Anyone doubting the resilience of the human spirit had their faith magnificently restored in the weeks after 11 March, 2011. Faced with the unimaginable destruction and loss of life unleashed by the Tohoku earthquake and tsunami, the people of Japan mourned their dead with dignity, calmly rolled up their sleeves, and set about making things good.
For Japanese equity portfolio managers, this response went beyond the inspirational - it was also informative, indicating how the shock waves might reverberate through Japan’s economy and corporate sector, beyond the immediate crash in production.
It is a grim fact construction-related stocks soar when an earthquake hits. One might have expected the same in Japan, especially as they were starting from a low base: for years the combination of modern infrastructure, low growth and high public debt had curbed investment in grand projects. Now, necessity had forced the government to set aside more than ¥20trn ($244bn) for reconstruction - almost 4% of GDP. Surely that represents a huge new source of domestic demand for a company like Hitachi, which has built a strong position in emerging Asia and the Middle East with its ‘smart city’ infrastructure business that includes expertise in railways and power stations?
“Infrastructure is a very important part of the budget, especially waste treatment, debris clearance, repairs to roads, railways and airports,” confirms Keizo Iguchi at Dalton Strategic Partners, whose Melchior Japan Advantage fund has Hitachi as a top holding. “But while we see support for the budget that has been approved, that money will only last through to 2013, and we don’t expect any increases. At that point, the immediate positive impact will be over. We need to be careful about that.”
While roads and railways were repaired with astonishing speed, the fragility of reconstruction as an investment theme is not all about the small window of opportunity. House-building is proceeding much more slowly, for example, but one reason is the fragmentation of the industry; most residential property is timber-framed and built by local, four-man carpentry enterprises. As such, the opportunity for building materials firms is limited and the ability to invest in listed house-builders virtually non-existent. Misawa Homes, for example, has performed well but, as a small-cap, its potential holders are restricted. Even if there were large-cap opportunities, few would want to invest: there is so much work to do that labour costs have already started to climb.
“I think sales for construction companies will be boosted this year,” says Kentaro Sasaki, head of equity research in Tokyo for JP Morgan Asset Management. “But demand is simply going to be too strong, creating a strain on resources and rising costs - top-lines will grow rapidly, but I don’t think profits will follow.”
That’s not to say reconstruction is not creating tremendous growth in other, less obvious places. Those rising wages will be spent - as will insurance and compensation payouts - which is why both Sasaki and Iguchi have been moving assets into the retail sector. That sector is surprisingly strong in Japan precisely because the survivors have had to struggle against two decades of deflation and falling wages, says Nathan Gibbs, Japanese equities portfolio manager at Schroders.
“It’s a difficult thing to say, but we really have gone through the period of pain and are now moving into the period of great benefit,” he says. “If you give these strong survivors in retailing just a tiny bit of top-line growth, if prices go up just a little for once, their operational gearing will give them very, very high bottom-line growth.”
Gibbs recalls how a long-term holding of his, Don Quijote, which operates more than 160 suburban convenience stores, was so well-positioned in the immediate aftermath of the disaster, providing essentials, from toilet paper to torches, that proved difficult to get hold of in city centres.
Sasaki agrees, and sees evidence of a longer-term effect. “Retail is definitely booming in the earthquake region, and there is a shift from the mom-and-pop-style shops to the bigger chain stores like 7-Eleven,” he says. “These retailers are accelerating their new store openings, and because they played an important role in securing supplies in the earthquake region, they now find that new stores are much more welcome than they would have been before.”
The disaster has given Japan one thing it has desperately needed for years - inflation. And construction demand is not the only source of inflation, of course: the Fukushima meltdown that ripped through Japan’s power supply, and has sent corporate energy costs up almost 20%, has finally turned Japan’s CPI positive.
Japan relied on 55 nuclear power plants for 30% of its energy, and as each one went into its regular maintenance shut-down since Fukushima, local authorities have proven reluctant to let them be switched back on. Without government intervention, there may be none running by May 2012.
“Usually politics just doesn’t matter to the equity markets in Japan - but the lack of leadership really has mattered in the case of energy policy,” says Gibbs. “National government needs to get out there and say: ‘This is not only about your local community, this is about the national economy.’ And they are just not doing it.”
It is not clear what, if anything, this means for corporate Japan. Portfolio managers agree that oil and gas, in general, and operators of gas-fired power stations, in particular, look more attractive now - Mitsubishi Heavy Industries and INPEX Corporation are among the names suggested. But while Iguchi at Dalton Strategic feels the new energy regime will favour his fund’s long-term thematic exposure to alternatives - including solar power but also hybrid automobiles - Sasaki at JPMorgan remains sceptical.
“Chinese suppliers of solar technology are very competitive; Japan doesn’t have very good sites for wind power; and while a company like Fuji Electric is strong in geothermal, and Japan has great potential, most of the sources of energy are located in the National Parks and development would require changes in legislation,” he says. “Overall, I don’t have big expectations of these industries.”
Sasaki is among those who play down the energy issue. He expects nuclear to remain a significant part of the new energy strategy to be announced later this year, and feels that short-term supply problems will merely focus minds on improving energy efficiency to an even greater extent than they have already.
“The supply-and-demand situation today suggests that there are few issues,” says Masato Kojima, lead manager for the Japanese equity fundamental growth satellite strategy at Sumitomo Mitsui Trust Group, the entity that will be formed by the merger of Sumitomo Trust Bank and Chuo Mitsui in April 2012. “We don’t expect serious problems in summer, due to the increased capacity with thermal power generation, and energy savings and in-house power generations on the user side. Companies in the capital goods and technology sectors specialising in greater energy efficiency should do well.”
Even Gibbs, who worries about “a significant hit to industrial production” if Japan enters its stifling summer without nuclear power, feels the medium-term impact will be limited. This is partly because of energy-efficiency drives, but also because it is smaller companies that are most at-risk - they did not have the staffing levels or the regionally-diverse sites to allow flexible shift working in March and Q2 of 2011, as larger companies did. Where there are potential problems, they are very idiosyncratic, Gibbs suggests, picking out Oriental L and, owner of Tokyo Disneyland.
“Everyone in Japan knows that it eats up as much power as 60,000 households and keeping the lights on there while everyone else has to endure it would be a public relations disaster,” he says.
As it happens, after a severe sell-off immediately after the quake, that stock has performed solidly for a year - perhaps symptomatic of the domestic wage-inflation story that seems to be taking hold.
Some investors are beginning to feel that that domestic story has been overplayed. Iguchi says that his immediate rotation out of export-oriented cyclicals is now giving way to a return to a slight overweight, reflecting a long-term emerging Asia theme through stocks like Nidec, Komatsu and Fanuc Robotics. Kojima agrees the market has started to discount positive news in domestic demand-oriented stocks.
“That means we now find the cheaper stocks to be in the exporting sectors, which have been severely hit by earthquake and Thai floods in 2011, and we see many opportunities among those companies recovering robustly,” he says. “In the medium-term, the domestic demand would be supported by reconstruction demand, but in the long run the production base going abroad, as a result of currency strength and power supply issues, could lead to lower domestic demand.”
As Kojima indicates, the underperformance from these sectors is related to the earthquake’s enormous disruption to supply chains. “Even without power issues, many companies were unable to re-start production in the summer of 2011 because of problems with supply,” notes Sasaki.
It would be tempting to assume that Japanese companies, famous for their just-in-time inventory management, are particularly vulnerable - and, indeed, there has been something of a re-think. Kojima says companies excessively reduced inventories over recent years and thinks that has “reversed”, replaced by a new emphasis on diversifying suppliers.
Sasaki notes companies like Renesas in the semi-conducter industry were especially badly hit. Although able to move production to alternative sites, their customers in the auto industry were so obsessed by strict quality standards that they found it difficult to accept anything not made by one supplier in one facility. “The two industries are now aware of the importance of alternative production sites and are co-operating on dual sites,” Sasaki observes.
Gibbs concurs: “Instead of sending 100% of your business to whom you consider to be the absolute best producer of the widget you need to put into your auto, you may split your suppliers regionally, even if it costs you a couple of basis points on margin.”
That all sounds like a perfect storm: companies that were especially vulnerable to supply-chain disruption are now acting to protect themselves against very-low-probability events, and compromising quality, efficiency or both as a result.
But again, it is too easy to single-out Japan here: “Corporations everywhere pushed the concentration of suppliers a little too hard,” says Gibbs. And it is also easy to blow the issue out of proportion and miss the strides corporate Japan has already made to diversify its suppliers, particularly in its pursuit of profits in emerging Asia.
“Japanese companies already have to be international in their production sites because of foreign exchange risk, and the earthquake is accelerating that trend,” says Sasaki. “They are already sourcing components locally.”
As Sasaki suggests, these moves had little to do with natural disasters and everything to do with a financial one, compounded by policy - the ever-strengthening Japanese yen. It long ago forced Japan’s exporters offshore - and shielded them from the worst of the power and supply-chain disruptions of 2011. When IPE asked its interviewees to rank four potential headwinds against corporate Japan in order of seriousness - yen strength, disruption due to the Tohoku disaster, Japan’s public debt, and a global economic slowdown - every one of them put the currency or a global slowdown at the top.
For corporate Japan, that’s as good as a sign saying: ‘Business as usual’. Higher wages and inflation is good news, as is a new political consensus on reducing debt, raising consumption taxes, and supporting trade initiatives like the Trans-Pacific Partnership - but these really pre-date and, for a while, looked like they might be derailed by the Tohoku disaster. The earthquake will not be the catalyst that finally unlocks the value in Japan. But what investor could be disappointed, when that fact stands as a testament to the scale of the triumph of its people and its companies in the face of catastrophe?