Letters from a Proactive Fund Manager in Tokyo

(BDTI has recently received this collection of interesting vignettes and musings by a fund manager in Tokyo, written over the past year. BDTI has received permission to publish them from both the recipient and the author.)

ON BEATING UP ONE FALL-GUY

A bit of unintended Japanese humor like that by the founder of Tohmatsu who without a trace of irony told me and a roomful of people at a seminar some years ago that the best way for Japan to police governance malpractice was the old bakufu-era principle of ichi-batsu hyaku-sho. Punish one to admonish a hundred.

The notion that beating up one fall-guy does not necessarily atone for the misdeeds of many others seemed alien to him. On his moral map, and that of many of his generation, the ritualistic, kabuki-like punishment of a wrong-doer (who brought shame to the community) is more important for system integrity than weighing the actual injustice and harm done, because it reasserts the sanctioning authority. As Kurosawa put it in his film-noir classic, The Bad Sleep Well – 悪い奴らほど良く眠る (the worse you are the better you sleep.)

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ON M&A

On a different tangent, M&A.

I found that companies like Hitachi and Sumitomo are getting much more tolerant of asset disposals. Great news to be coming out of core Japan Inc. firms.They will also buy and sell offshore, so there ought to be an uptick in activity.

What bothers me is the absence of M&A in the small-cap value segment where we place our portfolio bets. Lots of cash, and need to grow overseas.

But also conservative founder-family management. M&A is hard they assume and risky.

But if that is so they are not acting as good fiduciaries to people like us, only to themselves. Not kosher.

Steel Partners tried to shake up their complacency about incoming M&A. I am happy to shake them up into doing their own outgoing deals. Most prefer slow steady greenfield expansion of tried and true manufacturing processes under their control in the Buddhist influenced arc of East Asia. Go further than Miyanmar and it is no longer comfort zone Buddhist-Confucian stuff anymore.

What can be done? The guys at Taiyo Fund, with money and visible clout fromm CalPERS, are doing something along these lines having conferences for their 20-25 invested co. CEOs, meetings with foreign investors and so on. Most of their companies are in the Other Machinery area – companies with digits 79xx that are usually independent distinctive instrument companies and the like.

But have they had much success so far? I doubt it.

ON EARNINGS SEASON

I love earnings season. It reveals so much to even the casual observer of Nipponese Shihon Shugi as developed by Kishi Nobusuke and polished to gleaming perfection by every Keidanren chairman since the war. Core idea: Ownership capitalism sucks, as shown by the abuses of pre-war zaibatsu. Bureaucratic capitalism, with quasi-public ownership, rocks. Bureaucratic socialism, with quasi-private ownership, is what you end up with 60 years on.

OK, so at a kessan setsumeikai, this one company we own announced it expected a dip in net profit this year of 2.4% and as a result saw it prudent to cut its proposed dividend from ¥40 to ¥30.

The goal was to achieve a payout ratio of 30% and the past 5-year average comes to 28.2%, including two recent years of peak earnings in FY06 and FY07.

Sir, I ventured to ask, is there not a discrepancy there? A ¥10 dividend cut is a 25% cut, not a 2.4% cut, and the shares already fell 13% since you disappointed investors with the big cut in cash payout?

He looked at me befuddled. If we kept the ¥40, we might go above our promised 30% payout ratio, he said, searching for a way to put words to his internal logic.

Say what? Sir, what importance do you see in maintaining a payout at or below an arbitrary number of 30%.

Hmmmmm. Knitted eyebrows. I will take note of your comment, but we do need to keep cash on hand in case things don't go according to forecast.

The company has ¥21 bn. in cash and at ¥40 pays out just under ¥1 bn. of it. At ¥30 of course 25% less. Free-cash flow last year was close to ¥5bn. Give those poor souls in rags a bit this Christmas, you can hear the wife saying.

By the way, I asked, how is your business with Fanuc?

Oh, you know about that, his glance implied. Well, I am happy to say since August 2009, it has been booming, their orders came so abruptly we didn't have enough inventory, and it is still going strong….

Read my lips: I built this company, I am the boss, and I am the largest shareholder, so get lost.

ON COURTROOM ACTIVISM

It might be fun actually, about 12 more months of this I will notebooks crock full of you must be joking, Mr. Fuchs, it can't be THAT bad over there…

To which the next page and the next chapter would simply say, you are right, it's worse.

Actually more seriously…. I might be interested to become a courtroom governance activist.

Pick a couple of targets, not to own or to pillage, but to …. bring them to their senses. Even the initiation of the suit – well researched for sure, calm, diplomatic, but unyielding on principle – would rock the boat in Japan Inc.

For example, pick a company that happens to be a more than majority-owned sub of another listed company. Okinawa Cellular comes to mind. KDDI owns 51.51% – nice isn't it? – and the litigable issue could be the fact they have extended their parent, KDDI, a ・15 bn. loan, just over 1/3 of their entire balance sheet. If the parent can enforce that, where are the rights of minority shareholders?

Such cases could come to well over a dozen. The idea would be to set precedent.
Create a tapestry of precedent in governance cases that amounts to a definition of fiduciary obligation in Japan.

Plenty of good aggressive Japanese lawyers eager for a fight. So little of interest happening in the legal arena these days….

That would make grist for the mill of an interesting book.

ON PROFESSOR GRAHAM AND MANGERS’S ABILITY TO WASTE MONEY

But if you read Prof. Graham, he was constantly reminding investors to be on guard against management behavior that in most respects resemble that we see in Japan today.

That was in the US of the 1930s and onwards. Perhaps what Churchill said holds true for investors as well – the price of freedom is eternal vigilance.

More seriously, I have been on the road down here in sweltering Kansai visiting some of our problem-child portfolio companies that have conjured up some really bad ideas that we have to deal with. One small cap with a market value of only Yen 5bn is going to spend Yen 6bn on infrastructure investment, when it could use that money to buy us all out at a 50% premium. Dumb dumb dumb, and we may not be able to stop them. Do your other shareholders have problems with this investment? I ask. A look of surprise as if the question came out of deep space, beyond the solar system. No, none of them has mentioned it.

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ON HITACHI

We have been lobbying with Hitachi parent to stop the hemorrhage of shareholder value at one of its listed subsidiaries, and EVP Miyoshi told me on two occasions earlier this year that something would be done.

So far all talk, no action. Last year they executed TOBs to de-list 5 such subsidiaries including Hitachi Maxell, and in the first quarter just ended showed a tremendous rebounding nearly across the board – except the problem child that we happen to own.

We bought it as a turnaround story, and kept it as a parent-sub buyout play, but now we see the parent dithering. Parent owns 63% of said child, so minority shareholders have only shame and indignation as their weapons, unless they want to take the matter to some public trial.

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JAPAN’S FATE IS WRAPPED UP WITH THE STOCK MARKET

I have to decided to re-engage with the broader investment world having been more narrowly focused on raising the alpha returns of our small-cap long-only fund in this dreadful investment environment.

One catalyst for that decision was a chance meeting I had with one of Nobuteru Ishihara's staff earlier this week. Nobuteru himself usually comes and makes some remarks as it is a community sports event in his district but of course now he has new and more serious national responsibilities.

To make a long-story sthort, this legislative aide knew nothing about the stock market or about the macroeconomic forces putting pressure on Japan, or even about the policy measures that might help lift the gloom.

I am reminded of the talk I gave long ago to a group of about 100 women, mostly housewives. I asked how many owned stocks as household investment (this was before online trading had become ubiquitous.)

One maybe two raised their hands. OK. How many of you own life insurance accounts. All hands rose at once. Do you happen to have any idea of how the insurance companies manage your assets?

Silence.

The cognitive dissonance here is that everyone in Japan is intimately wrapped up in the stock market and its fortunes, and hardly anyone realizes it.

I told the Ishihara aide that there is a fabulous pool of buried treasure (the so-called Maizo-Kin everyone is looking for, like the fabled Marcos gold) right there in front of us, in the massive piles of cash in corporate bank accounts.

Did you realize, by the way, that Tokyo Blouse still has 103 billion in cash and marketable securities, but has a market cap of only 63 billion, and trades at price to book of 0.37x. Old man Takano who fought Murakami tooth and nail to defend that treasure died a few years ago, still at the helm at 75. None of current management own shares, and no institutional shareholder owns more than 4.8%.

What gives?

hy is no one able to wrest this pile of cash out of the hands of the dull-witted salary-man executives and pass it on to its rightful owners?

A question I hope to answer – and profitably. At 0.37x book, this stock is a steal, in any country except for Japan anyway.
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COMPARING JAPAN TO KOREA

I can pen some thoughts on why this problem of Japanese governance is so deeply rooted, and yet so easily eradicated. A sense of urgency some would call it. Pulling your ostrich head on your ostrich neck out of the whole in the ground and taking a fresh new look at the state of affairs around you another. The problems have amply demonstrated they will not go away by wishful thinking.

Look at what the Koreans (ROK, not the filthy DPRK) can achieve by staying hungry, paranoid and often on the edge. Man that country has in many ways come further than Japan, despite its bigger handicaps, and fewer resources. In 1978 when I first went there, they were still digging holes in the ground for what was to become the Seoul subway. Hell, the Ginza line goes back almost 100 years, so Japan had a huge head start.

Do Koreans care about the stock market? Is governance an issue? Both yes, but I'd take their dynamism anytime (though that edgy loopiness and the raw cow innards keep me in Japan instead of over there.)

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