MITSF - Why Buffett Is Betting On Japan And How To Follow Him

2023-04-21 10:51:30 ET

Summary

• Warren Buffett grabbed 5% stakes, worth a total of $6 billion, in Japan's five largest trading companies known as sogo shosha in 2020.
• The sogo shosha has diverse business interests ranging from energy and metals to food and textiles and has a rich history dating back to the World War II era.
• Mr. Buffett's investment in these Japanese trading houses is seen as a contrarian move as foreign investors have been pulling out of Japanese equities due to stagnant profits.
• In this article, I discuss the opportunities in Japan and the risks that come along.
• I also highlight a few funds that offer cheap exposure to trading houses owned by Buffett and the Japanese economy as a whole.

Renowned investor and CEO of Berkshire Hathaway, Inc. (BRK.A) (BRK.B), Warren Buffett, made headlines in 2020 when he invested in 5% stakes, worth a total of $6 billion, in Japan's five largest trading companies, known as sogo shosha. The trading houses have diverse business interests ranging from energy and metals to food and textiles. Mr. Buffett's move to invest in these traditionally considered "dinosaurs" of Japan's industrial era raised eyebrows and generated curiosity among investors and analysts alike. These conglomerates, including Mitsubishi Corporation ( MSBHF ), Mitsui & Co. ( MITSY ), Itochu Corp. ( ITOCF ), Marubeni Corporation ( MARUY ), and Sumitomo Corporation ( SSUMF ), have a rich history dating back to the World War II era when they played a vital role in helping Japan recover from the war's devastation by procuring resources from overseas and supporting exporters.

The sogo shosha have evolved over the years from commission-based trading businesses to investing in diverse operating assets across various industries and global markets. Despite facing challenges like the 1997 Asian financial crisis, the 2008 financial crisis, the China/U.S. trade war, and the recent COVID-19 pandemic, these companies have remained profitable and resilient, with healthy balance sheets and limited downside risk.

Exhibit 1: The performance of Japanese stocks held by Warren Buffett

Mr. Buffett's investment in these Japanese trading houses is seen as a contrarian move, as foreign investors have been pulling out of Japanese equities due to stagnant profits and poor market performance. Warren Buffett cited attractive valuations and diversified businesses as the reasons behind his decision to increase his stake in each of these firms to 7.4% from 5% recently. In a recent interview with Nikkei, Mr. Buffett expressed his satisfaction with his investments in these trading houses. He said he is considering additional investments in major Japanese trading houses, stating that he is "very proud" of these investments.

Why Is Buffett Betting On Japan?: Risks and Opportunities

Sogo shosha conglomerates have faced challenges in adapting to the changing global landscape and dealing with pressure from activist investors. Critics have pointed out their complex operations and growing exposure to international risks as they expanded globally. However, for Buffett, the diversified operations of these trading houses could be appealing. They offer high dividend yields and robust free cash flow. The trading houses have a history of offering stable or increasing dividends to shareholders, supported by strong balance sheets and cash flows. In an interview with CNBC, Warren Buffett expressed his excitement at the opportunity to invest in these conglomerates two years ago, stating, "I was confounded by the fact that we could buy into these companies. " He further mentioned that these trading houses had an attractive earnings yield of around 14% and the potential for growing dividends at the time.

Exhibit 2: Valuation metrics of sogo shosha just before Buffett's investment

These trading houses are transforming by diversifying their portfolios and reducing their exposure to cyclical sectors, which may align with Buffett's investment philosophy. For instance, Itochu, one of the major trading houses, has invested in businesses such as convenience stores, banana production, and smartphone payment systems, and reduced its dependence on commodities and energy. Mitsubishi, another major trading house, has focused on expanding its digital and environmental businesses, investing in companies such as Nexamp, a solar power generation company, and HERE Technologies, a location data provider, and partnering with Microsoft Corporation ( MSFT ) to create digital solutions for various industries.

Another characteristic of these trading houses is the exposure they provide to various parts of the Japanese economy and the global markets. Buffett mentioned in a recent CNBC interview that one of the reasons for his investment in the Japanese trading houses is that they are similar to Berkshire Hathaway as they are themselves investment companies with diverse portfolios spanning various sectors such as healthcare, minerals, and food.

I just thought these were big companies. They were companies that I generally understood what they did. Somewhat similar to Berkshire in that they owned lots of different interests. And they were selling at what I thought was a ridiculous price, particularly the price compared to the interest rates prevailing at that time.

This diversified presence in multiple sectors and geographies gives them access to different sources of income and growth opportunities, which can help them weather economic shocks and crises better than more focused companies. Buffett's investment in these trading houses may boost their confidence, competitiveness, and corporate governance, and open doors for potential business collaborations in the future as well.

Warren Buffett, in his interview with Nikkei, said:

We feel that these five companies are a cross-section of not only Japan but of the world. They are really so much similar to Berkshire. They own a lot of different things .

Buffett is "very proud" of these investments and shared his plans to meet with the companies to discuss their businesses. Buffett also mentioned the possibility of partnering with them in the future for specific deals, stating:

We don't think it's impossible that we will partner with them at some point in the future in a specific deal... We would love if any of the five would come to us ever and say, we're thinking of doing something very big, or we're about to buy something and we would like a partner, or whatever.

Buffett's interest in Japan may be driven by the undervalued nature of its stock market. Japan has been struggling with low growth, deflation, and demographic challenges for decades, which have resulted in its stock market trading at a discount compared to other developed markets. He is known for his value-oriented approach of finding bargains and buying quality businesses at a discount, and the low valuation of Japan's stock market may have presented an attractive investment opportunity for him.

Buffett also mentioned that Berkshire Hathaway plans to hold these investments for a long-term horizon of 10 to 20 years. Berkshire Hathaway has previously stated that it could increase its stakes in each of the trading houses up to an ownership stake of 9.9% subject to the approval of the firms' boards of directors.

Another possible explanation is that Buffett recognizes the potential of the sogo shosha to benefit from the changing dynamics of the global economy, especially in Asia. The trading companies have deep roots and networks in the region, where they have invested in natural resources, energy, logistics, finance, and e-commerce. As America's relations with China become more strained, the sogo shosha could play a key role in strengthening ties with other Asian partners, such as India, Vietnam, and Indonesia.

Buffett's investment has not only sent a positive signal to the market, resulting in boosted share prices for the trading houses, but it has also raised their profile and reputation among global investors. This could potentially lead other investors to take a closer look at these unique and versatile businesses. The sogo shosha may be due for a valuation reset in the market due to their potential in the evolving global economic landscape.

Buffett's bet on Japan does not come without challenges. One of the major challenges is deflationary pressures. In January, Japan's Prime Minister Fumio Kishida warned that the country could slip back into deflation if domestic demand does not pick up. Deflation, or a sustained decrease in prices, can negatively impact corporate profits and economic growth as it discourages spending and investment. The trading houses, which operate in various sectors, may also face challenges due to fluctuations in global commodity prices and demand, which can impact their earnings and dividends. As per recent data, household spending in Japan marginally increased by 1.6% in February but such growth will need to prove sustainable for these companies to meaningfully grow earnings in the next few years.

Exhibit 3: Change in consumption in Japan

Another challenge is the complex and unique corporate governance practices in Japan. Japanese companies are known for their hierarchical structure and close relationships among businesses, which can sometimes hinder transparency and accountability. Activist investors have criticized Japanese companies for their corporate governance practices and called for reforms to improve shareholder value. Buffett has been known to advocate for good corporate governance and may need to work closely with the trading houses to ensure that his investments are aligned with his long-term investment philosophy.

Furthermore, Japan's demographic challenges, including an aging population and a declining workforce, may also pose risks to the trading houses and the overall economy. The shrinking domestic market and labor shortages could impact the growth prospects of Japanese companies, including the trading houses, and their ability to compete globally. Japan has the world's oldest population, with a median age of 48.4 years, as reported by the IMF. The government of Japan has projected that by 2060, there will be nearly one elderly person for every person of working age.

Exhibit 4: Age distribution of Japan's population

Japan certainly seems like an interesting developed country to invest in but investors need to consider the many challenges faced by the Japanese economy before following Buffett's lead.

How to Invest in Japan

Warren Buffett's stake in five major Japanese trading houses and his recent trip to Tokyo are seen as a stamp of approval for investing in Japan. The guru has praised the country's economic potential and resilience in several instances in the recent past.

If you want to follow Buffett into Japan, you have several fund options that can give you exposure to the Japanese market. One of them is the iShares MSCI Japan ETF ( EWJ ), which tracks the performance of the MSCI Japan Index, a broad-based benchmark that covers about 85% of the Japanese equity market. The ETF has a low expense ratio of 0.50% and holds 243 stocks, including some of the trading houses that Buffett invested in. The ETF has returned 7.28% year-to-date as of this writing.

Another option is the Baillie Gifford Shin Nippon Trust (BGSHF), which focuses on small-cap Japanese companies that have strong growth prospects. The trust has a high active share of 95%, meaning it deviates significantly from its benchmark, the MSCI Japan Small Cap Index. The trust charges a management fee of 0.75% and holds over 70 stocks, mostly in the consumer discretionary, industrial, and Information Technology sectors. The trust has consistently outperformed its benchmark over the past one, three, and five years.

A third option is the Fidelity Japan Trust (FJVPF), which invests in a diversified portfolio of Japanese companies across all sectors and sizes. The trust has a management fee of 0.90% and holds 104 stocks, with a preference for quality companies with strong balance sheets and cash flows.

Takeaway

Japan, despite recent economic challenges, remains a formidable global economic powerhouse with a highly skilled workforce, advanced technology, and a strong tradition of innovation. The trading houses, with their rich history of international business dealings and global partnerships, could offer opportunities for growth amid expansion into emerging markets. The country is renowned for its technological advancements, particularly in areas such as robotics, automation, and renewable energy. Buffett's investment in these companies could potentially benefit from Japan's continued focus on technological innovation at a time when the world is rewarding frontrunners in making AI dreams a reality. By partnering with trading houses, which have extensive global operations and networks, Buffett can gain exposure to different markets and industries that may not be easily accessible otherwise. This could enhance Berkshire Hathaway's diversification and risk management strategies, while also opening up new business opportunities and partnerships for future growth.

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