New Yorker - United States
October 31, 2008
There’s a Reason It’s Cheap
The Nikkei Index has rallied sharply this week (although it was down today). But it’s still near its twenty-five-year low, and, in nominal terms, its value is less than a fourth of what it was in 1989, at the peak of Japan’s stock-market bubble. In the last couple of weeks, both Felix Salmon and Matt Yglesias have suggested that Japan’s experience should make us reconsider the assumption that stocks are a good investment because they go up in value over the long run. More specifically, Felix argues that Japan’s experience should make U.S.investors wary of buying stocks now (well, he was writing on October 17th, when the S. & P. 500 was ten per cent cheaper, but presumably he’d say his argument is even more applicable now, after stocks have jumped a bit) because “the lesson of Japan is that even cheap stocks can continue to decline for decades.”
Actually, that’s not the lesson of Japan. The lesson of Japan is that a country’s stock market is not going to rise over time if, over time, its companies fail to create economic value for their shareholders. Felix says that “Japanese companies are well-run.” But, in fact, they’re not well run, at least by the standards that are relevant to shareholders—return on equity, profitability, growth, and managing cash flow in a shareholder-friendly way. By these standards, Japanese companies have historically been run badly, and while they’ve improved some in recent years, they’re still far behind American firms on all of these metrics.
In the 1990s, the average return on equity for the Nikkei was around four per cent, and in the second half of that decade and into the early years of this one it fell below two per cent. (In the U.S., the average R.O.E. is closer to eleven to twelve per cent.) According to this report, between 1998 and 2003, of all large-cap Japanese companies, only eight had an R.O.E. above ten per cent, which is a completely ordinary performance by U.S. standards. And even now, Japan’s average R.O.E. is by far the lowest of any major economy.
What this means is that for much of the past two decades, Japanese companies have been destroying economic value for shareholders, using far more capital than they’re generating. Japanese firms’ profit growth is also well below what American companies would consider acceptable. And on softer metrics, too, Japanese companies don’t look like good investments: they’re still concentrated in capital-intensive industries, and are surprisingly weak in industries where immense profits can be reaped after small investments, like, most notably, software. Obviously, there are important exceptions—companies like Nintendo, Toyota, and Honda (although even the latter two require tremendous amounts of capital to keep growing). But they really do prove the rule.
None of this is too surprising—historically, Japanese companies have been disdainful of the idea of shareholder value and of traditional profit metrics. In 1998, the chairman of Mitsubishi Heavy Industries famously said, “I openly brag that I don’t cater to shareholders,” and, even more amazingly, “We don’t give a hoot about things like return on equity.” In part, this is because companies’ heavy reliance on debt financing and interlocking relationships meant that they felt they didn’t need shareholders. It’s also because many companies saw themselves as fulfilling a social role. In any case, the consequence was that Japanese companies tended to spend money in ways that were beneficial for managers and employees, not shareholders. (Dividend yields in Japan have finally started to climb some, but as of 2006, they were just 0.85 per cent, because the idea of returning cash to shareholders was not something Japanese executives thought was important.) You can, if you’d like, argue that having companies reject the idea of shareholder value is not a bad thing from the perspective of society. But it’s undeniably a bad thing from the perspective of investors. And this isn’t even to mention the effects of the massive debt overhang from their real-estate bubble, the effect of deflation (which is a bad environment in which to own stocks), and so on.
What the experience of Japan teaches us, in other words, is that when companies are not profitable (in an economic sense), their stocks will not go up. It also teaches us that bubbles exist, and they can lead to assets being crazily overvalued. But unless you think that we are still in a stock-market bubble (which is pretty much an impossible case to make), or unless you think that, over the next fifteen years, U.S. companies are going to earn historically low returns on equity, have historically low rates of profitability and profit growth, and are going to stop caring about shareholder value, then the Japanese experience is not in any way a reason to be skeptical about buying American stocks now.
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