Japanese stocks are cheap, but book value doesn’t tell the whole story

We’ve long been keen on Japan at Moneyweek. Some readers will thank us for that; some will not. It depends when you bought.

We recently reiterated our positive view on the market on the basis that inflation is now more likely than deflation; it has one of the few sound banking systems in the world; the Bank of Japan appears ready to join in the currency wars; and it is cheap. Very cheap.

Listed in the Topix are 380 stocks trading below their book value and with cash on their balance sheets. In the FTSE All Share there are 16, and in the MSCI Europe there are none. Which would you rather hold? It seems obvious to me. 

But I should strike one note of caution: I have been speaking to hedge fund manager Hugh Hendry who gives a slightly different view of the book value of some of Japan’s biggest companies. It isn’t, he says, always all it seems.

The problem is that corporate Japan (like much of Asia) is guilty of paying far too many “redundant quasi-state employees”. It failed to take the tough decisions it needed to secure its long term survival. And that is a policy that is “slowly but surely eliminating all of the residual equity value in far too many businesses”. 

As an example, Hendry asks us to consider Hitachi. It has a new CEO who has committed to improving operational efficiency. That has made the market happy. But it shouldn’t have.

“Let’s leave aside for a minute the sheer opaqueness of its balance sheet (try asking management about that $18.5bn of ‘other assets’), and let’s ignore the fact that, whilst people might tout the company’s fine cash flow record, its net debt in FY11 was much the same as it was FY03. That’s despite a purported $10bn of free cash flow in the intervening period”, he says.

Instead, let’s look at the fact that the firm has 376,000 employees. That’s clearly ridiculous, and it would seem obvious that Nakanishi-san, the new CEO, should get on with cutting it down (and raising operational efficiency and profit margins along the way). He needs to be “Hitachi’s Jack Welch”.

Let’s say he has a go and, as Welch did, gets rid of 25% of the employees. “Based on the cost of Sony’s recent restructuring it looks like it would cost Hitachi between $75,000 and $100,000 per redundancy. That’s an implied liability of around $8bn. No one calculating the book value that makes Hitachi look cheap takes this in account. So book value is hugely over stated.” Add this to the fact that the firm  has “$25bn of existing net debt and pension liabilities” and says Hugh, “with a market cap of $29bn Hitachi isn’t cheap. It’s far too expensive.”

There are a good many other companies in similar positions in Japan. That shouldn’t be enough to put you off what is a very cheap market – and if investors do come to believe that inflation is returning to Japan it won’t make any difference to the performance of the market as a whole.