Hedge funds pile up profits from M&A boom missed by most investors due to “can't make money in Japan” bias
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In May 2011 I was scheduled to come to Japan for our 2011 Roundtable which we had to postpone because of the tsunami and the Fukushima catastrophe. For the Opalesque 2012 Japan Roundtable, I stayed six days in Tokyo and found that the country has very nicely bounced back. Corporate Japan responded very well to the post-Tsunami challenge of re-opening factories. Many overseas investors still underestimate how well the Japanese people and corporations have responded to the situation, and for a number of reasons fail to realize the investment opportunities Japan now provides.
When it comes to investing into Japan, many global investors believe that “nobody can make money in Japan." But the reality is that this attitude makes it easier for the remaining players to make money in this market. While long-only investors in Japan, including domestic pension funds, are withdrawing from the markets, the hedge fund space continues to make money. As everywhere else, the hedge fund space has also contracted in Japan, however the opportunity set has grown at the same time.
“Japan is a hedge fund investor’s paradise if you are seeking lowered correlations and therefore lower portfolio volatility," says Ed Rogers, whose Japan hedge fund of funds returned close to 10% over the last five-and-a-half years, including a positive return in 2008, and has beaten TOPIX by over 60% over that period with less than one quarter of the volatility of the index. David Baran's fund was launched in September 2003 when Nikkei was about 9,500. The index has fallen since then, yet his fund is still up 56% after fees. Trond Hermansen's fund launched in April 2006 when the market was almost double where it is at the moment, but even during the challenging years since then has managed a net of fees compound annual return of more than 9%. Still, the industry struggles with the negative investor perceptions and macro issues of Japan. “If you could remove the word Japan from marketing materials and just show the performance numbers, many Japanese hedge funds would have over $1 billion in assets," says Rogers.
If you look closely, Japanese managers were amongst the best performing globally over the last couple of years. Apart from operating in the “largest and most diversified opportunity set with the least amount of coverage in the world," another reason could be that many U.S. or European managers are not used to adapting to declining or flat markets. Some investors think that Japanese managers have the better skills to navigate and produce returns in such markets.
How do they do it? How can you make money in Japan?
Japan is cheap and at the same time a value-trap. The paradigm for most investors is to presuppose a assume a free market and that share prices will gravitate towards fair value. But Japan is different. Does Graham-Dodd and the typical value investing work here? If there is no market for corporate control and free float is so low that you cannot buy enough of it in the market, isn't the market itself then dysfunctional? Where are the returns coming from? Is there a way out for the markets?
The secret to achieving returns in Japan is that you'll have to do more than just long-only investing. The unloved, under-covered nature of the Japanese market creates opportunities that ordinary fund managers are not capable of pursuing because it’s too hard to extract the value. Many Japanese firms, particularly the smaller ones, can boast about 40+% operating profits and 30+% EBITDA margins. They can have net cash positions and trade at 50+% net cash to market cap. Hundreds actually trade at over 100% net cash to market – which means the market is valuing these viable businesses at zero. “Investors in the U.S. equity markets would be falling over themselves to invest in a company like these - net cash, strong business moat and growth prospects," says Baran. But being “cheap” isn't enough – you need catalysts to unlock the value.
M&A activity flourishing in Japan
Corporate activity is such a catalyst. Many of the large Japanese conglomerates started to buy back listed subsidiaries. Management buyouts are gaining popularity due to: 1) low valuations; 2) increasing costs of maintaining listing; 3) stricter listed company disclosure rules; 4) cheap bank financing; 5) improved legal framework; 6) increasing shareholder pressure; 7) greater willingness by senior managers to conduct MBOs; and 8) Premiums are high (over 50%) because share prices are depressed. Research from Daiwa looking at all parent subsidiary takeovers since the year 2000 showed that they happen at a premium of between 30% and 60%.
The Opalesque 2012 Japan Roundtable was sponsored by law firm Bingham McCutchen and Eurex and took place in May 2012 at Bingham's Tokyo office with:
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