Asia Insight

June 2008

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What You Wished For

Virgil Adams
Senior Research Analyst
Matthews International Capital Management, LLC

To many investors, Japan is an enigma. The Japanese market has been stuck in a rut for nearly two decades, and it seems that every time we find encouragement in a single step forward, the country ends up taking two steps back. I was in Japan for most of these two "lost decades" and can empathize with investor frustrations over the behavior of both Japan's market and companies. However, I also believe there are some very positive changes that are occurring which may generate opportunities for investors in Japan over the coming years.

The headlines of nearly every investment periodical reference the problems of the U.S. housing market, challenges created by skyrocketing oil and commodity prices, and the threat of inflation. Another dominating story is the risk of a worldwide recession, given how "coupled" markets abroad relate to the American economy.

In Japan, not only do these problems exist, but there are the added difficulties of lame-duck political leadership, forecasts of declining profits for the new fiscal year, and fears of protectionism preventing needed M&A. Beyond the headlines, however, we are seeing the emergence of some important trends in Japan—trends that rarely make headlines because they represent structural (and thus, gradual) changes, rather than events that make for daily news. Perhaps the most significant, and yet also the most misunderstood of these trends is the return of inflation.

"Inflation" is a word that strikes fear in countries like the U.S., but in Japan— which has been suffering from the opposite condition for the last 20 years—it is a welcome change. The sales and profit growth of Japanese companies as a whole over the last 10 years shows that—in aggregate—Japanese companies have been able to grow profits consistently (and considerably) in a zero-growth sales environment. "Sales" for any company are simply a function of "volume" and "prices"; While Japan has seen healthy growth in sales volumes during its long recession, the average selling price of goods and services fell enough each year to keep overall sales flat-lined. In an inflationary environment, that is likely to change, and the result on corporate profits could be significant.

It was only a couple of years ago that Japan-watchers considered the deflation that was plaguing the country to be the largest hurdle to sustainable economic recovery. They wished for some inflation and their wish is now being granted. But many are now too preoccupied with the potential damage inflation can inflict on a country like the U.S. (with a negative net savings rate) to appreciate the positives it can have on a very different country like Japan. In this case, the old saying, "Be careful what you wish for, because you just might get it" is not applicable; the inflation Japan has been wishing for is finally starting to materialize, and its impact, we believe, will lead to strong corporate profit growth, increased bank lending, and more consumer spending.

Japan is still very much a manufacturing economy, with high fixed-cost bases and dependence on imported raw materials. If a semiconductor manufacturer increases sales volume, the increase would amortize the fixed-cost base and, in general, lead to higher profits. But much of that positive "volume impact" has been wiped out by erosion in selling prices (deflation). If manufacturers could increase the selling price of their products, all of the increase would flow to the bottom line—there is no new cost associated with simply charging more for the same product.

Japan hasn't been able to do that in the past, but we are seeing signs that pricing power is beginning to return, at least to certain companies and segments of the economy. Japanese companies have spent the last 15 to 20 years cutting costs and reducing debt; at this point, the survivors of the post-bubble period are, for the most part, lean companies that have no more fat to cut. When input prices such as copper, oil, steel and electricity rise, companies either have to pass this increase on to end users or absorb it themselves. Of course, simply passing on material cost increases does not raise profits, but it is beginning to change the mindset of corporate entities and consumers. People are beginning to expect persistent increases in the general price level—the very definition of "inflation"—and this expectation will lead to changes in behavior that will benefit the broader economy.

This expectation of inflation can be a powerful force. As the expectation spreads and real inflation returns to the Japanese market (we are seeing it now, not only in the price of energy and food, but increasingly in labor costs and a range of other goods) overall savings should increasingly be converted to consumption, interest rates will rise, loan growth will accelerate, and the value of long-term assets will increase.

Inflation will also help propagate Darwinism in a country in which nearly every industry is fragmented and populated with small, inefficient enterprises. In fact, the dichotomy alluded to above—one group of companies that can pass on higher costs and another group that cannot—is becoming increasingly pronounced. Companies that can't pass on the higher costs will be forced to merge with other companies in order to "get scale".

Slimming, Trimming and Consolidating

In nearly every Japanese industry, there are too many companies: Japan's three largest pharmaceutical companies combined are less than half the size of Johnson & Johnson. The largest retailer in Japan, the world's second-largest economy, is about one-tenth— yes, one-tenth—the size of the largest retailer in the U.S. Japan's largest chemical company doesn't even break into the top ten worldwide. How many fiber optic cable manufacturers can you name? In Japan, there are four. Think of that: there are more fiber optic companies in Japan than there are in the rest of the world. The fragmentation that exists in Japanese industries hasn't changed. What has changed recently is the need for scale amongst these small but increasingly globally focused players.

Japanese companies need M&A and consolidation to have the scale necessary to negotiate pricing contracts with both suppliers and end-users. There have been barriers to M&A that have existed in the past, such as cross-shareholding or the reactionary move to create poison pills. These have shielded Japanese industry from consolidation in the past, but the increase in input costs for lean organizations that don't have the ability (or scale) to pass on those costs is an undeniable force that will tear these barriers down.

But how can there be consolidation when companies such as Jpower seem to be violating the core principles of publicly traded companies? Many Japanese companies have been reactionary about being acquired by investment companies, which means being presented with nothing more than a demand for higher dividend payments and the potential of being chopped up and sold off piecemeal. However, they are not as averse to being acquired by strategic investors that can help grow their business. We expect to see more M&A between foreign and domestic strategic partners and their Japanese targets, and these marriages will likely result in larger, stronger (and we believe more profitable) enterprises. Of course, financial investors can still play a role in changing the landscape of the market, as Steel Partners' recent victory over Aderans shows.

Of course, there are many challenges remaining for Japan. But with each door closing, another seems to open. Asia is shifting from being merely a place for low-cost production to a market in and of itself, and the growth in business and consumer spending in the region could more than outweigh declines in exports to the U.S. Japan should also quickly transform from being a mass producer of commodity products (where deflation is felt most) such as laptops and mobile phones to being the world's source for new technologies such as earthquake-resistant construction materials, low-emissions diesel particle filters and ultra-energy efficient appliances. This shift to unique, value-added and highdemand products is in itself a powerful shield against deflationary pressures that might persist.

Finally, Japan is regaining some of its "attractiveness" relative to other large equity markets. Japan has been through the fire of a housing bubble. It has gone from being over-levered to underlevered, and it has spent the last 20 years becoming adept at cutting costs and not relying on growth to solve its problems. Japan, in other words, has been through the fire that the U.S. is in currently. Not having a financial industry that is tied together with CDOs (collateralized debt obligations) and other derivative instruments that cannot be valued or untangled is an added benefit.

As any Japan watcher knows, the tide changes slowly in the land of the rising sun, but when a critical mass is reached, the spillover is rapid and dramatic. Positive change is building in Japan, and sometimes—as with inflation—it comes in forms that might not at first be recognized as beneficial. When the "tipping point" comes is anyone's guess, but the upside will be surprising, and we are encouraged by the signs of change.

May 31, 2008

As of 5/31/08, Matthews Asian Funds did not hold any positions in Johnson & Johnson, J-Power, Steel Partners and Aderans.

The view and information discussed in this article are as of the date of publication, are subject to change and may not reflect the writer's current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investments vehicles.