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Performance The Economic Miracle Even more striking was the rising prominence of corporate Japan. Companies like Toyota and Sony rose from obscurity in the 1950’s to become global household names by 1980, in the process rivaling traditional American bellwethers like General Motors and IBM. Meanwhile, Japanese companies snapped up some of the Western world’s most coveted real estate. But Japan’s booming economy also inflated what was quite possibly the most damaging and out-of-control speculative bubble witnessed since the Great Crash of 1929. The average Japanese stock traded at well over 200 times earnings by 1990 and property prices soared in Tokyo to the point where even the smallest studio apartments were unaffordable to most consumers. In fact, The Economist magazine estimates that by 1990 the average Japanese residence cost nearly 40 times the average annual Japanese household income. To put that into perspective, consider that in the U.S. today the average house costs only six times the average American’s annual income. The Lost Decade Although Japan remained the world’s second-largest economy, it stopped growing and fluctuated in and out of recession for 13 years after the 1990 bust. Meanwhile, the nation’s most widely watched stock index, the Nikkei 225, fell from highs near 40,000 in 1990 to lows of under 8,000 last year--a more than –80% drop. In addition, real estate prices fell continuously. In fact, some prime properties in Tokyo are still worth less than 20% of what they were a decade ago. Perhaps the most damaging offshoot of the "Lost Decade" was a deteriorating financial system. The country’s major banks had lent generously to the largest companies during the bubble years, and as much as 80% of those loans were collateralized by real estate. However, thanks to collapsing land prices many of the nation's biggest banks soon found themselves sitting on piles of bad loans and no collateral. Even worse, the country’s once-vaunted “keiretsu” system made the country even more vulnerable to this problem. Keiretsus were industrial groupings of companies and a “main” bank. Each company in a keiretsu traditionally owned shares in the other members--a system known as cross-shareholding. By tying companies together, the keiretsus sought to enhance access to bank capital and help shelter companies in difficult business environments. The main bank was in charge of most of the lending to other businesses in the group. While this system ensures good, low-priced funding for keiretsu members, it also means that banks felt compelled to lend to other members at favorable terms regardless of business conditions. Bank loans were all too often a product of traditional keiretsu ties rather than business fundamentals. The result of this system was that banks were compelled to lend more and more money to weak keiretsu members simply to keep them alive. These large “zombie” companies ate up most of the big Japanese banks’ lending capital. The end result: bad loans piled upon bad loans and the banks’ financial situation quickly deteriorated. Not surprisingly, the Japanese government eventually tried to inject life into the economy. Unfortunately, the government’s primary policies involved spending money on construction projects. These certainly enriched a few well-connected companies. Unfortunately, however, they did little to stimulate growth. What's worse, public debt soared in the process as the government tried desperately to spend the economy out of its funk. Little was done to address the growing banking crisis. Periodic government-funded bailouts of the major banks served to temporarily stabilize the nation's financial system. However, they didn’t address the root cause of the problem: banks continued to carry excessive inventories of bad loans and continued to lend to favored “zombie” firms. Reform and Progress Japan’s Financial Services Agency (FSA) imposed profitability improvement orders on the nation’s 15 largest banks in 2002. If they fail to meet tough standards, then they can be forcibly nationalized. These orders include stiff and politically unpopular mandates to reduce staffing and cut costs. And last year, the FSA proved this wasn’t just another thinly veiled attempt to bail out favored banks; the FSA nationalized two major Japanese institutions, firing senior managers in the process. Capital adequacy ratios, a key measure of financial stability, have drastically improved at the nation’s biggest banks since 2002 and are approaching western standards once again. In addition, some of the nation's most prominent “zombie” firms have finally been allowed to go bankrupt--a move that has freed up large amounts of capital for lending to more competitive businesses. A recent survey of small- to mid-sized businesses in
Japan reveals that managers are increasingly confident in their ability
to borrow money to fund growth. In fact, according to the Bank of
Japan’s Tankan survey, businesses are more optimistic than they’ve
been at any time since 1990. (Please see the chart below for details.)
Business managers haven’t been this confident since the bubble days of
the late 1980s. Japan also decided to address the real estate decline directly through a series of tax and accounting rule changes. Thanks to a change in the corporate accounting rules, known as impairment accounting, firms are now forced to write down the value of real estate assets to fair market values before April 2005. Many firms have been carrying properties on their balance sheets acquired during the bubble years at inflated valuations. These artificially boosted the value of their total assets. However, the recent rule change has now prompted companies to sell assets and recognize losses in order to gain tax credits. At the same time, Japan has allowed the formation of real estate investment trusts (REITs). These firms are buying prime properties sold by the nation’s major firms, and many REITs now offer yields to investors in excess of 5%. In Japan, interest on savings accounts now sits at less than 1%. With this in mind, the so-called J-REITs have proven extraordinarily popular. The sale of distressed properties by corporate Japan has been easily absorbed by the newly formed trusts. Meanwhile, on the residential side, the government has finally changed the nation's inheritance tax code, allowing older Japanese to pass real estate holdings to their children at tax-advantaged rates. That has encouraged the purchase of residential properties as a means of wealth transfer. The result of these policies is that real estate
prices are slowly recovering. As you can see in the chart below, the
price of prime real estate in Tokyo has risen over the past year.
Although that might not seem all that impressive, it represents the
first increase in prices witnessed since the bubble burst in 1990. We
expect this trend to continue as Japan's economy recovers in the coming
years. What to Look For The best investment opportunities in Japan can be grouped into two key categories: globally competitive Japanese large-caps and stocks that are nicely leveraged to positive domestic reforms. The first category includes well-known exporters like Toyota and NEC--the vast majority of which are now benefiting from the global economic recovery. The second group encompasses mainly financials and real estate companies that were savaged by the long bear market and are now poised to benefit from reform mandates. Even better, most of our favorite Japanese investments
now trade at a discount to their foreign competitors, a far cry from the
inflated price-to-earnings ratios seen in the late 1980s. Favored Japanese Pick: Mitsubishi Tokyo Financial
Group (MTF, $8.73) Mitsubishi Tokyo, like most Japanese banks, found itself holding a pile of bad real estate debts in early 1990. But the bank was actually in better shape financially than some of its smaller competitors, many of which were teetering on the edge of insolvency by 1992. As a result, the government asked Mitsubishi Tokyo to bail out some of its weaker rivals, including troubled Nippon Trust. While these mergers of necessity may have temporarily swept the bad loan problem under the rug, they did little to fix the problem--acquisitions just added to the pile of non-performing loans at the nation's largest banks. By 1998, these issues finally reached a critical stage and Mitsubishi Tokyo was part of a government-funded $240 billion financial stabilization package (essentially a bailout of the troubled financial sector). In that same year, the company wrote down over $8 billion in bad loans, booking an enormous loss in the process. Reform and Recovery Mitsubishi Tokyo has also been by far the most aggressive firm in recognizing bad loans. And with a little prodding by the Japanese government, the company has also dissolved most of its “cross-shareholding” ties to other corporations, eliminating the final vestiges of the keiretsu structure. In fact, in this fiscal year alone the bank expects to sell off in excess of 750 billion yen in shareholdings ($7 billion). By reducing its direct ties to major Japanese corporations, the company’s lending practices are more likely to reflect sound business decisions as opposed to historical ties. These reforms have powered the bank’s capital adequacy ratio to about 12%--comfortably the highest among the larger Japanese financial institutions. Troubled loans now account for less than 3% of the total, about half of where they stood three years ago and well inside government-mandated levels. These improvements haven’t gone unnoticed by the outside world either. For example, bond rating agency S&P recently boosted the company’s debt ratings and placed a stable outlook on the firm's bonds. New Avenues for Growth While most Americans are intimately familiar with consumer loans and credit cards, these products are still in their infancy in Japan; only a few firms have operated with any scale in this business. The result: consumers are underserved and there’s a notable lack of competition in this area. This has led to extraordinarily high profit margins in this growing market. The average interest rate on Japanese credit card loans is over 20%--nearly double the rate charged on your average U.S. card. And keep in mind that Japanese interest rates are actually far lower than those in the U.S.; the central bank has maintained a zero interest rate policy since 2000. For a bank of Mitsubishi Tokyo’s size, the firm's cost of capital is virtually nothing. Even better, this higher interest rate isn’t a sign of increased risk. Even after a decade of economic troubles, Japanese consumers are among the most savings rich anywhere in the world. Consumer loans in Japan actually have a credit quality that meets or exceeds that of the rest of the industrialized world; there’s a less than 7% bad loan ratio in this business. The end result is that the profit margins available in the consumer lending business are huge. Traditional lending to corporations remains Mitsubishi Tokyo’s main business. However, the firm signaled its interest in the consumer finance arena this March by taking a controlling stake in Acom, one of the nation's largest dedicated consumer lenders.
This acquisition will not only improve Mitsubishi Tokyo's consumer business, but it will also help it in the small business arena. Acom has already developed a burgeoning business in lending to small companies. In fact, the firm has indicated that loans to self-employed small business owners make up about 20% of its overall portfolio. That’s another growth market for Mitsubishi-Tokyo. Small-business loans, like consumer loans, carry higher interest rates and are underserved by Japan’s biggest banks; in the past they’ve preferred to focus on the nation’s large-cap companies. Finally, despite cool political relations, China and Japan are increasingly tied economically and trade has soared over the past two years. Already, several Japanese insurers are expanding into China, offering life and casualty insurance products in this market. And with financial services still in their infancy on the Chinese mainland, there’s almost unlimited growth potential in this market. Mitsubishi Tokyo has already made some investments on the mainland, and this should continue to be a growth avenue in the future. Financials and Valuations On the valuation front, Mitsubishi trades at just a touch over 17X this year's projected earnings. That might seem expensive at first. However, when you consider the company’s still-depressed earnings picture, the stock is actually trading at a sizable discount to the firm's intrinsic value. In addition, the company's price-to-book ratio, a popular valuation metric for financials, stands at just 1.5, a discount that of its major foreign competitors. Mitsubishi Tokyo Financial Group (MTF, $8.73)
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