What is wrong with this picture? Japan is suffering from an irrational lack of exuberance. As Japanese stocks bump along at 20-year lows, the market now figures that hundreds of companies like Exedy are worth less than their liquidation value. No matter how grim you rate the future of Japan Inc., that can’t make sense. Many companies in this class, like Exedy, make a solid profit. This syndrome is most pronounced in the vast market of small firms, unknown to the outside world, which are the core of the Japanese economy, and account for 90 percent of its GDP. The market carnage has become so indiscriminate, hundreds of profitable businesses are trading “at valuations that can be compared to those of the late 1930s in the United States,” says Shuhei Abe, a Tokyo hedge-fund manager who thinks Japan has become, of all things, a land of opportunity.
It is, if you know where to look. The hunt for likely winners in the debris of the Japanese market is starting to attract foreign giants like Fidelity Investments and Morgan Stanley, which once avoided the sector as an impenetrable market of secretive mom-and-pop companies, hostile to outsiders. According to a new report by Morgan Stanley, a staggering 83 percent of listed companies in Japan are worth less than $500 million today–compared to about 59 percent in the United States. No doubt, many of the 3,000 Japanese firms in this very-small-cap class are still difficult to penetrate and destined to fail, but at prices this low, the search seems worth the risk and trouble. Japanese small caps offer “massively unexploited opportunities,” says John Alkire, managing director of Morgan Stanley Asset Management in Tokyo. “There may be a dozen or two that become the next Nintendo or Sony.”
The window of opportunity for bottom feeders reflects changes in Japan Inc. Many small companies once thrived as bit players in huge keiretsu, the cozy industrial conglomerates that led Japan’s postwar rise. Since the early 1990s, however, price competition has disrupted old supply chains as giants like Mitsubishi shed subsidiaries and affiliates. These weakened little companies are the single worst source of Japan’s huge bad-loan problem: banks have often been unwilling to write off these loans because, in another incestuous habit, they often hold stock in their business customers. Now, many banks fear that the bad-loan crisis is approaching the meltdown stage, and are finally starting to liquidate stock in firms that could fail. The problem, says one small-cap analyst, is that banks are selling the good with the bad–“throwing the baby out with the bath water.”
The trick is to position oneself to catch what Abe calls the “little Nissans”–companies that could duplicate the market-beating success of Japan’s most remarkable corporate turnaround story of the last decade. It’s quite a trick. For starters, brokerages in Japan follow less than 2 percent of all small-cap companies; the rest have probably never seen an analyst walk through their doors. Experts theorize that the universe of 3,000 small companies contains 500 to 700 potential winners, some that are simply undervalued and others that must reinvent themselves to succeed. To find companies with real potential takes more than picking up an oblique financial statement: bottom feeders have to do real legwork and interview management, which may be reluctant to open the front door. Yet dozens of investment houses are getting into the game, and small-cap funds in Japan now number about 100. Carlos Ghosn, the outsider who turned around Nissan, says the idea of replicating his success is sound: “There is a lot of value locked in Japan, and much more potential than most people see today” (following story).
Japanese small caps still scare off most potential investors because they’re anchored to a sinking domestic economy. Historically, few have exported. And most occupy Old Japan sectors like manufacturing, construction, wholesale or retail. Interested parties must balance micro potential against the consensus view that deflation, slack consumer spending and aging will continue to ravage the Japanese economy. On the up side, most small caps aren’t exposed to currency fluctuations, and the sheer magnitude of the market collapse means that the vast majority of all publicly traded firms in the world’s second-largest economy are now selling at fire-sale prices.
Even in Japan, then, it’s possible to pick winners. Morgan Stanley’s small-cap fund has defied the slump since its launch early last year, rising 8.5 percent while the Tokyo Stock Exchange fell by 18 percent. Of about 500 “real gems” in the small-cap rough, Alkire and his research team aim to pick out the best 150 or so through “negative screening.” High share prices, transparency issues or stubborn founding families, for example, are common causes for elimination. His aim is to craft a “long only portfolio”–industry jargon for the traditional buy-and-hold strategy popularized by Warren Buffett. “We want valuations that are ridiculously cheap,” he says.
In the long run, managers are betting not only on specific companies but also that small companies as a class will rise in value over time. The logic: Japan Inc.’s big stars are overpriced in comparison with the rest of the stock market–an imbalance that will eventually self-correct, says Masatoshi Kikuchi, senior strategist at Merrill Lynch Japan. Forces pushing a correction include increased investment by Japanese pension funds in small caps, the growing appeal of niche manufacturers over sprawling conglomerates and government plans to liberalize rules governing mergers and acquisitions in ways that will make small companies potential takeover targets. That has attracted the interest of foreign-takeover experts like Ripplewood of New York, which is now trolling Japan for potential acquisitions.
Abe is perhaps the most interesting of the bottom feeders, because he’s out to change Japan. As founder and CEO of Sparx Asset Management in Tokyo, he manages $3.2 billion, including $490 million in small caps. Last September he sealed a deal with the biggest U.S. pension plan, the California Public Employees’ Retirement System, to establish a new fund targeting small, underperforming companies that are willing to follow a very specific blueprint for reform.
Based on Ghosn’s turnaround plan at Nissan, Abe’s strategy is outlined in a presentation he calls “Japan: Transfer of Power.” Ghosn made the tough layoffs and cost cuts that define corporate turnarounds everywhere, but that was the easy part, says Abe. Besides, most good Japanese companies have downsized already because “fighting is structured in their DNA.” In his pitch to the CEOs of target companies, Abe instead urges them to “put the market ahead of the longstanding relationships” that have defined Japan Inc.
His point: send a message that you are more serious about free-market reform than Japan itself. Disengage from the clubby financial-support network by selling land and any shares you hold in your banks, or in affiliate companies. The markets hate to see such “nonessential” assets clouding the books. And to show investors that you have faith in your own company’s growth prospects, take the proceeds from those sales and put it in your own company. “I tell the CEO to sell these bank shares and use the profit to buy back your own stock,” Abe explains. “I’m saying to him: ‘Commit to the market’.”
One thing small companies have going for them is that they are relatively quick to change. Less beholden to demanding unions or tied to full-employment promises than giant multinationals, they’ve proved capable of restructuring on a dime if the top brass orders it. For better or worse, the ability to change tends to depend on the attitude of the founding family, which is often still in charge.
For competitive reasons, bargain hunters like Abe are reluctant to identify their most promising finds. And under Japanese law, the funds are restricted from touting or even naming specific companies in their portfolios. But generally speaking, investors look for nimble niche manufacturers with proprietary technology. One example is Kuroda Electric, which makes backlights for the liquid crystal displays on cell phones in Japan. Last September the company announced a major new investment in China that will boost its capacity in that market tenfold to a million units a year. The company’s share price is up 76.8 percent from a year ago.
It’s hard to imagine that the next Sony will emerge from this crowd, given the niches some of the edgiest small caps fill. Nakanishi Inc., for example, is Japan’s dominant maker of dental tools–a position that’s helping it expand into China, Korea and the United States. Ebara Jitsugyo, once a supplier of automobile exhaust pipes, is a rising star in the dirty business of sanitizing and deodorizing sewage. Then there’s Hamakyorex, a freight-transport company based in Shizuoka prefecture that’s reporting 30 percent annual sales growth. Last year its president told automakers that he’d haul their spare parts free of charge so long as they put them in the trunks of new cars during transport–a concept so logical that a Fidelity fund manager added the company to his portfolio after hearing it.
But success is not only defined by Sony. Two weeks ago electronics giant Hitachi dumped most of its stake in Horiba Ltd., a measuring-device manufacturer, ending a run as the company’s biggest shareholder that began in the 1950s. In the old days Horiba’s loss of a Fortune 500 patron would have been devastating. But Horiba’s share price has dipped only slightly as other investors–many of them foreign, no doubt–grabbed stakes. For Horiba, the development “was received as positive news,” says Shinichiro Hidaka, a small-caps analyst at Shinko Securities in Tokyo. It wasn’t a bad omen for the Japanese economy, either.
