Financial strength should now be recognised as the plus it always was

The importance we attribute to the strength of a company’s balance sheet has over the last year or so led us to Japan where we have been able to pick up potential winners at the price of actual losers

08/06/2020
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Authors

Simon Adler
Fund Manager, Equity Value

Depending on your cultural reference point of choice, you might recognise ‘Everything changes’ as a quote from the Roman poet Ovid’s Metamorphoses or the title of a number-one single and album by Take That. Either way, the phrase is also a neat summary of one of the foundation stones of value investing – times, fashions, people, tastes ... everything changes.

What that means is, if you have a process that enables you to identify good yet unloved businesses – as well as the mental fortitude to buy and hang onto them when others are selling – you should profit as the pendulum swings once more in your favour. As the American Economic Association highlighted in a 2014 paper, From Sick Man of Europe to Economic Superstar, this happened in the early part of the last decade with Germany.

Looking ahead, here on The Value Perspective, we now believe something similar will occur with Japan. Yes, we know some people may find that hard to swallow – after all, over the last decade and more, Japanese companies have been the target of huge amounts of ridicule on account of their balance sheets. To be clear, this was not because they were weak but because they were seen as ‘unnecessarily’ strong.

An odd concern

For much of the last decade, when markets were often inclined to reward businesses that took on cheap debt, that was at least an argument – albeit one we never found persuasive, as we have explained in articles such as Tackling concerns about rising debt levels by way of a rugby analogy. With markets and businesses now hit by the Covid-19 pandemic, however, concerns about overly strong balance sheets look especially odd.

Now that times have changed again, investors really need to be reconsidering their stance on the importance of companies’ financial strength. Certainly one can imagine the many highly leveraged business in the US and Europe looking enviously at their Japanese counterparts, whose cash reserves – as this Financial Times article puts it – “are now a great source of advantage”.

In the interests of balance, it is worth noting the author of that piece, Jesper Koll, has been researching and investing in Japan for more than 30 years – but presumably that also means he knows what he is talking about when he observes: “Japan’s listed companies went into this crisis with the biggest cash reserves ever recorded.”

‘War chest’

“Collectively, they had slightly more than $6.5 trillion [£5 trillion] of cash and short-term securities on their balance sheets at the end of December, according to data I tallied from the Tokyo Stock Exchange,” Koll continues. “This war chest amounts to more than 130% of the country’s gross domestic product: more than three times the equivalent ratio in the US.”

Despite the adverse environment they now face, then, Japanese businesses will still be in a position to invest in both capital expenditure and research and development. They will still be able to remunerate staff and pay dividends for far longer than companies anywhere else in the world. And, as Koll argues in his article, this state of affairs may well also lead to a surge in merger and acquisition activity, both in Japan and abroad.

As we wrote recently in Why balance sheet strength should interest investors more than ever, this aspect of a business has always been a major focus for us, here on The Value Perspective. Over the last year or so, that has led to us increasing the exposure of our global portfolios to Japanese companies – with the remarkably high calibre of their balance sheets being matched only by the remarkably low nature of their valuations.

In effect, then, we have been buying what our own analysis tells us are winners at the price of losers – and then waiting for everything to change.

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Authors

Simon Adler
Fund Manager, Equity Value

Topics

Behavioural finance
Value
The Value Perspective
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