How Did I Come Up With My 16 JNets?

A couple days ago someone who follows my Twitter feed asked me what criteria I had used to pick the 16 JNets I talked about in a recent post. He referenced that there were “300+” Japanese companies trading below their net current asset value. A recent post by Nate Tobik over at Oddball Stocks suggests that there are presently 448 such firms, definitely within the boundaries of the “300+” comment.

To be honest, I have no idea how many there are currently, nor when I made my investments. The reason is that I am not a professional investor with access to institution-grade screening tools like Bloomberg or CapitalIQ. Because of this, my investment process in general, but specifically with regards to foreign equities like JNets, relies especially on two principles:

  • Making do with “making do”; doing the best I can with the limited resources I have within the confines of the time and personal expertise I have available
  • “Cheap enough”; making a commitment to buy something when it is deemed to be cheap enough to be worthy of consideration, not holding out until I’ve examined every potential opportunity in the entire universe or local miniverse of investing

That’s kind of the 32,000-ft view of how I arrived at my 16 JNets. But it’s a good question and it deserves a specific answer, as well, for the questioner’s sake and for my own sake in keeping myself honest, come what may. So, here’s a little bit more about how I made the decision to add these 16 companies to my portfolio.

The first pass

The 16 companies I invested in came from a spreadsheet of 49 companies I gathered data on. Those 49 companies came from two places.

The first place, representing a majority of the companies that ultimately made it to my spreadsheet of 49, was a list of 100 JNets that came from a Bloomberg screen that someone else shared with Nate Tobik. To this list Nate added five columns, to which each company was assigned a “1” for yes or a “0” for no, with category headings covering whether the company showed a net profit in each of the last ten years, whether the company showed positive EBIT in each of the last ten years, whether the company had debt, whether the company paid a dividend and whether the company had bought back shares over the last ten years. Those columns were summed and anything which received a “4” or “5” cumulative score made it onto my master spreadsheet for further investigation.

The second place I gathered ideas from were the blogs of other value investors such as Geoff Gannon and Gurpreet Narang (Neat Value). I just grabbed everything I found and threw it on my list. I figured, if it was good enough for these investors it was worth closer examination for me, too.

The second pass

Once I had my companies, I started building my spreadsheet. First, I listed each company along with its stock symbol in Japan (where securities are quoted by 4-digit numerical codes). Then, I added basic data about the shares, such as shares outstanding, share price, average volume (important for position-sizing later on), market capitalization, current dividend yield.

After this, I listed important balance sheet data: cash (calculated as cash + ST investments), receivables  inventory, other current assets, total current assets, LT debt and total liabilities and then the NCAV and net cash position for each company. Following this were three balance sheet price ratios, Market Cap/NCAV, Market Cap/Net Cash and Market Cap/Cash… the lower the ratio, the better. While Market Cap/Net Cash is a more conservative valuation than Market Cap/NCAV, Market Cap/Cash is less conservative but was useful for evaluating companies which were debt free and had profitable operations– some companies with uneven operating outlooks are best valued on a liquidation basis (NCAV, Net Cash) but a company that represents an average operating performance is more properly considered cheap against a metric like the percent of the market cap composing it’s balance sheet cash, assuming it is debt free.

I also constructed some income metric columns, but before I could do this, I created two new tabs, “Net Inc” and “EBIT”, and copied the symbols and names from the previous tab over and then recorded the annual net income and EBIT for each company for the previous ten years. This data all came from MSN Money, like the rest of the data I had collected up to that point.

Then I carried this info back to my original “Summary” tab via formulas to calculate the columns for 10yr average annual EBIT, previous year EBIT, Enterprise Value (EV), EV/EBIT (10yr annual average) and EV/EBIT (previous year), as well as the earnings yield (10yr annual average net income divided by market cap) and the previous 5 years annual average as well to try to capture whether the business had dramatically changed since the global recession.

The final step was to go through my list thusly assembled and color code each company according to the legend of green for a cash bargain, blue for a net cash bargain and orange for an NCAV bargain (strictly defined as a company trading for 66% of NCAV or less; anything 67% or higher would not get color-coded).

I was trying to create a quick, visually obvious pattern for recognizing the cheapest of the cheap, understanding that my time is valuable and I could always go dig into each non-color coded name individually looking for other bargains as necessary.

The result, and psychological bias rears it’s ugly head

Looking over my spreadsheet, about 2/3rds of the list were color-coded in this way with the remaining third left white. The white entries are not necessarily not cheap or not companies trading below their NCAV– they were just not the cheapest of the cheap according to three strict criteria I used.

After reviewing the results, my desire was to purchase all of the net cash stocks (there were only a handful), all of the NCAVs and then as many of the cash bargains as possible. You see, this was where one of the first hurdles came in– how much of my portfolio I wanted to devote to this strategy of buying JNets. I ultimately settled upon 20-25% of my portfolio, however, that wasn’t the end of it.

Currently, I have accounts at several brokerages but I use Fidelity for a majority of my trading. Fidelity has good access to Japanese equity markets and will even let you trade electronically. For electronic trades, the commission is Y3,000, whereas a broker-assisted trade is Y8,000. I wanted to try to control the size of my trading costs relative to my positions by placing a strict limit of no more than 2% of the total position value as the ceiling for commissions. Ideally, I wanted to pay closer to 1%, if possible. The other consideration was lot-sizes. The Japanese equity markets have different rules than the US in terms of lot-sizes– at each price range category there is a minimum lot size and these lots are usually in increments of 100, 1000, etc.

After doing the math I decided I’d want to have 15-20 different positions in my portfolio. Ideally, I would’ve liked to own a lot more, maybe even all of them similar to the thinking behind Nate Tobik’s recent post on Japanese equities over at Oddball Stocks. But I didn’t have the capital for that so I had to come up with some criteria, once I had decided on position-sizing and total number of positions, for choosing the lucky few.

This is where my own psychological bias started playing a role. You see, I wanted to just “buy cheap”– get all the net cash bargains, then all the NCAVs, then some of the cash bargains. But I let my earnings yield numbers (calculated for the benefit of making decisions about some of the cash bargain stocks) influence my thinking on the net cash and NCAV stocks. And then I peeked at the EBIT and net income tables and got frightened by the fact that some of these companies had a loss year or two, or had declining earnings pictures.

I started second-guessing some of the choices of the color-coded bargain system. I began doing a mish-mash of seeking “cheap” plus “perceived quality.” In other words, I may have made a mistake by letting heuristics get in the way of passion-less rules. According to some research spelled out in an outstanding whitepaper by Toby Carlisle, the author of Greenbackd.com, trying to “second guess the model” like this could be a mistake.

Cheap enough?

Ultimately, this “Jekyll and Hyde” selection process led to my current portfolio of 16 JNets. Earlier in this post I suggested that one of my principles for inclusion was that the thing be “cheap enough”. Whether I strictly followed the output of my bargain model, or tried to eyeball quality for any individual pick, every one of these companies I think meets the general test of “cheap enough” to buy for a diversified basket of similar-class companies because all are trading at substantial discounts to their “fair” value or value to a private buyer of the entire company. What’s more, while some of these companies may be facing declining earnings prospects, at least as of right now every one of these companies are currently profitable on an operational and net basis, and almost all are debt free (with the few that have debt finding themselves in a position where the debt is a de minimis value and/or covered by cash on the balance sheet). I believe that significantly limits my risk of suffering a catastrophic loss in any one of these names, but especially in the portfolio as a whole, at least on a Yen-denominated basis.

Of course, my currency risk remains and currently I have not landed on a strategy for hedging it in a cost-effective and easy-to-use way.

I suppose the only concern I have at this point is whether my portfolio is “cheap enough” to earn me outsized returns over time. I wonder about my queasiness when looking at the uneven or declining earnings prospects of some of these companies and the way I let it influence my decision-making process and second-guess what should otherwise be a reliable model for picking a basket of companies that are likely to produce above-average returns over time. I question whether I might have eliminated one useful advantage (buying stuff that is just out and out cheap) by trying to add personal genius to it in thinking I could take in the “whole picture” better than my simple screen and thereby come up with an improved handicapping for some of my companies.

Considering that I don’t know Japanese and don’t know much about these companies outside of the statistical data I collected and an inquiry into the industry they operate in (which may be somewhat meaningless anyway in the mega-conglomerated, mega-diversified world of the Japanese corporate economy), it required great hubris, at a minimum, to think I even had cognizance of a “whole picture” on which to base an attempt at informed judgment.

But then, that’s the art of the leap of faith!

16 Japanese Net-Nets I Put In My Portfolio

Listed below are the 16 Japanese companies that currently compose my “basket” (portfolio-within-the-portfolio) of Japanese net-nets, which I refer to as “JNets”. While most of my picks were classic Benjamin Graham-style companies trading for 2/3rds or less of their Net Current Asset Value (current assets minus total liabilities), some were selected on the basis of being a Net Cash Bargain (trading below the value of the company’s cash minus total liabilities) or as a Cash Bargain (profitable company with no debt trading for less than the cash on the balance sheet).

Strictly speaking, a Net Cash Bargain is a more conservative valuation than a Net Current Asset Value Bargain as there are more assets in front of the liabilities, while a Cash Bargain is a less conservative valuation (it may or may not be an NCAV Bargain) but typically you are getting a higher quality company with stronger earnings power as a result. As Graham noted, equities can be analyzed much like bonds and the true safety of a bond comes from the underlying company’s earnings power, not necessarily the asset values which are a worst-case fall back measure to protect against loss.

The figures in the list below are all in Yen, typically in millions of Yen besides the per share price. At the time of purchase, the approximate exchange value of the dollar against the Yen was 1 USD = 78 JPY. All figures and prices are the most recent available at time of purchase.

For comparative purposes, I summarize at the end of the list the metrics for the entire basket (as if it was a conglomeration of 100% of the equity of all companies included) as well as on an average basis as a representative for an individual company within the basket.

Links in the name of each company take you to their website, if available. Links in the symbol of each company take you to their Bloomberg business bio page, if available.

16 Japanese Bargain Shares (Net-Nets, Net Cash and Cash Value)

Name: Sakai Trading
Symbol: 9967
Industry/product: imports, exports, and wholesales chemical products, synthetic resins, and electronic materials
Market Cap (Ym): 2,210
Share price (Y): 235
Debt (Ym): 0
Cash (Ym): 2,851
EV/EBIT (10yr avg): 12.3x
NCAV (Ym): 4,973
 
Name: Shinko Shoji Co. Ltd
Symbol: 8141
Industry/product: sells electronic parts and equipment such as integrated circuits (IC) and semiconductor devices, liquid crystal (LC) display modules, condensers, ferrite cores, coils, power supplies, thin film transistor (TFT) thermal printers, head magnets, transformers, motors, sensors, and connectors
Market Cap (Ym): 16,905
Share price (Y): 625
Debt (Ym): 3,000
Cash (Ym): 10,610
EV/EBIT (10yr avg): 12x
NCAV (Ym): 41,899
 
Name: KSK Co Ltd
Symbol: 9687
Industry/product: develops computer software for various systems related to telecommunication and LSI (Large Scale Integration), provides data processing services for government and insurance group, sells OA (Office Automation) equipment and computer peripheral
Market Cap (Ym): 3,300
Share price (Y): 450
Debt (Ym): 0
Cash (Ym): 4,461
EV/EBIT (10yr avg): 1.6x
NCAV (Ym): 4,926
 
Name: Daichii Kensetsu
Symbol: 1799
Industry/product: constructs railways mainly for East Japan Railway, constructs infrastructure such as sewage facilities, tunnels, and waterways, builds commercial, institutional, and residential buildings
Market Cap (Ym): 15,124
Share price (Y): 685
Debt (Ym): 151
Cash (Ym): 17,230
EV/EBIT (10yr avg): 2.3x
NCAV (Ym): 19,099
 
Name: Choukeizai Sha
Symbol: 9476
Industry/product: publishes economics, finance, law, accounting, and tax related books and periodical magazines and business related books, operates a planning center which handles advertising on publishes, provides design & production services for sales promotion pamphlets
Market Cap (Ym): 1,434
Share price (Y): 326
Debt (Ym): 0
Cash (Ym): 2,501
EV/EBIT (10yr avg): -0.1x
NCAV (Ym): 2,933
 
Name: CLIP Corp
Symbol: 4705
Industry/product: operates a network of cram schools in Nagoya, operates soccer school and lunch box delivery services
Market Cap (Ym): 4,022
Share price (Y): 886
Debt (Ym): 0
Cash (Ym): 5,029
EV/EBIT (10yr avg): 0.1x
NCAV (Ym): 4,196
 
Name: Noda Screen
Symbol: 6790
Industry/product: processes electrical components such as plastic package substrates and printed circuits boards (PCBs), through a subsidiary, manufactures and sells screen stencils and fluoride chemical products
Market Cap (Ym): 2,849
Share price (Y): 27,000
Debt (Ym): 0
Cash (Ym): 3,641
EV/EBIT (10yr avg): -0.2x
NCAV (Ym): 4,146
 
Name: Kitakei Co Ltd
Symbol: 9872
Industry/product: wholesales housing materials and home furnishings based in the Kansai area, sells housing facility products such as bathroom units, wooden building materials, special wooden products, housing equipment, veneer boards, chemical products, and housing preservative agents
Market Cap (Ym): 2,963
Share price (Y): 296
Debt (Ym): 0
Cash (Ym): 5,045
EV/EBIT (10yr avg): 16.8x
NCAV (Ym): 5,133
 
Name: Ryosan Co Ltd
Symbol: 8140
Industry/product: distributes electronic components, such as integrated circuits (ICs), electronic tubes, semiconductor elements, and personal computers, manufactures heat sinks
Market Cap (Ym): 47,582
Share price (Y): 1,387
Debt (Ym): 172
Cash (Ym): 36,452
EV/EBIT (10yr avg): 7x
NCAV (Ym): 92,515
 
Name: Daiken Co
Symbol: 5900
Industry/product: manufactures and sells metal and other material parts for building construction and exterior products including curtain rails, exterior panels, garages, and bicycle parking units, provides installation of these products and real estate leasing service
Market Cap (Ym): 2,245
Share price (Y): 376
Debt (Ym): 0
Cash (Ym): 1,753
EV/EBIT (10yr avg): 5.4x
NCAV (Ym): 4,375
 
Name: Ryoyo Electro Corporation
Symbol: 8068
Industry/product: wholesales electronic components including semiconductors, sells workstations, personal computers, and printers, operates offices in Singapore and Hong Kong, trades semiconductors from Mitsubishi Electric
Market Cap (Ym): 22,205
Share price (Y): 771
Debt (Ym): 0
Cash (Ym): 28,443
EV/EBIT (10yr avg): 1.6x
NCAV (Ym): 54,847
 
Name: Nihon Dengi
Symbol: 1723
Industry/product: designs, constructs, and maintains integrated building management systems for air-conditioning, security, and electrical facilities, develops integrated production systems for industrial factories
Market Cap (Ym): 4,805
Share price (Y): 586
Debt (Ym): 0
Cash (Ym): 6,313
EV/EBIT (10yr avg): 4.3x
NCAV (Ym): 8,613
 
Name: Odawara Engineering
Symbol: 6149
Industry/product: manufactures automatic coil winding machines including micro motor, coreless motor, universal motor, and stepping motor type, provides reconstruction, repair, and parts replacement services for its winding machines
Market Cap (Ym): 4,154
Share price (Y): 650
Debt (Ym): 0
Cash (Ym): 5,411
EV/EBIT (10yr avg): 2x
NCAV (Ym): 6,423
 
Name: Natoco Co Ltd
Symbol: 4627
Industry/product: manufactures and sells various types of paints including paints for metals, building materials, and auto repair, manufactures high polymer compounds which are used as material for liquid crystal displays
Market Cap (Ym): 4,414
Share price (Y): 603
Debt (Ym): 0
Cash (Ym): 5,403
EV/EBIT (10yr avg): 5x
NCAV (Ym): 6,967
 
Name: Fuji Oozx
Symbol: 7299
Industry/product: manufactures automobile engine parts such as valves, valve adjusters and rotators, has subsidiaries in Korea, Taiwan, and the United States
Market Cap (Ym): 6,189
Share price (Y): 301
Debt (Ym): 0
Cash (Ym): 6,884
EV/EBIT (10yr avg): 1.6x
NCAV (Ym): 11,623
 
Name: Excel Co Ltd
Symbol: 7591
Industry/product: sells electronic products, such as liquid crystal devices (LCD), semiconductors, and integrated circuits (IC), including thin film transistor (TFT) modules, TFT-LCDs, cellular phones, car navigation systems
Market Cap (Ym): 6,208
Share price (Y): 683
Debt (Ym): 0
Cash (Ym): 6,679
EV/EBIT (10yr avg): 4.7x
NCAV (Ym): 18,574
 
Total Basket
Market Cap (Ym): 129,974
EV (Ym): -15,499
10yr avg EBIT (Ym): 27,046
Debt (Ym): 3,323
Cash (Ym): 148,796
NCAV (Ym): 291,244
EV/EBIT (10yr avg): -0.57x
P/NCAV: 0.45x
P/Net cash: 0.89x
P/Cash: 0.87x
EBIT yield (EBIT/Mkt Cap): 21%
 
Representative Company (Avg)
Market Cap (Ym): 8,123
EV (Ym): -969
10yr avg EBIT (Ym): 1,690
Debt (Ym): 208
Cash (Ym): 9,300
NCAV (Ym): 18,203

Video – Hugh Hendry Interviewed By Steven Drobny At LSE

Hugh Hendry interviewed by Steven Drobny at the London School of Economics, 2010

Major take-aways from the interview:

  • How he got his start: began at an eclectic asset management firm in Edinburgh, which rotated its young associates; began at age 21 in the Japanese stock market the year after it peaked in 1990; the next year rotated to UK large companies; the next year US equities; moved to London in 1998/9 and no one would employ him because he was a jack-of-all-trades, master of none
  • 1929/1930 marked a “revulsion with debt” period, which changed very slowly, ultimately eradicated from society in 1973/74; then the opposite cycle occurred, with society massively leveraging; during this upswing, it has paid to be optimistic and the financial economy has become the economy; we appear to be on the verge of a generational shift again, where farmers will reign over hedge fund managers
  • Macro opportunities are created by the interactions of economics and the abilities of politicians to try to fudge them
  • “The best trade is the one where you don’t fear the consequences of being wrong”
  • China
    • China’s economic development strategy is not unique, it’s just large-scale; economy is being directed toward sovereign-profit, not corporate-profit
    • Pursuing sovereign power over economic power results in building your economy on foundations of sand; Japan tried the same thing and it appeared to work until it was revealed to have not worked; Confucius saying, “Wise-man not invest in over-capacity”
    • China is like the sun, you can’t get too close or you’ll melt (can’t short equities in China, HK, or commodity futures or equity derivatives in the West); used the “satellite”, bought CDS on a basket of Japanese industries, as Japan is very reliant on trade with China– steel, for example
  • If we’re going to have hyperinflation and the dollar loses its value, you need something profoundly negative to shake the course of economic growth globally, because only if that happens will the central bankers respond with this dramatic decision of hyperinflation
  • Slowdown in China, economic restructuring in Europe would be the economic equivalent of a meteor hitting Earth
  • Market call: the Yen and the USD could appreciate greatly, because there is so much borrowing in those currencies, if asset values take a hit, you have a shortage of dollars or Yen to pay against the collateral values of that lending; combined with calls on the Nikkei at 40,000, 50,000 (want to be very long equities at that point)
  • Good hedge fund managers give great weight to the consequence of their actions and are fearful of them, so they won’t be hurt too much if they’re wrong
  • Being plasticine: we spend so much time trying to see the future, we’re deluding ourselves because we have no chance to see the future; better to be careful and flexible, avoid dramatic injury and maintain optionality to respond to whatever the future holds
  • Be a centipede, not a mountain climber; have a hundred legs so you can let one or two go if you have to do so
  • Strategically, it’s not rational to try to outsmart bright people; bright people are encouraged to be logical in their constructions; my business franchise is trying to get opportunities from the arcane world of paradox, disciplined curiosity, the toolset of the maverick