2023-05-01 05:15:10 ET
Summary
- This thesis elaborates on the reasons Warren Buffet may have chosen Japan's top five trading houses collectively referred to as the Sôgô Shôsha, which include Itochu.
- For this purpose, some of the value investing guru's criteria are particularly useful.
- I focus on profitability, debt, and cash flow.
- In a world full of uncertainties, be it economic or geopolitical, investing in lower-valued Japanese Itochu makes sense.
- The stock is a buy, and a moderate 13.7% upside can be expected on a stock that trades around $66.5.
Warren Buffett's Berkshire Hathaway ( BRK.B ) recently disclosed that it had increased its stake to 7.4% in each of Japan's top five trading houses, namely, Itochu ( ITOCY ), Mitsui & Co. ( MITSY ), Sumitomo Corp ( SSUMY ), Mitsubishi ( MSBHF ), and Marubeni ( MARUY ), collectively referred to as the Sôgô Shôsha. That was in November last year after it acquired about 5% in each of them at the height of Covid's first wave in August 2020.
My objective with this thesis is to cover one of these, Itochu with the purpose of showing that with high inflation and tight monetary policy in the U.S., rest-of-the-world diversification in Japan where the CPI (consumer price index) is much lower makes a lot of sense. In this respect, the stock which trades around $66.5 remains significantly undervalued with respect to the sector median as shown below.
This undervaluation is one metric considered by value investors, and my approach will be to use some of the criteria used by Buffet when choosing a stock. First, I provide insights about these trading houses which are quite unique to the Japanese economy and do everything from financing activities, trading, manufacturing, and mining to name a few industries.
Reasons for Choosing Japan's Sôgô Shôsha
In the current global macroeconomic environment characterized by higher costs of doing business since the advent of the pandemic in 2020, amid heightened geopolitical tensions between the U.S. and China while a war plays out in Eastern Europe, Japan's risk-averseness culture is attractive, for a value investing guru.
Risk-averse culture means that Japanese companies focus on sustained profitability and thus are able to make continuous dividend payments. Also, they pay minimal distributions to shareholders to prepare for the worst-case scenario. To this end, ex-Japanese Prime Minister Shinzo Abe also contributed to promoting stronger corporate governance, and for investors to be treated better.
Coming to the Sôgô Shôsha, after its defeat in World War II in 1945, Japan was occupied by the Allies. In accordance with their directives, trade resumed after the war, first of all in an administered form. Subsequently, with the return to free trade in 1950, the activity of trading companies increased, giving birth to the Sôgô Shôsha. It started with textile trading for some like Itochu, and metal trading for others, to be followed by expansion into new areas through M&As.
Another contributing factor was the post-war dismantling of the big industrial-financial cartels, like Mitsubishi, into a multitude of small companies which were then reunited in a period of solid growth that lasted until the mid-1960s. These companies dealt with very diverse products and services and were also active in fields other than trade as illustrated by Itochu's eight operating segments (table below) from food to ICT as well as metals and energy and chemicals, or nearly all sectors of the Japanese economy.
Interestingly, one of these segments is called the 8th company whose role is to collaborate with the other seven to fully leverage various business platforms, particularly in the consumer sector, one of the group's key strengths.
Applying Buffet's Criteria to Itochu
Looking at the criteria Warren Buffet looks for, I start with profits, namely the operating margins. As seen in the table below, these have been increasing since 2019, but, before that, their progression was more erratic. This problem was addressed through a restructuring exercise in 2017 whereby some mining assets were disposed of and the business model was altered in favor of a better balance between investment and trading with the aim of being less dependent on the prices of resources like commodities and industrial materials traded worldwide.
To be realistic, another key factor that accounts for the higher profitability is revenues doubling for the year ending in March 2019 over 2018, thanks mainly to the expansion of Itochu's food business.
However, gross profit margins did not progress in the same way as operating margins, as the cost of revenues stayed on the high side. This can be explained by higher commodity prices and supply chain costs impacting everything from textiles, machinery components, infrastructure, and energy production.
Still, the steady progression in operating margins shows that the company managed to increase both productive and allocative efficiency to offset the effects of high inflation. Part of the improvement can also be attributed to cost competitiveness measures initiated as part of the restructuring I mentioned earlier.
Looking at the consolidated financial position, another criterion considered by Buffet is leverage. In this case, net interest-bearing debt decreased by 12.2% from FY-2021 to FY-2022 as pictured below on the back of stable operating revenues and cash generated through sales of investments. These were partially offset by distributions to shareholders and stock buybacks.
Checking the balance sheet , the decrease in debt in the quarter ending in March 2022 is the first annual reduction after the uptrend seen since 2018, and here, a ratio that is particularly useful is the ratio of shareholders' equity to total assets which increased from 29.7% in 2021 to 34.6% in 2022, signifying lower leverage.
Third, there is the RoE or return on equity which increased from 12.7% in 2021 to 21.8% in 2022 with the plan being to maintain a 13%-16% range in the 2022-2024 period. Now, with exposure to so many industry verticals, the mid-point of 14.5% seems appropriate when compared with some benchmarks and also with Berkshire itself.
Valuing through Comparison while Considering Risks
Making a comparison with Japan's three other major trading companies, at a market cap of $48 billion, Itochu stands out with a superior FCF margin as pictured below. With such cash-generating capacity, the company's trailing Price/Cash flow ratio of 7.28x appears on the low side, with respect to Sumitomo's higher value of 10.7x. On top, Sumitomo has a negative FCF margin of -1.76%, synonymous with consuming rather than generating cash from operations.
Therefore, adjusting for a Price/Cash flow of 8.28x, I have a target of $75.68 (8.28/7.28 x 66.54) for Itochu based on the current share price of $66.54. This represents a modest 13.7% upside and prices in factors like higher inflation in Japan inducing an upside in prices for goods and services in 2023. I remain cautious as the group's profitability depends on the trading of metals, minerals, energy, and food products, and these remain subject to prices of raw materials in the world market, fluctuations in the Japanese Yen as well as distribution costs.
Therefore, do expect volatility in case commodity prices as measured by the Bloomberg Commodity Index increase. The index's falling from 135 in June 2022, at its peak to 104 this month, as well as China reopening both help to explain the stock's year-to-date performance of 6.5% .
Along the same lines, Itochu's lower Debt-to-FCF ratio of 24.21x is much lower than peers. This signifies that in case the company has to use all its free cash flow to repay debts, it would be able to do so much faster than its peers, implying better financial stability in case economic conditions deteriorate rapidly.
Undervalued Company Amid Risk-Averse Culture
Thus, after considering the opportunities and risks, the stock is a buy.
In conclusion, by making use of some of Warren Buffet's criteria, this thesis has shown that an investment in Japan's Sôgô Shôsha through Itochu makes sense. In this respect, the company is not only undervalued with respect to its sector based on the Price-to-Earnings and Price-to-Sales ratios but has better cash flow metrics when compared to Japanese peers.
Now, no investment is without risks and Itochu remains vulnerable to higher commodity prices if inflation in Japan rises further, and, profitability, especially for the food business could be impacted by a depreciating yen. However, to mitigate against these, there is China's Covid reopening and favorable debt metrics. Looking at the bigger picture, there is Japan's risk-averse culture amid more challenged economic conditions and geopolitical uncertainty.
Last but not least, there is diversification into a broad range of industries, which reminds us of Berkshire itself, which is engaged in insurance, transportation, energy distribution, services, manufacturing, retailing, etc.
For further details see:
Chose Japan's Itochu, Just Like Warren Buffet Did