This post is about net net investing in Japanese stocks
Before setting out to buy Japanese net net stocks, you should consider not buying any Japanese net net stocks.
Let’s look at the premise used in buying net next stocks in general, and then compare how that matches against the reality of the Japanese market.
The whole net net strategy is extremely attractive theoretically.
You are buying a business below liquidation value. What could possibly go wrong?
How about this: The company you bought at around liquidation value has steadily falling revenues and earnings, and eventually it has to come out with many negative earnings surprises. This causes the market to completely distrust the management, and discount future declines in earnings. The stock price goes well below liquidation value (which itself has fallen).
Although there are hundreds of stocks like this in Japan, I can only think of a few off the top of my head, largely because I do not think about dog stocks much: Veriserve, 中央経済社 (9476), 日本アンテナ (6930) , and近畿車輛 (7122).
Clearly, you can get burnt with Japanese net nets – third degree burns in some cases.
Secondly, when you buy a net net the idea is that the market is inefficient at present, but in the future it will become more efficient, recognizing the real value of your stock. But what if it becomes less efficient? What if there is less liquidity for your stock, and at the same time the company is not as attractive as you expected? This sounds like theoretical nitpicking, but actually it is the opposite – this is the actual experience of many investors in the Japanese market. (NB: In actual fact, I think that the actions of central banks outside Japan will force the BoJ to increase liquidity within Japan, causing a rerun of what happened in the January/February of this year, but on a larger scale – yes folks, that means trash will be popular one day again.)
So, what is to be done?
You can buy Japanese net nets relatively safely, as long as you know what you’re doing.
Firstly, if you can read Japanese, that is an advantage. Most Japanese small caps do not put out information in English.
Secondly, try to get net nets with relatively stable cash flow and in areas of business which are inherently stable. Remember when you read Security Analysis? (I hope there are no red faces amongst readers– shame on you for practicing Graham Dodd without reading Security Analysis! If you are a beginner, just read The Intelligent Investor.) In the discussion of bonds, you will recall that Graham gives the example of a car manufacturer with better apparent safety in the financials than a grocery store. It then later turns out that after a few years the bonds of the car manufacturer fell significantly, while the grocery store was in good credit with the market.
Security analysis
Thirdly, if possible, try to not focus blindly on just net nets, but buy companies which are both good and cheap. Examples of this which have worked for me recently have been: Yakult Honsya, Doshisya, Sotsu, and Technomedica – all of which were good companies in the first place, and secondarily were very cheap.
Graham warns us in Security Analysis (in the section on bonds, again) that collateral is not the best premise on which to buy securities. He gives the example that if you buy a railroad bond which has a senior claim over some land, the land might not be sufficient security in the case of bankruptcy, because the very value of the land is determined by the operations of the railroad. (Also, the bankruptcy itself will likely not redeem senior bonds at par, and will not pay out for ages.) So, collateral should be secondary to having an eye to sidestepping potential bankruptcy or financial deterioration in the first place.
Therefore, I believe that excitement over low valuations in Japan should be tempered with consideration of whether the relevant shares are any good.
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