to be the weaker the yen, the better. When the yen went through 140, Japanese companies started saying, you know, this is not good for us anymore. So they've already been signaling that they don't want the yen to go to 160. So they're prepared for even our round tripping back to the 140s where we are today. So last year, we had a positive move in stocks. As you look out, when does the banging the table of this is an exciting time to be investing in Japan get normalized? I have been thinking about Japan a long time. And only last year did I make the fateful decision to say this time is different.

52:15First time in my career that I've really felt that this time is different. The bang the table is you start seeing funds getting the green light to play defense against bad governance in a way we've never been enabled. If the company just gets too cheap, we can bid for it. What speaks to bang the table more than that? We no longer have to beg, cajole and hope. We just show up with capital and buy. Up until this market for control, the market really wasn't functioning. Japan was a museum. You could come, you could look, you could examine, you could read about, you could be interested in, but you couldn't buy anything.

52:55So you're at the whim of the museum. And often closing time meant you had to go home. But now this transition to a market means if you want it and they're not responding, you can buy it. That's a pound the table moment. When the capital that is piled up in private equity finally feels like they can actually make bids for companies, get financing, get the support of the share transfer agents. There have been so many informal blockages to these bids, but tick by tick, all these blockages are getting removed. Konami Capital today can make a bid for a company and expect every part of the unsolicited bid chain from investment bank, share transfer agent, Japanese bank and lender to provide financing services to get it done.

53:48This is different. Toby, I want to make sure I get a chance to ask you a couple of fun closing questions before we wrap up. What's your favorite hobby or activity outside of work and family? Offshore sailing. It's a passion. It's simple to explain. When you're offshore and you're on day two, you've managed to get four hours of sleep every day and you're handing off navigation and trimming and sailing at night to another team of people, you create a really high trust team. You work really hard. It's an adventure and your world becomes incredibly small. It's 11 people in the space of 40 feet. You're a little cork and you can see other people that you're competing against.

54:29But when you get to your destination, you get into that harbor sometimes at three in the morning. It's a feeling of elation that's hard to describe. What's one fact that most people don't know about you? I love Air Jordan 5 shoes. I wore them for the first time in 1991. And something about connecting with Michael Jordan through those shoes, I'm a sucker for it. Nothing creates more startup impromptu conversations than being anywhere and somebody coming up and saying, wow, nice shoes. I've even had someone at O 'Hare Airport offer to buy the shoes off my feet. These are my pride and joy. What's your biggest pet peeve?

55:10People that waste time. Ben Franklin famously said that life is just composed of moments in time and anyone who's wasting your time is wasting your life. And I remember reading Ben Franklin in college and thinking, I promise to do as little harm to others and their time. And I hope to have that favor returned to me. Which two people have had the biggest impact on your professional life? I first have to say my wife. And the answer there is coming home from a day at work, she looked at me and said, did you have one of those days? And I said, I had one of those days. And she said, do you really think it's time for you to do something on your own?

55:47I said, it's time. She said, you should do it. And I'm giving you 18 months to do it. If you're going to do this, I want you to give it your all. I want you to have an end point. And I don't want it to always be around the corner. So she put a time horizon on my ambition and I had to show results. That's a really important partnership that helps bring great clarity to something as hard as starting your own company. I think the second is a mentor in Japan, Wakabar -san. Wakabar -san is a titan intellectually, an engineer. When I first got to Japan, almost as a stowaway, found my way into an investment bank.

56:27I was the only foreigner in the investment floor of the research group. And nobody thought a foreigner could bring any informational advantage in the Japanese equity market. And I was seated purposefully by the head of research next to Wakabarsan, who was the axe on Japanese semiconductor stocks, famous for three days of being awake and getting information. He was truly a titan of the brokerage industry, informationally, intellectually, that's when I realized, oh my God, that's my pace car. That's the person that if I can prove to him that I can be helpful and valuable, then I've proven something to myself and to this entire company.

57:11It took six weeks. He saw me grinding away on the Docomo IPO and being a downstream beneficiary, given his sector coverage At 2 .30 in the morning, he came over and said, so what's the semiconductor content of a base station? And is this going to drive semiconductor demand? It's the first time he'd ever asked for a data point. And that's the foundation of a relationship that today I cherish and gave me the confidence that I could push through some of those cultural barriers that seemed daunting at the time. That was the first test that I passed and probably the most important. What's the best advice you've ever received?

57:49I won't say who told me this, but it was three pieces of advice. The first was never work in a cost center. The second was never join a company that's just merged. The third was do your taxes, because if you do your taxes, you'll vote. I'm pleased to say that I've broken the first two and that worked really well for me. But to this day, I still do my taxes. All right, Toby, last one. What life lesson have you learned that you wish you knew a lot earlier in life? I learned it, but I didn't know that I learned it. I learned to ride a bicycle when my mother put me on top of a grassy hill and just pushed me down the hill.

58:25And it was one of those bicycles where the rear wheel is connected directly to the pedals. So as I was going down this hill, the pedals started spinning faster and faster, and I had to take my feet off the pedals. At the bottom of the hill was a parking lot, and the parking lot had those cement bumpers. So all of a sudden I realized I had an eight inch gap that I had to shoot. The lesson I learned was it's okay to be marginally in control as long as you have confidence that you can shoot the gap. That's great. Toby, thanks so much for sharing this really compelling case for what's going on in Japan.

58:57Enjoyed it. Thanks very much. Thanks for listening to the show. To learn more, hop on our website at capitalallocators .com, where you can join our mailing list, access past shows, learn about our gatherings, and sign up for premium content, including podcast transcripts, my investment portfolio, and a lot more. Have a good one, and see you next time.