It is no secret that SocGen's Dylan Grice has not been a big fan of the Japanese economy, or stock market for that matter. We have highlighted his perspectives on the island nation in the past, and his concerns about a likely demographic-induced funding crunch have been picked up by the likes of Hayman Capital's Kyle Bass. So when Grice comes out with constructive suggestions on how to play Japanese relative value, especially if it is based on liquidation value considerations, one would do well to listen.
In a note released earlier "Are Japanese equities worth more dead than alive" Dylan goes through the motions to first show why the Japanese market, broadly, is rich.
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.
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. The chart on the right shows this to be roughly in line with the overvaluation seen in other equity markets, suggesting little relative value either.
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.
As distressed investors know all too well, liquidation valuation present a last backstop in the valuation pyramid: the liquidation analysis in any Disclosure Statement appendix usually is the source of many laughs for analysts and attorneys as it lays out any given company bare, and shows, without accounting gimmicks, just what happens when one strips away the going concern patina. Here is what happens when this is performed at a broad level in Japan.
Let?s define liquidation value as distinct from book value and calculate it as cash on the balance sheet plus two-thirds the value of other tangible assets (receivables, inventory, plant and property) less the total value of liabilities. So cash gets a 100% weighting and liabilities do too, since they have to be paid regardless. But I assume that in a firesale liquidation, we wouldn?t get ?full price? for hard assets and we?d get nothing for intangibles. These are both quite harsh assumptions, but let?s err on that side in the spirit of building in a margin of safety.The following chart shows that around 5% of stocks in the FTSE Japan index trade below this estimate of liquidation value, amounting to around 1.5% of its market capitalisation.
Puting the vulture hat on in Japan would seemingly yield several interesting opportunities.
Clearly, with the percentage of stocks higher than the corresponding percentage of market cap, the companies being priced as liquidation candidates have a small cap bias. And maybe this is what we?d expect to see, with only Japanese exporters offering any real hope of future growth. But there are some interesting looking exceptions. Here is a list of Japanese stocks trading at less than liquidation value but with market caps greater than $1bn.
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...
The following chart shows the debt to shareholders? equity ratios for each of the stocks highlighted as a liquidation candidate above, rebased so that the last year?s number equals 100. It?s clear that these companies have been aggressively delivering in the last decade.
But as it happens, most of these companies have also been buying back stock too. So per share book values have been rising steadily throughout the appalling macro climate these companies have found themselves in. Contrary to what I expected to find, these companies that are currently priced at levels making liquidation seem the most profitable option have in fact been steadily creating shareholder wealth.
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?
We will conduct a comparable liquidation value analysis for U.S.-based equities shortly and present the results in due course.