Japanese frogs
Japan looks like an island, but it’s not. It is an archipelago, composed essentially of 5 islands (in fact there are over 6000 although mostly very small). Honshu is the largest island, where resides not only the capital Tokyo, but also the other major cities: Osaka, Yokohama and Nagoya. To the north is Hokkaido, whose capital Sapporo sounds familiar to beer lovers. To the south we find Shikoku, a little smaller than Sardinia and with fewer inhabitants than Sicily, an island that the well-known magazine Lonely Planet indicates as the most beautiful destination in Japan. Continuing further south we find Kiushu, famous for its wild nature, full of waterfalls, volcanoes and hot springs. Finally, much further south, we find Okinawa, the Hawaii of Japan, with its white beaches, tropical climate and turquoise waters.
Japan is divided into eight regions. The three islands of Hokkaido, Shikoku and Kiushu each represents one region. The other five regions (Tohoku, Kanto, Chubu, Kansai and Chugoku) are located on the large, main island of Honshu.
In turn, the regions are divided into prefectures, and there are as many as 49 in Japan. Each prefecture has its own customs, dialects, foods and even … banks! They are called regional banks, but these small banks are actually focused not on regions but on prefectures, areas whose inhabitants can range from a few hundred thousand to 10 million. There are over one hundred regional banks in Japan, of which about seventy are listed. These companies, unlike the Japanese mega-banks created by the restructuring of the financial system in the early 2000s, are very close to the territory and play an essential role in the survival and development of small businesses. They also assist local communities in times of difficulty, more directly and effectively than national banks. As, local banks normally do. Two years ago, the FSA (the Japanese financial regulator) released a study showing that in about 50% of prefectures, even a single bank that controlled the entire market could not be profitable with its characteristic business alone (see graph below, source FSA).
This risks endangering a sector that is fundamental to the area and therefore the priority of the government and the BoJ (Bank of Japan) is to strengthen it. Otherwise many of Japan’s regional banks risk ending up like the frog in the famous urban legend that, placed in a pot of cold water on a fire, is condemned to die slowly without realizing it.
An unacceptable option.
Yoshihide Suga, the Japanese Prime Minister, has always been a strong supporter of an industry aggregation process and has promoted legislative initiatives in this sense. For some months now, a new law has been in force that eliminates all regulatory scrutiny for regional banks that merge in the same prefecture. Furthermore, in the event of a merger between regional banks, the BoJ will increase the return on the reserves left with it by the new group by 0.1%. Finally, in the case of a merger involving regional banks exposed to rural prefectures with
declining populations the government will grant aid of approximately $25m to cover the costs of reducing the workforce. Cutting jobs is taboo in Japan and bank staff, like those in many other large companies, are used to working a lifetime for the same company. Layoffs can be a much more dramatic experience in Japan than anywhere else in the world. That’s why retraining or rich early retirements are the only possible solutions.
After so many years of waiting, a wave of M&A is inevitably coming. What about the market? Japanese regional banks have lost between 30% and 70% in the last 3 years and now trade at valuations between 0.1x and 0.3x tangible equity. An M&A wave in the sector has been evoked for years, cyclically, and each time it is disappointed and the stocks in the sector are further penalized. Why should this time be different? This time A) the political will is absolutely determined and agreed upon, B) digitization is now clear how inevitable but also expensive it is, and C) these companies valuations are so low that there is only money to be gained from a merger for all parties involved. Few companies can be more cautious and experienced in lending policy than Japan’s regional banks, which have had to manage 30 years marked by multiple financial bubble bursts, natural disasters, the country’s economic recessions, deflation, and structural industry crisis. Unless an exceptional and prolonged recession is foreseen, the values at which these firms trade today can represent a floor. A rerating between 0.25x and 0.4x as happened to some Japanese regional banking companies that merged can lead to appreciations not far from 50%. Clearly you need to focus on those where the franchises are stronger, the capital is solid and possibly those with more modest size, where synergies can be more significant. And in any case, as always, you have to diversify.
A large part of the regional banks are poorly covered by analysts or not covered at all, so they naturally belong to the Orphan Companies Niche of the Pharus Asian Niches fund, where we bought 7 regional banks for a total weighting of just under 1.5%.
Logbook
There were still many companies that reported last week. We mention the results of a few stocks we hold in our portfolio.
Axa reported nice data with the often-criticized XL reinsurance division particularly strong. 
The stock is worth about 7x earnings, 1x tangible equity and for the next 3 years should pay about 10% per year between ordinary and extraordinary dividends and buy backs.
Bayer fell despite reporting reassuring data. Here we have one of the stocks functional to the second agricultural revolution trading just above 8x earnings. The ex-Monsanto lawsuit undoubtedly weighs on the valuation but the liabilities from it are discounted several times.
LG U-PLUS, the smallest of the Korean telecommunication companies, reports nice data. Growth is 10% for the next three years with a free cash flow yield of 16% and an EV/EBITDA of 3.6x. In Korea it is the most expensive in the industry …
GAM also reported data indicating a stabilization of the business, in terms of AUM and earnings. The company is worth CHF 300 bln and has tangible equity of nearly CHF 200 and CHF 250 bln of net cash. Stable assets at CHF 36 bln and private label CHF 90 bln. It reiterates CHF 100 mln of EBIT in 2024 and clearly the market does not believe it (neither do we). GAM remains a perfect take over target, providing the opportunity to cut costs dramatically and pay back the acquisition in 3 years.
CVS posts good results, helped by COVID tests, vaccines and new diagnostic-related projects. Solid financial business. 10x earnings, FCFY of 9%, sustainable growth of 6/8% per year.
Toray, the world leader in carbon fibers, reports good data on the chemical side, while it is still weak on carbon fibers. This apparently bodes ill for our niche on the Pharus Asian Niches fund, The Magic of Graphite: Carbon Fibers and Steel Recycling. Planes still aren’t being built and demand for electric cars using these materials will take some time before becoming significant. In due course it will come, and it will be huge. In the meantime, let’s take advantage of the weakness to accumulate a sector that will see exponential growth over the next 5 years and it is now trading at depressed valuations.
Oji Holdings. The “Japanese Stora Enso” reported its quarterly results; this is a company operating in wood-derived materials and managing forests. The company did not raise its outlook although results for the quarter were strong, a common feature of many Japanese companies that prefer to remain cautious. The company presents structural long term growth in the business, very low valuations (8x this year’s earnings) and debt covered by forest value.
JAL and ANA. The two Japanese airlines reported better-than-expected results due to cargo-related revenues. Both companies are very solid and in comparison make American and European carriers look very fragile. The companies trade below tangible equity value and are good players for recovery with modest risk.
Standard Chartered. This represents one of the most global bank among those focused on Emerging Countries. For several years since the great financial crisis the company has been trading at more than 3 times tangible net worth, on average 5 times higher than other large global banks, not being active in the rogue sub prime business and buoyed by the market’s belief that it would be the prime beneficiary of the growth in developing countries. Mr. Market was distracted by the fact that many of its profits were made by raising money cheaply in the markets and deploying it in high-yielding emerging market bond instruments, that internal compliance practices were not very rigorous (to say the least), and that a number of acquisitions were clearly mispriced. The CEO of Standard Chartered Peter Sands was first elevated to a role model (Harvard Review named him at the top of its High Ambition Leaders list) and then became a model NOT to be followed (sic transit gloria mundi…), as happened before him to Sir Goodwin of Royal Bank of Scotland (the title of Sir was even revoked…). When the business model became clearer Mr. Market threw the baby out with the bathwater, bringing a structure that benefits from great diversification in high growth (and risk) areas to bankruptcy valuations. This institution anchors its structure into over a century of history that has seen it, as the Chartered Bank of India, Australia and China and The Standard Bank of South Africa (which merged in 1969) as a trading company, accompanying the British empire in its project of colonization and development of emerging countries.
The bank reported excellent results during the week with a very low cost of risk. The stock trades at 0.4x tangible equity and 6x next year’s earnings.
