In the last couple of months I attended two investment conferences in Tokyo to meet up with some of the Japanese corporations that we own in our investment funds. These conferences were a unique opportunity to sit down with senior management of these companies and discuss their business and the current state of their affairs.
These trips were also good opportunities to get a glimpse of everyday life in the largest metropolitan area in the world. I visited the retail stores of the companies owned by our funds, discovered some of the products that I had until then only seen on photos or read about in annual reports. In the following lines I put down some of my takeaways from these trips and share my thoughts on some of the Japanese companies and segments we are invested in.
The lost decades
When arriving in Tokyo, one can only be impressed by this vibrant and modern city. It starts with a hassle-free one-hour trip with the express train from Narita airport to Tokyo station, that gives a first impression of the very advanced and well-maintained infrastructure in Japan. This impression will be confirmed when using the efficient metro system (the busiest in the world), where trains rarely encounter delays and run on very tight schedules transporting almost 10 million users per day. In the city, modern architecture and design is omnipresent. In the Ginza area, you can find spectacular department stores, while the famous Omotesando street is lined with outlets from the world's leading fashion designers. The neighbourhoods of Shibuya and Harajuku draw crowds of younger shoppers seeking the latest fashion trends, while Akihabara, the major shopping area for electronic goods, illuminates the night with its neon lights and animated billboards.
Akihabara electronic town
Nearby these glamorous shopping districts, there are quiet neighbourhoods with cosy restaurants, original mom and pop stores, extensive recreational areas and parks, and impressive historic buildings like temples or the Imperial Palace. Meiji Jingu for instance, a Shinto shrine located in a forest of 70 hectares in the heart of Tokyo offers a breathtaking sight. To me, the shrine and its adjacent parc was like an oasis of calm seperating the very shopping and business districts of Shibuya and Shinjuku. Tokyo is also often referred to as one of the world's safest cities and is the second most livable city in Asia (behind Osaka, another Japanese city) according to a recent ranking by the Economist Intelligence Unit (EIU).
Although Tokyo might not be representative of Japan as a whole, it is difficult to imagine that this is the capital of a country that has been enduring two so-called " lost decades" with stagnant economic growth, recurring periods of deflation and rising public debt levels. An interesting article published a year ago in the New York Times points out this discrepancy and showed that, by many measures, the Japanese economy has being doing well in the last 20 years and that "its citizens, despite the many economic setbacks, might be better off than in many other developed countries in the world". The article is entitled "The myth of Japan's failure"and is definitely worth a read.
Offering hall of Meiji Jingu shrine
This more positive view on the current state of Japan can, however, not hide the fact that Japan is facingsignificant challenges for the future. The lack of economic growth, high public debt levels, the deflationary pressure the government is desperate to fight against and poor demographics with a rapidly ageing population, are some of the country's biggest challenges. However one should not forget that many developed economies, especially in Europe, may be faced with similar challenges in the years ahead.
The economic outlook and what to make of it
So what do we make of all this in terms of our equity investments in Japan? The short answer would probably be not much:
- I don't know if the new government under prime minister Shinzo Abe will manage to revive the economy, bring an end to deflation and restore economic growth, or if the expansionist monetary policy will put the country's future in jeopardy, knowing that the public debt level is already very high.
- I cannot assess to which extent inflation will be beneficiary to companies exposed to domestic consumption, who might stand to gain from higher consumption, but who will also face pressure on their cost side with higher wages and higher input costs.
- I cannot judge if the push to end the strength of the yen will be successful and to which extend export oriented companies will be able to fully benefit from this, as rising input costs and pricing pressure from their customers might erode some of the potential gains.
- And it is unclear, how the strong generational inequalities will play out in the future, with an ageing population where old people own most of the wealth, whereas the financial future of the younger generation is far from secure.
I might agree, that for me as a fund manager, short-term political and economic developments have to be monitored, at least to some extent. But at the end of the day, my task is to find attractive long term investment candidates, without paying to much attention to short-term noise: profitable companies that have the potential to grow their business over time, without being too dependent on sociopolitical and economic developments.
So where to find these companies in a country that in economic terms has virtually been at a standstill for more than two decades and whose demographics don't bode well for future growth either? A country, whose booming 1980s economy has lead to enormous amounts of capital stock being accumulated by the private sector and where the opportunities to find adequate investment opportunities for this money are scarce. When looking at individual companies, one is often surprised by the amount of cash that sits on their inflated balance sheets and shocked about the lack of profitability that most of these companies get from their investments. In most market segments, differentiation among companies is low and there is way too much capital chasing too few investment opportunities, leading to structurally low returns on investment. This makes the task to find fundamentally attractive long-term investment candidates very challenging.
Japan's Hidden Champions
One domain where Japan has always excelled in, is in so-called 'industrial technologies'. In the broadest sense, this term applies to an industrial branch that develops engineering and manufacturing technologies that allow industrial production to become faster, simpler, more precise and more efficient. In this vast field of industrial automation, Japanese companies often occupy small niches for specialized technological applications and continue to deliver cutting-edge technologies that allows them to stay ahead of competitors from China or other emerging countries.
Keyence: Sensors and sensitivity
One example of such a company is Keyence, a leading supplier of sensors and measuring instruments for factory automation. Keyence is one of the most innovative and profitable industrial corporations in the world. The company's unique selling point is the quality of its products, its responsiveness to client demand and its capacity for innovation. From one year to the next, between 20% and 30% of sales are generated by 'new' products (i.e. that have been launched over the last two years). Keyence pays some of the highest wages in Japan and as such succeeds in attracting the best engineers and keeping them over the long term.
Fanuc: I, Robot
Another example of a company fitting into this category would be Fanuc, a leading Japanese manufacturer of industrial machines for the automation of factory systems. Fanuc is the leading manufacturer of industrial robots and computerized numerical control (CNC) systems. Fanuc's CNC-systems, which allow to control the functions and motions of an automated machine, have become something of a world standard, resulting in a market share of over 60%. This dominant market share reflects Fanuc's competitive advantage in terms of technological know-how, distribution network and production costs.
Industrial robots at a car manufacturing plant
Demand for industrial automation continues to accelerate. Companies like Fanuc or Keyence are, for instance well positioned to benefit from factory automation in China, where raising labor costs and increased efficiency awareness pushes production companies to automate their manufacturing processes. A good example is Apple, which in the last couple of years has significantly increased its investments in factory automation and has become one of Fanuc's biggest buyers of robots and so-called 'robomachines'. This equipment is to be installed in the plants of its leading contractor Foxconn and are, for example, used to carve out metal casings for Apple's portable electronics devices such as the iPhone or the iPad.
The companies in the field of factory automation are not the only Japanese companies benefiting from the growth in smartphones and tablets. Although big and well-known Japanese consumer electronics giants like Sony, Panasonic or Sharp missed out on this trend and nowadays struggle to stay profitable, smaller electronics companies still occupy attractive niches as leading suppliers for highly added value components for mobile devices. A recent study for instance finds that more than half of the components used in the iPhone 5 are made by Japanese manufacturers.
Murata Manufacturing: Miniaturization Giant
Murata Manufacturing, a world-leading manufacturer of ceramic-based electronic components, is one company that stands out in this field. These components, many of which are made of the ceramic materials that have been a Murata specialty since the company was established, are used in many sorts of electronic devices, such as computers, mobile phones, automotive navigation and air bag systems, and medical equipment. It holds significant market shares in multilayer ceramic chip capacitors (MLCC) and certain components used in wireless telecommunication and supplies modules from both of these categories to Apple for the production of the iPhone5. In Septembre 2012, the company announced that it had developed theworld's smallest monolithic ceramic capacitor with a size of 0.25 x 0.125 mm!
Nitto Denko: Skills on display
Nitto Denko is another key supplier for the production of portable devices. Nitto Denko is one of the world-leading producers of adhesives and coating films and has more than 20 products with top market share worldwide, including optical films for LCDs. Most of the products are related to flat-screen televisions, mobile phones and computers. The company has a competitive edge in the manufacture of transparent conductive films used in the production of touch screens. Although companies like Apple or Samsung are not publicly divulging their suppliers, it can be assumed that Nitto Denko is suppling its products to almost every tablet PC and smartphone manufacturer in the world.
All the companies mentioned above can be characterized as export-oriented companies. The biggest chunk of their turnover is related to global demand and not to domestic consumption. In the past, these companies had to adapt to a very competitive landscape with rising competition from low-cost Asian countries. Not only did they have to defend their technological edge, but they also had to enhance their efficiency and productivity in order to compensate the drawbacks of high labour costs and a very strong currency.
