Japan, invisible beauty
Japan is one of the worst performing markets in 2021. The Topix, a far more significant index than its sexy fellow Nikkei, has only been homoeopathically positive since the beginning of the year. The reasons given are many. New Prime Minister Yoshihide Suga does not communicate well, seems to be just a functionary, and has neither the charm nor the character necessary to drag the country along. Vaccinations started late for different reasons. The most valid one is that Japan wanted to conduct additional domestic tests on the Pfizer vaccine before authorizing it, not being satisfied with those conducted by the manufacturer.
A worldwide unicum that is hard to explain … if we weren’t in Japan! Although the pandemic has been less severe here, the time to exit seems long and the restart of the economy is yet to be seen. In the meantime, the delay in vaccinations has once again put in doubt the Olympics scheduled for two months from now, which in any case will be a shadow of what could have been expected only a few months ago. It is normal for this situation to cause investors to take profits, particularly following last fall’s sharp and widespread call on the Japanese stock market by several brokers (clearly on strength), which led several investors to stretch the area. Then there are the Japanese investors. As mentioned, many times, in Japan taking profit on upturns is institutionalized behaviour and always appreciated in the financial arena. Like making scarpetta in Naples or drinking prosecco at eleven o’clock in Veneto. The outlook is not encouraging. There is a lack of catalytic personalities of the calibre of Koizumi who could electrify the country and promote the necessary reforms. After the summer there will be Lower House elections. What to do? Our advice is absolutely not to give up. In the face of a gloomy horizon there are a number of green shoots that are heartening: 1) weak Yen; 2) solid corporate results; 3) global trade, on which the country’s recovering depends; 4) increased investment across the planet in infrastructure and manufacturing, great for a Japan strong in machinery; 5) possibility that vaccinations will quickly reach one million per day, allowing us to live the Olympics with greater serenity; 6) the Olympics are always a nice catalyst and a nice showcase and here expectations are already low; 7)valuations; 8) valuations; 9) valuations. Let’s add that it is not clear to most people the true level of undervaluation of Japanese companies due to their unique structure and the accounting approach used to analyse them. When it becomes more so, the Japanese market will have another substantial step to take, while remaining at value. Let us not exclude that in this general pessimism something decent will emerge from politics, in terms, if not of personality, of reforms. Finally, let us not forget the giant steps that the country is taking in terms of transparency and corporate governance. The Toshiba dossier is still on the table and potentially represents only the beginning. In short, good stories also require a few tears.
It’s hard to find more bizarre creatures than listed central banks. They are not properly equity, they are not bonds. Central banks are public law institutions whose function is to manage the monetary policy of the country or economic area that shares the same currency. These institutions are usually controlled directly or indirectly by the state or by the same banks authorized to operate in the country, or by a combination of the two, and bound by a strict statute which, in turn, can be modified by the guaranteed bodies. However, in some rare cases, these institutions are listed and the shareholder base open to the general public. This opens up a series of questions about the valuations of these entities and their risk/benefit profile. Central banks are involved in a number of operations, generally related to the management of the money supply in circulation. Given their privileged positioning, central banks tend to make money in a rather methodical manner. The treatment of shareholders in these strange creatures varies greatly and is tied to the bylaws. Some pay no dividend at all (Bank of Japan), others pay a fixed minimum dividend (Swiss National Bank – SNB – pays 15 CHF per year which today corresponds to 0.3% yield), others variable dividends (Banque Nationale de Belgique and the Bank of Greece). When dividends are variable, their calculation is fixed by the statute according to defined methodologies. However, these methodologies can change as was the case for the Bank of Greece from 2012 to 2020 and for the BNB from 2016.
In the case of the Swiss National Bank (major shareholders the cantons and the big Swiss banks) and the Bank of Japan, the capitalization is a fraction and of the tangible net worth (less than 1% for the Bank of Japan and 0.3% for the SNB). Here the hope in holding shares in the company lies in the possibility of a part of the reserves being distributed. In fact, one drop of distribution would be enough to multiply the capitalization of the stock. In a world that looks for volatile “assets” without an underlying for a short speculation or for deistic reasons, it is normal not to look at these companies with a huge underlying compared to the purchase value but with an absolutely uncertain monetization horizon. Let’s focus now on BNB, the Banque Nationale de Belgique. The methodology with which it pays the dividend is curious. The dividend is independent of the bank’s characteristic profit. The dividend is taken from the yield of a portfolio (called the statutory portfolio) made up of the bank’s reserves, 90% of which are various Euro area government bonds (over 80% Belgium, France, Germany, Holland, Finland and sovereigns) with a long duration and 10% from equities, including a large share of the BIS (Bank for International Settlements). The yield from this portfolio is earmarked for dividend payments. Since 2016, the Management Committee (Conseil de Regence) of the bank has decided to allocate only more than 50% of the yield of this portfolio to the payment of the dividend (the other 50% is set aside as a reserve along with 50% of the bank’s characteristic profits which are therefore not paid to the state), as it was judged that the risk profile of the bank has increased as a result of QE (quantitative easing). This leads to a halved dividend, but also to a statutory portfolio that continues to grow and will therefore generate more interest in the future. However, in spite of the 50% cut, the dividend (paid in the past week) was over 6%, this is due to the fact that this statutory portfolio is over 6.5 billion euros and the capitalization of the bank is close to 700 million. So, we have a security that is equivalent to a basket of long duration bonds with 5x leverage (10x when the yield is all distributable again). If rates don’t go up, I continue to collect an attractive dividend, albeit downward (the rollover of long bonds gradually reduces the yield although the portfolio increases). If rates went up, I would not experience capital losses and would see my dividend stabilize and gradually rise again (for 2020 the yield realized by the statutory portfolio was 1.5%). If the bank decided to stop setting aside half of its dividend to offset the increased market risks associated with QE, a plausible event, the stock’s dividend would double. Finally, there is a remote free option related to the fact that if the bank were to be liquidated tomorrow, perhaps because the state central banks were incorporated into the ECB following a true banking union. In that case, the shareholder would collect 12 times his investment given that the ratio of capitalization to tangible net worth is less than 0.09x. In the bleak environment of Euro government bonds this can represent a diversification tool. BNB is held in the Pharus Asian Niches fund, in the Orphan Companies niche (1%).
Despotism and radical socialism have often followed each other in history, according to a sinusoid that tends to more than balance the damage of the previous regime. In democratically less advanced areas this continues to happen. South America is certainly one of them. Cuba, Venezuela, and Argentina survive under socialist regimes. As Ted Gortzel says in his book Changing Cuba, the culture of “I pretend to work, and they pretend to pay me” continues to take root without fail, without memory. After Argentina, Brazil, Colombia, Peru and Chile seem to be moving towards more or less radical leftist governments. Lula, freed and cleaned up by the Supreme Court, seems destined again for the presidency in the next Brazilian elections in 2022. This will be a moderate left that is not scary. Gustavo Pedro, former mayor of Bogota, former “guerrilla” fighter and admirer of Chavez, is listed as a sure winner for next year’s elections in Colombia. Pedro Castillo, of the communist Free Peru party, is given the lead in the run-off with moderate Keiko Fujimori to be held on June 6 in Peru. In both cases, the fears are many. And Chile is fresh from a surprising election of the Constituent Assembly (the body that will have to revise the Chilean Constitution) that saw the defeat of the right wing in power. The latter obtained less than a third of the representatives, the minimum number to block unwelcome resolutions and, together with the Democratic Left, the largest and historical centre-left party founded by Allende, failed to obtain 2/3 of the votes necessary to pass resolutions. This means that the two traditional parties that have ruled Chile for 30 years since the fall of Pinochet will have to come to terms with the new left that led the 2019 protests. Or, reading it differently, that the traditional left and the new left will be able to rewrite the new Constitution undisturbed. In this new left we find everything from extremist factions to populist factions, but also many members of Chilean culture, science, and business who want a more just country.
This unexpected result caused the Chilean stock market to plunge 15% in USD. As we had a chance to mention recently, Chile is the only country to appear among the developed countries in Latin America and to have solid economic and financial fundamentals. However, increased country risk, coupled with a fair amount of Western investment fund exposure to Chile, has resulted in this rough stock market adjustment. Some considerations are in order, however. 1) The two traditional parties combined possess the third-party needed to block resolutions perceived as too extreme and anti-market. 2) A series of changes to the Constitution promoted during the Pinochet dictatorship are absolutely necessary, since this Constitution does not sufficiently protect the rights of indigenous people, women, political minorities, access to education and health, housing and environmental policies, sustainable exploitation of natural resources and redistribution of its profits. 3) Although the country has grown tremendously since 1985, inequality is very high, with 10% of the population getting 60% of the income. There has been an improvement since 2015 but not fast enough to prevent the protests that nonetheless there have been around the world, producing more inclusive policies almost everywhere. What is reassuring, however, is that the bourgeoisie is there and can be seen, with the median 40% of the population in terms of income, controlling more than 30% of resources. The bourgeoisie guarantees us a constitution and a government (to be elected in November) that can be more equitable, but without the extremism we are used to in South America.
Against this backdrop, Enel Chile, the country’s largest electric utility, fell on the stock market in line with the market. Here again, it is worth remembering a few points:
1) The new left is rightly focusing on the environmental damage caused by the mining industry (through enormous consumption of water and fossil fuels). The solution will lie in demanding that mining companies develop desalination plants and use renewable energy, of which Enel Chile is the leading supplier in the country. And the process is already well underway, at least among the largest mining groups. So, let’s look at opportunities for Enel Chile.
2) The high price of electricity in Chile is linked to its dependence on coal. Enel Chile recently closed its last coal-fired power plant. The company trades just above tangible equity and has a modest 7% ROE. There is no room to cut profitability without jeopardizing employment and service quality.
3) The country needs strong infrastructure investments in renewable energy, both for domestic use and to be able to export it one day. If political conditions worsen, these investments will not be made, which will have a major impact on growth.
4) In an extreme case, if the new administration decides to expropriate mines or other third-party assets, it will have to pay cash for such expropriations, in line with international treaties signed and confirmed by the Parliament before the referendum.
5) The country has a low public debt and a limited unemployment rate despite Covid but if extremist policies are implemented the debt and unemployment will quickly rise and foreign capital will liquefy.
6) Corporate tax rates are already in line with other countries in the area.
7) Argentina, after its populist policies, must heavily subsidize its utilities which are inefficient and chronically loss-making.
We see with satisfaction the recent changes and believe that this is not the classic and dangerous socialist utopia but a necessary step towards a more equitable and sustainable Chile. Although in the short term it is fair that there is some volatility and tension in the market, also to remind some of the new Constituent dreamers that every choice has a price, we remain positive on the country and its future opportunities. On the recent weakness we gradually increased the position in Enel Chile which is within the NEF SDG Renewables fund’s trendSDG.
Numerous companies, among those in our portfolio, reported last week.
In the U.S., Macy’s reported strong results. The company reported online sales in the last quarter of 40% of the total. We are now at the inflection point of online sales and we believe that on average, in the long run, no more than 50% of sales will be made online. Man is a social and emotional animal. The stock has given positive guidance that has it trading at less than 9x 2021 earnings. For a retailing landmark like Macy’s this is a modest multiple. We hold the company on the Pharus Asian Niches fund, in the Internet Victims Niche (0.4%).
In Europe we highlight BCP Millennium which reported solid results. Portugal is doing very well and the normalization of sub-standard loans continues. With the Portuguese economy in good recovery, we believe that this problem is now behind us. The problem continues to be Poland, which has to resolve the long-standing issue of mortgages in Swiss francs. The acceleration of provisions and the government’s willingness to find a solution reassures us that this issue can be resolved this year. Although Millennium is as exposed as all Polish banks to these mortgages so much demanded by customers a few years ago, it is certainly not the one running the greatest risk, thanks to its solidity and size. Although we see the possibility of further significant provisions in case of settlement, we consider this solution positively for the group and would allow the stock to move into the 0.2 area from the 0.16 euro where it is now. The stock has performed well in recent weeks and now needs this catalyst or time for a further rerating to 0.2 euro per share which would imply a capitalization/equity ratio of 0.5x, still very attractive. We have exposure to BCP Millennium in the NEF SDG fund, in the trendSDG La Buona Banca (1%) and in the Pharus Asian Niches fund, in the Internet Victims niche (0.5%).
Telecom Italia’s results confirm that 2021 will be the year of inflection point after 15 years of decline. There are many questions to unravel on the unique network, but we must remember that there is now the need to stimulate investments for 5G and digitalization. We hold Telecom Italia in the NEF SDG fund, in the 5G trendSDG (1%) and in the Pharus Asian Niches fund in the 5G niche (0.5%). Vodafone’s results were taken poorly in our view more because of the premium the company boasts over the sector than the results themselves, which were good. The company seems to be gradually moving from a cash flow and dividend story to a growth story and this should please the market even if it is no longer accustomed to combining the noun “growth” with “telephone”. We hold Vodafone on the NEF SDG fund, in the trendSDG 5G (0.3%).
In Japan, three financial stocks that we hold in the NEF SDG fund have reported, MitsubishiUFJ (0.35%), Resona Bank (0.2%) and non-life insurer MS&AD (0.45%). All three companies report discretely and, in all three cases, valuations are extremely low enough to merit substantial rerating. In addition, all three stocks boast substantial dividends, particularly in the Japanese context.
In Korea, DB Insurance reported which we have on the NEG SDG fund (0.35%), in the trendSDG, The Good Insurance and the Asian Niches fund, in the Korea Reunification Niche (0.3%). The damage cycle in Korea is not propitious, but that will inevitably have to change. Low rates don’t help, but again there are elements to be positive. The company trades at 5x earnings and less than 0.5x equity. Hyundai Elevator also reported: optically disappointing results, but normalized growth is strong. Shanghai plant is finished and will begin production shortly. New apartment pre-sales growth accelerates and bodes well for demand over the next twelve months. The stock trades at a 50% discount to its large competitors. Over 20% of the capitalization is in net cash. We hold the company on the Pharus Asian Niches fund, in the Korea Reunification Niche (0.4%). Lastly to report, SFA Engineering, a medium-sized, high-quality company operating in the field of machinery and robotics used for the production of OLEDs and lithium batteries. The battery component continues to grow strongly and we believe this is just the beginning. The decline in the OLED part has limited the positive reaction of the stock. However, we see the company’s diversification as supportive, limiting risk and volatility in the stock. SFA Engineering trades just above tangible equity, less than 10x earnings and holds over 20% of the market cap in net cash. We hold this company’s stock on the Pharus Electric Mobility Niches fund, in the Satellite Areas Niche (2.2%).
By now there are only a few companies in our portfolio that need to report this week.
In the US we report DXC Technology.
In Indonesia we report XL Axiata.