Why I am not investing in Japan

Quite a few sites, including Geoff Gannon, have mentioned that Japanese stocks appear to be quite a compelling value at the moment, especially in wake of the damage done by the earthquake. Another site, run by Sivaram Velauthapillai, has a breakdown of stocks that have traded in the past year, and after the earthquake. Larry Macdonald also touches upon the issue of Japanese equities.

In fact, you can simply look at the Japanese Yen currency chart and see that people have been piling into the yen, which would suggest that capital is being moved into the country at a rapid pace:

And when looking at the company in the centre of it all, Tokyo Electric Power Company (JP: 9501), they have been hacked down from about 2100 yen per share to 800 yen today – their traditional range over the past 5 years has been roughly 2000 yen to 4000 yen a share. One would think they are a compelling value without even looking at any financial statements.

I will not be investing in Japan. One of my basic investing rules is not to invest in countries that do not have English as their primary language. I very rarely make exceptions to this. The other reason is that I do not think my vantage point across the Pacific Ocean gives me any better advantage than somebody domestic – Japanese traders are just as active as well as everybody around the planet. It is very difficult, culturally, to tell what the true impact of this disaster will be in terms of domestic sentiment – you can generally only get that impression by being there.

The Japanese government also has severe issues concerning its finance and being able to maintain the standard of living of its citizens. I do not get the impression that investors have sufficiently priced in hidden risks concerning the outcome of this disaster – what if this is earthquake is the trigger to a sovereign debt crisis in Japan? Is a 200%+ debt-to-GDP ratio not low enough to have people a little skittish about giving the government another $500 billion to clean up the mess? Note that 5-year credit default swaps in Japan are now at around 1.25%!

Although looking at charts of utility companies dropping by 2/3rds may seem like there is value, I will be letting this one pass by. I am sure there is huge opportunity, but being able to dig through the necessary information to make rational investment decisions in individual equities in Japan is not something I can do. One might considering investing in an index fund, but investing in index funds is not my style of investing – it will not produce outsized gains. In fact, in the longer run, domestic Japanese consumption could be taking a bigger nose dive than what most people expect.

There is too much unknown risk, which is why I am standing on the sidelines.

The trend is clearly broken

The uptrend in the major indicies over the past six or seven months has clearly been broken. Here is a chart of the S&P 500 with my retrospective scribble on the chart, indicating the prevailing trend:

Note that volatility has increased considerably:

VIX is not predictive; however, it does say that market participants have been spooked to pricing in more volatility in the future. The question is whether they are spooked enough – my gut instinct says we may get a sucker rally here or there, but it is more likely than not that the prevailing trend will either be choppy or down – not exactly the type of environment for a buy and hold investor.

Playing conservatively is likely the better option at this point, just as it has been for the past few months.

How to deal with the black swan market event

Although the trigger of this recent trend down in the markets feels like it stemmed from the Japanese earthquake, it appeared to start with the civil unrest in Egypt.

The Nikkei today is staging a comeback – up about 6% after yesterday’s panic volatility that took the index a further 20% down before bouncing back. International traders presumably are mining their selections of Japanese equities. I will provide a list of directly (from the NYSE and NASDAQ, although Interactive Brokers clients have direct access to Japanese equity markets):

Company Name Symbol Sector
ADVANTEST CORP ATE Electronic Technology
CANON INC CAJ Electronic Technology
HITACHI LTD HIT Producer Manufacturing
HONDA MOTOR CO LTD HMC Consumer Durables
INTERNET INITIATIVE JAPAN INC IIJI Technology Services
KONAMI CORP KNM Consumer Durables
KUBOTA CORP KUB Producer Manufacturing
KYOCERA CORP KYO Electronic Technology
MAKITA CORP MKTAY Consumer Durables
MITSUBISHI UFJ FINANCIAL GROUP INC MTU Finance
MITSUI & CO LTD MITSY Distribution Services
MIZUHO FINANCIAL GROUP INC MFG Finance
NIDEC CORP NJ Producer Manufacturing
NIPPON TELEGRAPH & TELEPHONE CORP NTT Communications
NOMURA HOLDINGS INC NMR Finance
NTT DOCOMO INC DCM Communications
ORIX CORP IX Finance
PANASONIC CORP PC Electronic Technology
SONY CORP SNE Consumer Durables
SUMITOMO MITSUI FINANCIAL GROUP INC SMFG Finance
TOYOTA MOTOR CORP TM Consumer Durables
WACOAL HOLDINGS CORP WACLY Consumer Non-Durables

Very quickly mining the selections above (which generally represent global large-capitalized Japanese companies), Kyocera appears to have decent value, with similar valuations to the old-school technology index.

However, investors should be cautioned that they are not nearly out of the woods yet – the civil disruptions in Northern Africa and the Japanese earthquake could be the trigger to a prolonged downslide in the markets. It is very difficult to determine whether now, a moment of relative uncertainty, is a good time to jump in, or whether the markets will reward the patient.

I’m choosing to be patient. My portfolio has been extremely defensive and I continue to wait with a large amount of cash and cash-like instruments that are uncorrelated to the woes of the equity marketplace.

Some might argue that the damage has all been priced in – my guess is that there will be damage to the market beyond the immediate economic impacts of geopolitical uncertainty and natural disasters that we have seen over the past month.

Quick review of some large cap technology stocks

I am continuing to look at the US large cap sector, just for personal review rather than serious consideration. I am continued to be surprised by relatively good valuations, around the 10% yield levels. Most of these are in the first-generation “old-school” technology sector. Very well-known companies include the following, with some very anecdotal remarks on my behalf:

Microsoft (MSFT) – Trading at 9.3x FY2012 projected earnings, with $30B net cash on balance sheet, Windows/Office empire continued to be chipped away at with competition;
Intel (INTC) – Trading at 9.5x FY2012 projected earnings, $20B net cash on balance sheet, likely to be around for a long time, competition in mobile processors, but nothing in really ‘large scale’ CPUs except AMD;
Dell (DELL) – Trading at 8.6x FY2012 projected earnings, $8B net cash, well-known customer support/service issues, but otherwise entrenched in computer/IT market;
Hewlett-Packard (HPQ) – Trading at 7.3x FY2012 projected earnings, $10B net debt, along with Dell, entrenched in computer/IT market;
Lexmark (LMK) – Trading at 7.7x FY2012 projected earnings, $600M net cash, major supplier in printer/imaging market;
Xerox (XRX) – Trading at 8.3x FY2012 projected earnings, $8B net debt, in a similar domain as Lexmark;
Seagate (STX) – Trading at 7.2x FY2012 projected earnings, $0 net cash/debt, hard drive/storage manufacturer;
Western Digital (WDC) – Trading at 9.3x FY2012 projected earnings, $3B net cash, in a similar domain as Seagate;
Micron Technology (MU) – Trading at 8.4x FY2012 projected earnings, $600M net cash, memory manufacturer;

One would think that diversifying a position into these nine companies and calling it the “Old-school technology fund” would probably be considered a relatively safe alternative over the next 10 years, compared to the 3.4% you would achieve with a 10-year US treasury bond.

My gut instinct would suggest that these companies would still be around in 10 years, especially Intel, which has the biggest competitive advantage out of the nine listed above.

I am also assuming that smarter eyeballs than my own have looked at these companies, which is why I suspect there isn’t much extraordinary value here other than receiving a nominal 10% return on equity, which is pretty good for zero research.

Holloway Lodging REIT – Default on radar screen

The last time I wrote about Holloway Lodging REIT (TSX: HLR.UN) was back in December when there was a corporate governance spat between a significant shareholder and management. That conflict resolved differently than what I had expected, with the significant shareholder being given a minority slate of trustees.

I have been continuing to dump my debentures in Holloway (the 2012 issue, TSX: HLR.DB.A) at around the 65 cent range and got rid of my last piece today at 62, leaving $1,000 in par value of debt just so I can see how this train wreck ends.

Holloway released their 2010 annual results yesterday, and reading it contains two not-so-subtle inclusions on their financial statements and management discussion that warrants further analysis:

The REIT is also subject to financial covenants on its mortgages and loans payable, which are measured on an annual basis and include customary terms and conditions for borrowings of this nature. These include the Debt Service ratio presented above. The REIT is in compliance with, or has obtained waivers for all of its financial covenants except one. One lender has not provided a waiver however, as a result of discussions with this lender, management believes the loans will not be called prior to maturity. The two mortgages with this lender, on hotels in Fort McMurray and Drayton Valley, are included in current liabilities and mature in October 2011 and January 2012.

Notably, the company has $153M of mortgages outstanding which are secured by the property and buildings within those mortgages. If the company does not abide by their debt covenants, in theory, the lender can call the debt unless if the company can cure the breach. If this occurs it would likely result in the company being pushed into creditor protection as their line of credit is not large enough to cover the difference.

The REIT has $25.4 million of mortgages maturing in 2011. The REIT expects to refinance its maturing mortgages at similar or better terms with existing or other lenders.

The REIT also has $20.2 million in convertible debentures that mature on August 1, 2011. The REIT has a signed term sheet to finance the repayment of the debentures. The Board and management continue to explore other alternatives to raise funds to repay the debenture holders which may include other debt financing, the sale of certain properties or some combination, thereof.

HLR has $45 million in debt in 2011 that they must be able to roll over in order to avoid creditor protection. The mortgage debt they should be able to renew at acceptable rates (they did so in 2010 for about 6.6% for a 5-year term). The August 1, 2011 debenture is an interesting issue ($20M) in that it is trading near par (TSX: HLR.DB, 93.5/97 bid/ask presently, albeit very illiquid) which suggests the company can refinance that, but the June 30, 2012 debenture (a $45M issue) is down to 62/63. This suggests the market is betting on the company being able to rollover the 2011 debt but not the 2012 debt. Both debentures are equal in seniority to each other.

It would be a logical and low-risk paired trade to short the 2011 debenture and long the 2012 debenture, but I could not short the 2011 debenture.

The business is not generating a sufficient amount of cash and this is in large part due to the interest bite that comes out of operating income. In 2010, the business pulled in about $19.3M in operating income, but the interest expense was $15.8M. This does not leave much room for other incidental expenses, such as general and administration, and future capital expenditures. Capital expenditures in 2010 I am presuming were of a maintenance-type nature, totaling $3.6 million.

There is nothing to suggest that they will be able to improve their revenue per room or capacity utilization rates over the next couple years.

There is probably residual value left in the operations, but I don’t want to be around to find out what low-ball offer management will be offering to the convertible debenture holders when maturity comes around. I’ve exited the 2012 debentures, short of $1k par value. My basis was about 44 cents on the dollar, so this is a nice gain for nearly 2 years of holding, but as I pointed out earlier, one of my largest mistakes during the 2008/2009 economic crisis was putting money in the debentures of this company compared to Innvest (TSX: INN.DB.B) at the same time period.