Wednesday, September 9, 2020

Sogo Shosha

Not quite a whale, and pretty small investment, but interesting nonetheless. As usual, people are trying to read all sorts of things into this investment, from bullishness on Japan, bearishness on the U.S., the U.S. dollar, inflation hedge / exposure to natural resources etc. It almost feels like nobody ever reads anything Buffett writes. He doesn't base investments on themes like inflation or economic views or views on foreign currency exchange rates. 

But anyway, one can only assume that Buffett feels that these Japanese trading companies are decent businesses with decent managements trading at attractive prices.

Foreign Investments 
This investment really reminds me of his Korean stock trade a while back. He said he was flipping through a Korean company handbook and noticed that a lot of stocks were trading at very low valuations. It seemed like he didn't need to dig into the details of every company to know that they were cheap enough and buying a basket would be profitable. This shosha investment kind of feels like that.
I remember noticing a while back in a photo or video of Buffett in his office that the Japan Company Handbook was sitting on his desk. So you knew he was flipping through that thing one company at a time looking for bargains. This may have been how he found this group. I would not be surprised if he has been reading all the annual reports of the big Japanese companies for years. Why wouldn't he, with so much capital to allocate?

First of all, I won't go into too much detail about the Japanese trading companies. They all have English annual reports on their websites, and you can just read about them on Wikipedia etc.

But I have to say my first reaction was not positive. I think many of us who are familiar with the Japanese market were a bit surprised. One pro said he was "disappointed". 

What does he see?!
Anyway, first, let's see what Buffett may be seeing. Since he bought five stocks, this is clearly not about any individual company or management. 

Let's just look at the big picture on these names. This table below is current as of early September 2020.
Since he has been accumulating these stocks for the past year or so, the most recent annual report he would have seen last year would have been for the year-ended in March, 2019 or more likely 2018 (as English versions of annual reports come out late). I have highlighted the March 2019 year figures, but he may have evaluated things based on 2018 figures too.
Prices haven't moved much (except Itochu), they are within sort of the range they have been for the past couple of years. So the table just compares everything to current prices.
In short, what he was seeing was a group of companies earning double-digit ROEs with single-digit P/Es and P/Bs below 1 (except Itochu).  Where can you get that combination? Maybe in some emerging markets. These are blue-chip companies with solid reputations, at least socially (banks and shosha were the two industries that parents traditionally wanted their fresh college grads to join). 

Initial Reaction
So just by the numbers, this makes total sense. No mystery here. It is exactly the sort of thing Buffett would jump into.

What about the reputation of incompetent Japanese management? That's what I would worry about most. Japanese management is and has been improving over the past few years, but I can't say I would be completely comfortable with management there, particularly in the big companies.

There are many cultural reasons why management in Japan has been so inept over the years. Things like seniority, lifetime employment, constant annual rotations of staff and the short put nature of employee positions have been really detrimental to companies there. I do have first-hand experience with this. It is getting better, I hear, but if you remember how a Korean airlines flight went down because it was culturally unacceptable for a co-pilot to point out an error to the pilot, cultural factors can be quite destructive. 

In Japan, one of the big ones is the notion of seniority. Meritocracy is increasing over there, but there is still a notion that older people know better so must be respected and not challenged. A lot of this gets mixed in with the natural tendency to defend your own turf. This combination may make it difficult for energetic, creative, competent young people to move up to benefit the company. Also, the lifetime employment 'promise' makes it difficult to make room for more competent employees. This combination of lifetime employment and seniority can be lethal in a fast changing, dynamic world.

The other big problem is that a lot of large companies tended to want to rotate people every three years to give them a broad experience to prepare them for senior positions at HQ. I remember dealing with some of these employees in NY and was shocked at how things worked. They come over to NY knowing nothing about finance, for example, and they speculate using firm capital not knowing what they are doing. Of course, by the time they start to understand what is happening, they are 'rotated' out to London or somewhere else. So they barely get to understand anything before moving on and they eventually end up at the head office, not really knowing much.
There were some trading companies that were close to blowing up or had to merge because they were on the verge of bankruptcy, and given my first-hand observations, that was no surprise at all. Did I tell you about one of the trading companies that would call our swap desk every day and ask for anything above a certain LIBOR spread? And they were indifferent to the risk; they didn't care. They mechanically just bought anything above a certain hurdle rate. I used to get invited sometimes to client dinners and I heard it directly too; they don't care about the risk, just give them something with this yield. They are willing to take whatever risk is implied in that given yield. Why this rate? Oh, that's our funding rate. Oh. Well, you have to take some risk, then. That's OK. Do you care what kind of risk you take? No, we just need to clear our funding rate. But structured products can be very risky. That's OK, we like structured products. etc...  You get the point. It was crazy.
This is one reason, by the way, why I thought a lot of the criticism against the banks during the financial crisis was baloney; a lot of these clients knew what they were doing, knew the risk they were taking. Or they simply didn't want to hear anything. They just wanted certain things regardless of the risk. Of course, I was never a salesman so would simply state facts, and they were like, OK. That's fine with us. Scary stuff. I'm sure things are better now (but I wonder. I just finished the GE book, and Immelt sounds very much like a clueless salaryman! Frightening. Except GE may have been worse; how is all of that stuff not fraud?!).

Of course, I am making all these sweeping, generalized statements, but here's another thing that you may have noticed. Some Japanese corporations do really well globally, particularly the manufacturers. If you look at Toyota, Canon, Sharp and many others, they have tended to do well in the past (although a lot of them are now under pressure from Korean / Chinese competitors). They succeeded because they mastered their craft in Japan and exported around the world and eventually built plants around the world implementing their techniques. 

But if you look at the businesses that tried to expand globally through acquisitions and / or the financial/service companies, they have failed miserably. The Japanese tend not to be great acquirers. Well, data show that this is true everywhere and anywhere; M&A tends not to work out well. But I always had the sense that it was worse for the Japanese when they venture overseas. 

As I mentioned above, I just finished the GE book, and it's funny how Immelt sort of acted like a Japanese salaryman; they just want to get the deal done no matter the price, and people are afraid to challenge the 'senior' person. In big companies, so often, things are decided by politics, so you can't afford to upset people. If you think a deal is bad, why would you risk your own career and point it out? 

This goes on to the next part of the problem in Japanese companies, and that's the short-put aspect of the employment contract. Again, there has been some change, but in general, Japanese companies are not known for paying outsized bonuses for success (well, you can argue that the Americans are very good at paying outsized bonuses for failure), so this discourages risk-taking. Why bother? If you step up and try to do something big and it succeeds, you get a nice pat on the back and maybe a small bonus. But if you fail, this can be detrimental. They may transfer you out of your job and send you to corporate Siberia. We've all read about the madogiwazoku. They can be like those empty rooms with no windows that we read about, but more often it is probably some transfer to some branch somewhere that nobody wants to go to. 
Although the long-call nature of U.S. business can create problems, the short-put structure of Japanese employment can be troublesome too.

Anyway, enough of this. Things have probably changed a bit. The above problems usually manifested itself in low profits, low margins and low ROE in Japan, as businesses pursued market share at all costs, spent money building facilities for their employees, created companies where the main company can dump unnecessary workers etc. 

But at least in the above table, we can see that ROE has been decent in these trading companies in the recent past. 

BPS Growth
OK, so we see that the stocks are cheap on a P/B basis. If we are going to evaluate something on a P/B basis, unless we are expecting liquidation, we have to look at how BPS has grown. So here is a quick table that shows the BPS of these companies; most recent, 2015 and 2010 figures, so we can see how BPS has grown for these companies in the past 5 and 10 years. I also added stock prices for the same time frame so we can compare.

BPS Growth of Buffett's Shoshas

Itochu is pretty good; they have grown BPS 11.2%/year over the past decade and 5.5%/year over the past five. This may even be better than BRK! (I didn't look). Stock price returns are not bad either. The other ones? Not so impressive, but including dividends, most of them look decent on a 10-year BPS growth basis, actually.  (Stock price change excludes dividends).
Anyway, moving on...

I will spend some time over the next few weeks reading the annual reports of these companies, so maybe I will post more about them if I find anything interesting. 

But first, I took a quick look at Itochu. Itochu has been one of the top trading companies for years, and has a reputation of being a little more modern and 'hip' than some of the others which were part of a zaibatsu. Shosha as part of a zaibatsu makes you wonder where their real interests are; are they trying to make money for the shareholders? Or do they have a specific role to fill as part of the industrial group which would force them to do things that might not be economically rational? They also might seem a little more traditional / conventional, which is not a complement when it comes to Japanese business.
This is a great chart from the 2020 annual report. But this is illegible, so I cut it up below so you can see the tables below. 

It's hard to see, but the below tables are what's at the bottom of the above table. They show the stock price and valuation of the stock every year from 2011 through 2020. And you can see that the stock has always been really cheap; single digit P/E's and trading at around BPS. 

Despite this, their historical returns are pretty decent.

A cheap stock that has grown nicely over time is sort of a no-brainer, if you believe in the quality of the earnings and accounting values of book.


Trading companies are hard to analyze. I have spent time on them in the past, and they were usually just big, black boxes. They have evolved over the years from a purely import / export business to more of an investment business. A lot of investments, though, are related to their client businesses. For example, a company might buy a farm that produces products to export to Japan, or may invest in an oil field that will export oil to Japan etc.

There was a little block in the 2020 annual report explaining how they differ from private equity funds.


Here's another snip showing the ROE of Itochu going back to 2011. This is very unJapan-like, with double-digit ROEs for the whole period.

...and here's a nice snip showing labor productivity. But I am not so sure how relevant this is as they are investing more. Investments will increase profits and may not necessarily increase number of employees. Kind of like Berkshire Hathaway; not all employees are directly related to the revenues the holdings produce. 

...and here is a snip of all the medium-term plan targets and results in the recent past. They have achieved most of their goals. 

As Buffett explained about his IBM and Petrochina investments, he likes it when managements say they will do something and they accomplish it. IBM used to succeed in hitting all their goals too, which was one reason Buffett was attracted to the stock (which didn't work out in that case).

So Itochu looks very interesting. This doesn't count as much of an analysis, though, as you would have to go and dig into the balance sheet and see what's in there and how they're valued. Buffett said the accounting is good, but I think he means that many of these companies report under IFRS or GAAP standards and are audited by major accounting firms (well, this was true with GE and Enron too, not to say shosha are either of those). 

Marubeni took a big writedown in 2020, so you never know when these things will happen. I don't think we have enough information to make our own estimate of what these things are worth. So you have to just look at and use what we have. And I guess that would be cash flows and dividends. You can't really fudge those.
This is kind of interesting, and as I said, I will spend some time looking at these companies. But I am not at this point jumping with excitement about buying these names. If any, Itochu is certainly interesting. The others? Not sure.

A lot of these companies talk about wanting to invest for the future, but you can't just wake up one day and decide that you are now suddenly a venture capitalist. Marubeni has a fixed amount they said they want to invest in new businesses, which is kind of frightening. When you say you want to invest X in a certain sector, it makes management want to fulfill that regardless of the opportunity. Why would you want to do that? Maybe 0 is the best course of action. 
I probably told you guys about a supplier in Japan who told me that certain period-ends, they get a big influx of new orders. Why? Clients say they have money left over in their budgets and if they don't use them up, it will be cut next year. Nobody wants their budgets to be cut! Makes sense for the division, but a nightmare for shareholders!

Some of these annual reports eerily resemble Immelt's nonsensical ramblings about investing in the future and technology too. Scary.

Shosha investments in the past have been related to their clients; buying a factory that manufactured goods for them or a client, buying mines, oil fields, refiners, processors or farms that exported supplies to Japan etc. So there was this expertise and some proprietary knowledge behind those investments. 

But venture capital?  I'm not sure how that would work. It might work!  But it might not. Who knows. 

Anyway, I will probably follow up with more posts because this is sort of interesting.