Lots More on Why Japanese Stocks Are Surging

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1:17Bloomberg Audio Studios. Podcasts, radio, news. How's Hong Kong? It's okay. We're perking along here. It's feeling a little bit better, you know, the last week or two here. Oh, that's good. Than it did for much of the second half of last year. Have you watched The Ex-Pats? No. I'm debating. I categorically refuse to do so. I think I'm going to watch it once all the episodes are out just for nostalgia value. But yeah, I have heard mixed reviews.

2:05Yeah, I objected to the way they did it and I objected to... I was sure I was going to object to certain portrayals and I bet I'm not going to be surprised. Joe, did you know about that? No, what is the expats? So this was a huge thing in Hong Kong where during the pandemic, they let Nicole Kidman in without having to go through quarantine in order to film scenes for this show, which is all about expats living in Hong Kong. It was like a huge controversy. Everyone was so annoyed about it because it was just such an obvious double standard. I did a deadlift. One, two, three. Hegemony. Hegemony.

2:48Okay, good. Hegemony. Barges. This is an after-school special, except... I've decided I'm going to base my entire personality going forward on campaigning for a strategic pork reserve in the U.S. Where's the best squid ink pasta? These are the important questions. Is it robots taking over the world? No, I think that, like, in a couple years, the AI will do a really good job of making the Outlaws podcast. And people are like, I don't really need to listen to Joe and Tracy anymore. We do have... Cha-ching. The perfect guest. Welcome to Lots More, where we catch up with friends about what's going on right now.

3:24Because even when Odd Lots is over, there's always lots more. And we really do have the perfect guest. It seems like it's fun to be an investor in the Japanese market again. But after like 35 years... Yeah, you had to wait a while. I think stocks for the long run, right? The Nikkei, I think recently on some measure broke its 1989, the infamous 1989 peak is back. So yeah, there it is. There's the chart. I just pulled it up on my terminal. Pretty impressive. Travis, is it fun? Has it been enjoyable? Yes and no. Partly, you know, being in Japan, you're constantly, and I'm not in Japan, I'm in Hong Kong, But being involved in the Japanese market, you're constantly told, well, you know, the Magnificent Seven, they were up like, you know, 73 % last year.

4:15How about you? And then, okay, well, Japan's up 40 % and the S &P's up less. Okay, but yeah, but that's in yen. And, you know, the dollar was strengthened against the yen. And so there's always some naysayers here and there. But yeah, it's been okay. And there's been a lot of changes, and those changes have really been rewarding for those of us who've been watching and waiting for these changes to manifest themselves more publicly. Yeah, so we are speaking to Travis Lundy. He is, of course, a repeat all thoughts guest and a special situations analyst who publishes on Smart Karma. One of the smartest people I know when it comes to both markets and general trends, I guess, in Asia, based out of Hong Kong.

4:55But you have a lot of historical experience with the Japanese market, right? In fact, this is sort of your bread and butter, corporate Japan, special situations, big events in that market. Yes, I've been involved in the Japanese markets for 20 plus years. I lived in Japan for 20 plus years. I moved to Hong Kong for a job and I'm still here. But I do a lot of my work related to Japan. So this is the thing that you hear. The thing is, you've been hearing it for a while. So this is why I'm not entirely satisfied. But a thing that you hear is, oh, well, suddenly corporate Japan, management in Japan have become much more focused on returns or become more shareholder friendly, et cetera.

5:39I guess there was this perception at one point, you know, that management in Japan for a long time ran the business for management or insiders. And now they're running for shareholders. For salarymen, for their employees. Is this true? Is this actually a phenomenon that's changed? Yeah, it's changed quite a bit. It really has. And part of this is if you go back to the history, you know, back in 1642, seriously, the post-war, you know, the Occupation Administration broke up the Zybatsu, but they were afraid of communism. So they allowed the corporate groupings to reform. Instead of vertically, they allowed them to reform horizontally around banks and financial institutions.

6:25And a bunch of the shares in corporate Japan were handed off to individuals, but individuals then sold over the years. And there were no buybacks, but the financial institutions just accumulated them. So by the mid 80s, financial institutions, that is to say banks, trust banks, regional banks, life insurance companies, property and casualty insurance companies, and then, of course, corporations, they held two thirds of the market, which is just nuts. Right. Since then, it's gone way, way down. And part of this is, you know, banks support, you know, companies. A company has a need to invest capital, so they go borrow some money from the bank.

7:10The bank says, here, I'll buy some warrants too. And the warrants become shares. Okay, now you IPO a subsidiary of a major company. And that subsidiary has three different insurance companies, three different banks, five different supplier partners, ten different customers already as shareholders. They sell some off to retail, but it's still 80 % corporate and finance. and this is it's part of society you know cross holdings wasn't some you know malicious thing designed to to to keep out you know voting shareholders it was really you know let's go all do this together support each other be nice and friendly and suddenly became rude to sell you know why would i would sell this in order to go make money for myself you know i'm part of a society i'm just going to support this now eventually you know they started selling down because they needed to.

8:02There was a, you know, we ate 1989. And then, you know, by 1998, we were, you know, half off. And, you know, there was a banking crisis in the late 90s that persisted through the early noughties. A couple of brokers went bust in the late 90s. A couple of insurance companies went bust in the early noughties, mostly because they held too many shares, which had gone too far down. That and real estate, obviously. And, you know, the shares started going down and the banks and insurance companies and corporates started seeing this as kind of an existentialist risk. So they sold shares and, you know, those shares ended up in the hands of foreigners, retail and more public shareholders engendered more questions about what management was doing.

8:51So one of the things I'm curious about is what the the proximate trigger is or was for this newfound, I guess, like investor slash return focused idea in Japan Inc. So, you know, when it comes to Japan, I think I can remember like for decades, almost everything touching the Japanese market and economy tends to be discussed in almost cultural terms. It's kind of weird, but like people were always debating whether or not the culture of the Japanese economy could change, whether or not it would be more open to things like imported labor, immigration, or whether that was just impossible given attitudes towards foreigners, but also whether or not the, I guess, the sort of like internal focus of companies was down to a different type of societal value.

9:43So more of a collectivist society versus maybe the rampant individualism that we see in the U.S. So what was the change here? Because people were kind of like dismissive of the idea that this could happen for a long time. I think a couple of things. First was, when the dollar yen went from 150 in 1990 to 79 in 1995, all of Japan Inc., which produced in Japan and sold abroad, you know, the giant export machine. And they lost huge, huge sums. And so all of the Japanese companies, they set up production bases abroad. So now you have, you know, Toyota making cars in America sold to Americans. And, you know, Japan turned the demographic corner.

10:32Japan was much slower to come back after its banking crisis than, you know, And the Japanese business of Toyota didn't make nearly as much money as the U.S. business. So profits piled up abroad and companies became cash rich. Because companies had found that they were unable to borrow when they needed to invest, simply because the banks were too weak to lend too much money and they were always afraid of lending to companies who had a plan rather than companies who had assets to back their loans, companies started to hoard cash. They hoarded cash and they hoarded shares. Shares were not marked to market.

11:15And so they became a rainy day fund. And as long as they didn't get hit, you know, you were okay. Go down 50%, you have to impair them. But as long as they don't go way, way down, you're generally okay. So they became a rainy day fund just because they needed to hold on to this stuff to be sure that they had access to money when they needed it. And so we kind of went through the naughties. Japan, you know, came through the GFC better than most people, I think. And then there was a push towards increased stewardship and increased corporate governance. Part of this was, you know, based on the Scandinavian experience where some of the pensions decided to go whole hog on better stewardship and better corporate governance pressuring companies back in the late 90s.

12:04The UK did so in the early noughties. The TSE set up a corporate governance code in 2004, which nobody will remember and nobody ever paid attention to. The UK set up more of a stewardship code and more of a corporate governance code as time went on. There were more reports about the effectiveness. Japan copied that and set up a stewardship code and a corporate governance code after much back and forthing in the political arena. And it finally got there just after Mr. Abe was elected in late 2012. It showed up in 2014 and the corporate governance code in 2015. There was pressure. People saw it.

12:42It was finally, you know, starting to push. From what it sounds like, you know, I started in the beginning with my cynicism. It's like, oh, you always hear this. It's like Japan is turning the corner on management styles and corporate governance, etc. What it sounds like is actually all that's been true. It's just a very long process. So there's the long process of the sort of diminution of the cross holdings, the long process of the various expectations of the TSC, etc. So all of it was always true. It just takes a while for these things to sort of come to fruition. Yeah, that's exactly right.

13:19And Japan hit bottom in 2012 when the dollar yen was super low. And it's been up since. We've had a four-bagger, five-bagger in the Nikkei in 12 years, call it. and that is not bad you know it's been in yen terms which means it's less in dollar terms but uh that's where we started from and we had to come up the hill through abenomics through a bunch of different privatizations to get some leadership examples out in the public so that the the the media could point to that company that company did something good and the hint that everyone's supposed to take is i should be more like them

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14:54So, have you heard the story about the prescription plan with savings automatically built in? It's where a family of any size can feel confident the cost of their medication won't hold them back. Go to cmk.co.stories to learn how CVS Caremark helps members save just by being members. That's cmk.co.stories. R-I-E-S. I understand that, you know, at a high level, there are examples of shifts in Japan corporate governance. So, you know, there are actions being taken at a sort of like executive slash strategic level. But I kind of wonder how much that filters down to day-to-day business. Because I remember a lot of my friends from high school in Tokyo, you know, they stayed in the city and they went to work for a Japanese company.

15:47and admittedly the last time I spoke to them, a lot of them was pre-pandemic. So this would have been like 2019 or 2018. And so many of them were just miserable. Like the working culture was terrible. You know, the gender dynamics were terrible. I just wonder like how much of that aspect of Japan's corporate culture has actually changed. That's actually changed a lot. And it It changed a lot in, you know, post-GFC in part because, you know, companies weren't making any money and Japanese companies didn't want to pay overtime. And so one of the things is, you know, you pay overtime and eventually people end up with a little bit more cash in their pocket.

16:33The manager, you know, his job is to take out the subordinates. They all go to some bar and, you know, that's where they end up at the hostess bar. but they no longer had any money. And Japan really, you know, when I arrived in Japan in 1990, you know, this was Juliana's Tokyo. Actually, they went under just before that, but, you know, it was really, you know, Japan's great. Japan's fantastic. Japan's the top of the world. We will conquer the U S in five years. And, you know, Hong Kong was much like that when I arrived in 2011, but japan you know took us uh you know a step back and they really you know 15 years of of being beaten down economically uh speaking you know household incomes not going up asset prices going down real estate prices going down people decided that you know leisure hobbies foreign travel all of this is much more interesting if i'm going to have a job which really stinks well guess what i'm going to quit that job and i'm going to go work for a foreign company where i'm treated better.

17:30Travis, you mentioned the importance of you need some company to do it, and then everyone wants to emulate them. So some company takes some actions, the stock goes up, shareholders get rich, then other shareholders want to get rich. Which company did that in Japan? Who is that prime mover? That's a good question. The example which was perfect here was when the Tokyo Stock Exchange and the FSA changed the corporate governance code the first time after So the original, they made an amendment to it, one of the general principles, which said, if you hold corporate crossholdings, you are obliged to check them every year to see whether you need to hold them in order to do business.

18:11And strictly speaking, you should never need to hold crossholdings in order to do business. You should be able to do business with partners all the time anyway. and no company should restrict other companies from, you know, selling their shares that withholding business as a threat would be a really bad thing. So they put that in there and then they said, okay, we're going to do this as an example. And CSE owned 4.9 % of the Singapore exchange. And they, you know, they made a little presentation and says, well, we've decided we've talked with the Singapore stock exchange. We've decided we don't need to do this, but we'll have a continued good relationship with them and partner on products and services.

18:52And so we've decided to sell one third of our stake every year for the next three years in order to not disrupt the market and not cause market consternation. And we will apply the proceeds to improving shareholder returns. And that was the example just as they changed the corporate governance code. Since then, we've also seen activists coming in. Actually, a perfect example, an absolutely perfect example is Tokyo Electron. In 2013 to 2015, there was a long-running merger negotiation and approval process between Tokyo Electron and Applied Materials in the United States. And they ran a similar business.

19:33And Tokyo Electron was always kind of stodgy. They held some cross-holdings. They held a lot of cash. And they kind of built their business in a certain way. And they spent, you know, basically the better part of two years talking to AMAT. And they walked out of it and the deal broke. The DOJ, you know, blocked it. And it was announced at the end of April 2015. And they came out and said, all right, we've learned so much in the process of two years. We're going to completely change our business. The stock is going nuts. I'm just looking at it. The stock is going nuts. It's a 10-bagger, right? Wow, yeah.

20:08They basically said, you know, they said, we're going to concentrate on our customers in a different way. We're going to have a different dialogue with our customers, much the way AMAT has a dialogue with their customers. We're going to take all of our extra cash. We're going to buy stock back. We're going to set a minimum payout ratio of 50%. So every quarter or every half, you know, we're going to pay out exactly half of our earnings. So you know what you're going to get as a dividend. And we will strive to produce more shareholder return. It wasn't noticed at the time, but, you know, people noticed it later.

20:42The stock is way up. Other companies, you know, took a less good governance stance at the time. But, you know, there were a bunch of examples and it's slow and but it's it's kind of, you know, rolling stone. So speaking of people noticing, I mean, you mentioned just then there's been more activism. We've certainly seen a lot of inflows into the market as well. And I think the fact that, you know, stocks, the Nikkei is at a record is obviously catching a lot of people's attention. But are you seeing that impacting investor behavior? Like, are people responding to the market maybe differently than they once did?

21:22And I'm also thinking back to, again, this is kind of a cliche, but the Mrs. Watanabe idea. It used to be that a lot of retail investors in Japan would be focused on currency arbitrage because that was kind of a way of getting returns in a period of slow economic growth and the lost decade and all of that. But, I mean, now you can invest in stocks and get a return that way. Yeah, it's an interesting question. Last year, there were a lot of strategist comments and a lot of some of the famous Japan specialist Twitterati were commenting on how much foreign inflow there was into the market. And indeed, in the first half of 2023, we saw about 4.5 trillion yen come in, which was a really big thing.

22:06That was the biggest inflow we had seen in almost 10 years. But the second half kind of dampened it and we'd lost 1.5 trillion. But if you go back 2022, 2021, 2019, 18, you know, that 3 trillion yen didn't cover half of the outflow during the previous five years. So it was nice to come back, but we were at no means, you know, overweight foreign exposure. The other thing is, you know, you've seen this everywhere. The rise of passive has been, you know, dramatic. And that includes, you know, American pensions investing with American fund managers who manage international portfolios. A lot more of it's now in passive than active.

22:48And so we've seen a rise of passive flows and a decrease of active flows. But the activism itself depends on active investors, not passive investors, because the passive investors, you know, they just go with the thing. If it gets taken over, it gets taken over. It doesn't get taken over. It doesn't get taken over. What am I going to do? So one investor who's bullish on Japan and even wrote about it in his recent note, Warren Buffett, and he has stakes in five companies. And he says they follow shareholder-friendly policies. Some of their Mitsubishi, Mitsui, Sumitomo, or Beni Itouchu. I don't know if I'm pronouncing all those correctly.

23:24And he says they also – they don't pay their executives as much as U.S. executives. So what is it about these companies or like what is this opportunity or the sort of the new Buffett and Japan trade? Well, so that was a fantastic trade. And the reason why it was a fantastic trade was because those companies are really great companies. They are effectively listed private equity funds. They are very competitive. They pay their young people a lot of money. They recruit very, very good personnel. The personnel get trained. They enter a kind of a little pod and go forth and do projects. There's a project leader, you know, that's a flying V, goes up into the hierarchy for the next five or 10 years.

24:07Eventually, you know, you kind of get kicked out. You get sent off to another project. Maybe you spin out and you do an IPO or you take control of a project, which they then invest in. But back when Warren Buffett started investing, they were able to buy the projects at or buy the company at 0.5 times book. That's pretty good. You generally can't buy private equity funds at 0.5 times book. And these guys had had a couple of years of bad returns because they were heavily invested in the oil patch, oil and gas. And when oil and gas was very high in 2014 and got crushed in 2015, 2016, these guys had to write off a lot of their investments or write down the investments.

24:53So they did. And, you know, it got kind of, it stayed weak for a little while. They started buying back some stock, but they were kind of, you know, under, under loved, but they are still very, very good companies for what they do. They are very financially savvy. They are a bit like private equity because most of their investments are non-listed and they actually have a fair bit more leverage than you can see by looking at their financial statements, but they just manage it well and they've got long-term funding. They're super professional and it could be that the top bosses don't get paid, you know, like$50 million a year.

25:28They get paid pretty well. And, you know, that's just part of the Japanese way. Really, executives around Japan don't get paid stupid money. Carlos Ghosn was one of the examples and he got paid$10 million, I think. And everyone's like, oh my God,$10 million. Oh, Carlos Ghosn. Oh, my gosh. That was such a story. I just remembered I did a TV ad for Mitsubishi. This was my other high school job was doing like ads of various sorts. And it must have been like 2000 or 2001. I think I got paid probably like about the equivalent of$50. I should have asked for stock. Yes, you should have. Yeah. That'd be not a million.

26:07Well, it went down from there for 10 years. Tracy would have held. Tracy would have held the whole buy and hold investor here. I would have, actually. There's one other thing I wanted to ask you, which is, you know, we've been very focused on corporate Japan. But how much is this whole conversation we're having about changes? How much of this is a reflection or even a vindication of Abenomics? I think it is a vindication of Abenomics in part because part of what Mr. Abe wanted to do was he wanted to make Japan conscious of its, shall I call them, positive attributes. Where Japan had something to offer the world, he said, you know, go forth and make money.

26:52We will support you. We will, you know, figure out how to get you loans that you need to do to go, you know, spread the good word. And I think that at the same time, we had the introduction of the Japan Stewardship Code, which gave activist investors basically a stick to beat on companies and then gave the corporate governance code as part of the anvil, if you will. And there were simply a bunch of things which entered into the framework which helped companies get out of some of the doldrums post-March 2011 earthquake and end 2011 Thai floods, which impacted the Japanese economy dramatically. systematically i think that it was all kind of came together to bring japan out of what had been five-year doldrums which had been at the tail end of you know 20-year doldrums and i think that that he gets a fair bit of credit but i really think that kind of a societal change which happened with a large number of inputs and it's just as you mentioned joe it's going to take time a perfect example is cross holdings right we talked about that before japan is effectively the world's largest long short fund.

28:04There's something like 70 trillion yen of crossholdings across corporates, banks, property and casualty insurers. Actually, 70 trillion was last year's number. I think we're probably up to 100 trillion now. This is a lot of money. But basically, all of those crossholdings are funded by the equity of the holders. That is to say, if a bank sells its crossholdings, it gets money. Then it takes the money and it buys back its own shares. Well, if you unpack that, it basically means all of these companies and banks and insurance companies have effectively shorted their own stock in order to own the crossholdings.

28:40Now, that's really, really bad governance. And I don't know that Japanese companies have figured that out yet. But by the idea of saying, I don't need to hold the crossholdings in order to do the business, and then I will take that money and buy back the stocks, that's really great. The thing about this is, you know, the banks hold a thousand different stocks and every one of these cross holdings is a strategic position. This is a corporate to corporate relationship. It's embedded in the DNA of the corporates for the past decades. It's part of their business. You know, it's, it's a huge number of, of relationships, which need to be unwound politely.