Japan, the ultimate contrarian trade

Japan, the mere mention of the country for investors elicits disregard and apathy.  Mention a company in the UK trading for less than net cash and growing earnings and interest explodes.  Mention a company in Japan with the same metrics, and investors come up with reasons to not invest.  Japan is a fascinating place, a first world country, ultra modern, yet for investors something less than a third world market.

In 1939 John Templeton called his broker and asked him to buy $100 worth of every stock trading for less than $1, bankrupt or not.  His broker obliged, grudgingly and purchased 104 stocks for him.  That initial $10400 turned into $40,000 four years later, and got John started on his investment career.

In retrospect John Templeton's trade seems obvious, yet at the time is was something only an investor a few slices short of a loaf would undertake.  I think we see the same dynamics with Japan today.

For most investors Japan is a place where money goes to die.  Japanese bonds are famous for their widow maker trade, and Japanese equities have destroyed a few legacies themselves.  No self respecting investor takes a chance on Japanese equities, which have been in a bear market for the past 20 years.  A mention of a purchase in Japanese equities is usually met with a response that Japan is about to enter hyper-inflation, or the Yen is going to be destroyed, or the country is about to default on their debt.  I don't want to minimize the finances of the Japanese government, but these characterizations have been going on for the past decade or more.  That's not to say they won't come to pass eventually, but a lot of people have lost a lot of money trying to guess the timing.  Eventually Japan will have to deal with their debt problem, but so will the US, and so will Europe, so Japan is not unique in that regard.

So with all this I want to introduce what I call the greatest Japanese trade ever.

Long time readers know that I've toyed with the Japanese net-net market.  I've done numerous posts on Japanese equities, and even bought a few Japanese net-nets.  Each time though I keep coming back to the same problem, there are so many Japanese net-nets, how do I choose the ones to invest in?  I've translated financial statements in an effort to pick the "best" cheapest companies.  I've built out spreadsheets of various metrics, yet I've never had the feeling that I'm fully capturing the cheapest companies.  Do I purchase the ones at the lowest P/NCAV, or the ones with the highest ROE, or the ones with the best dividend yield?  I really don't know what will work the best in the future.

In thinking about Japan I've started to think about the John Templeton approach.  I've often thought that if I could buy ALL of the Japanese net-net's I'd be happy.  Sure, some would go bankrupt, but who cares, some would also quadruple.  I've told a number of investors that I'm convinced that someone buying the cheapest Japanese companies could not go wrong.  The trade might not work out over the next four to six months, but over the next four to six years it would for sure.  Why do I think this?  Because it's absurd that profitable companies are selling for less than net cash, or less than net current assets.

I've thought about this trade a lot, buying all the net-nets, the problem is one of both capital and commissions.  As of today there are 448 companies selling for less than NCAV, and with the funky Japanese rules regarding lot sizes, I estimate it would take close to $4.4m to buy every single one of these companies.  I don't have anywhere near $4.4m in capital, and at my broker the commission to enter an exit each trade would be a serious hamper to results.

Recently I found out that Schwab created a new Global Trading product as part of their brokerage account.  As a promotion for this new account they're offering free trades until March 2013.  Free trades on international equities got my attention, I started to think that maybe the ultimate Japan trade might be possible.

While Schwab trades all Japanese exchanges (Tokyo, Osaka, JASDAQ), they only trade securities where they offer an equity rating, which is 882 equities.

Using the Schwab platform I'm hoping to pull my own mini-Templeton trade.  I'm looking to buy 20-30 Japanese net-nets, in addition to the four I already own.  Doing this will more than double my exposure to Japanese net-nets.

So here is the plan: I am going to open a Schwab account and purchase 20-30 Japanese net-nets.  I'd like to purchase more, but my capital is already tied up in other great opportunities, and this is the most I can spare at this time.  I'm going to also hedge my exposure to Yen with a future or options in case of a Yen explosion.  This way I'll still get the market return these net-nets provide, but won't have to worry about the Japanese debt problems.  My hope is that I can forget about this account for three or four years, and at that point I'll have at least 2x my money if not more.

Some readers might wonder exactly how I'll pick 20-30 companies out of 448.  I'm going to approach this in a similar fashion as John Templeton.  I'm going to start with the lowest priced equities first before layering on any other criteria.  My second criteria will be discount to NCAV, my third criteria, discount to BV, and my fourth criteria ROE ex-cash.  I also want each of my holdings to pay a dividend, so I'm paid to wait this out.

Talk to Nate about the ultimate Japan trade

Disclosure: no equities mentioned