Time to Buy Japan?

I was on Spring Break last week with the family, and missed a lot of interesting market movement and global news.  I did hear of course the tragedy that hit Japan:  earthquake, tsunami, nuclear shutdown and potential nuclear meltdown.  The triple whammy had markets swooning, not only in Japan, but everywhere.  The US markets gave up all of their gains year-to-date for a brief time, down almost 7%.  As of today though, markets have rebounded so that the S&P is up around 3% year-to-date.  Even worse, the Nikkei Index fell 18% at its lowest, and has since regained more than half its losses.  Here are a few of my thoughts on Japan, utilities, and tech stocks.

Japan's Market in General
The Nikkei Index is now down 8.5% from pre-disaster levels.  Barron's put out an article that was very bullish.  "Buy Japan Now" it proclaimed over the weekend.  Warren Buffett and Bill Gross have made bullish comments on Japan as well.  (Bill Gross calls his a "tactical" position in Japan, that is, he is just trading it for the short term).  Toyota shut its plants, but only until March 26th, 4 days from today.  Both the Japanese government and the Bank of Japan have announced multiple monetary and fiscal stimulus packages to come, so it does seem likey that this will be more of a one or two quarter "blip" in Japan as opposed to a long drawn out recession.  That is, as long as Japan avoids a nuclear disaster.  I have no clue how to handicap that one.

However, after the Kobe quake in 1996, the market fell 25% before rebounding entirely over the next six months.  According to the World Bank, this quake will cost $235BB, almost double the impact of the Kobe quake.  Today, with the broader Japanese market down only 8.5%, I guess I am not that excited.  "Be greedy when others are fearful" is a great Buffett quote, but I am not sure people are that fearful here. 

Regarding particular ETFs or stocks in Japan, the obvious way to play Japan is via EWJ.  It holds all the big cap and mega cap Japanese companies, including:

Toyota
Honda
Mitsubishi Financial
Canon
Sumitomo
Mizuho
Takedo Pharmaceutical
etc etc

I am even more surprised by the performance of EWJ however.  After initially falling 16.5%, EWJ has recovered to the point where today it's only down 6.5%.  The US market is still down 3%, so I would say that it doesn't seem that compelling to me.  Investors are taking a lot of risk now for a mere 3.5% underperformance vs the US market.  Even the XLU, an ETF of US utilities, is still down 4.5% from pre-quake levels.  More on that later.

As far as valuations, I am sure that there are cheap Japanese stocks, but the market as a whole is trading at around 14.8x earnings, about inline with the US market.  (this is also before downward revisions which are pretty likely).  To me, if you were nimble enough to buy at the lows last week, then I would say that it was obviously a good trade, and maybe there is a little room left, but not enough to make me buy anything now.  Have people forgotton that Sendai, a major port city, was just about wiped off the map?

What is even more surprising is that EWJ now trades at the largest premium ever to its NAV.  The 4.5% premium I assume is a result of investors rushing to get long Japan as quickly as possible, and perhaps some BOJ stimulus money flowing into equities too.  Since January 2010, the range of premiums/discounts to NAV has been -3% to +2%.  I don't recommend buying this when it's at any premium to NAV.

The final problem with buying Japanese equities right now is that G-7 Central Banks are coordinating efforts to depress the Yen.  The Yen rallied initially after the quakes, but bankers will ensure the Yen goes lower.  That is negative for any dollar-based investor buying Japanese equities or ETFs.  Sure, you benefit by owning stocks that export goods to foreign countries.  A lower Yen makes their goods cheaper.  But a lower yen means that when you translate that back to dollars, you lose.  Finally, given that only 12.5% of GDP in Japan is exports, net net you are much more long the Yen than short it via export-driven equities.  

Next I comment on utilities and tech, as they got pretty crushed last week.

Utilities

The nuclear meltdown potential has caused concern among US utility investors.  Are nuclear plants in the US now likely to face additional regulatory scrutiny?  What about ones that reside in earthquake prone areas?  PG&E (ticker PCG) has a nuclear plant called Diablo Canyon in coastal California.  Its license doesn't expire until 2024 however, so I suspect its a safe bet as a stock to pick up on the cheap.  It's down 11% ytd, trades at 11.7x 2011 earnings, and its stock yields 4.2%.  They did $3.42 in EPS last year, so at $43.75 its 13x trailing earnings, also pretty reasonable.  There was an unfortunate gas pipeline explosion last year, but they have reserved for this and I wonder how much more unexpected bad news is out there to push the stock lower. 

With the stock down $2.15, from $46 bucks a share, its lost almost $900mm of market value.  I can't imagine that the FERC can dream up almost $1BB of costs to extend their license in 2024.  Already Diablo Canyon can safely operate during a 7.5 magnitude quake, that is if you believe the company.  Supposedly, the area can only produce quakes of up to 6.5 magnitude.  The entire plant is probably worth $4-5BB, as nuclear plants today are probably worth $2000 per MW.  (its a 2k MW plant).  So the market has already dinged them for 20% of the total value of the plant.  Probably overdone.

Tech Stocks

The supply chain in Japan is likely to cause some delays in producing products like the iPad2, which news crushed Apple.  I still think AAPL is a buy at $325, that's where I plan to add, but it didn't quite get there.  Hewlett Packard supposedly has little exposure to Japan, and suffered less.  However, the bigger picture is that tech is a terrible performer this year, especially in big cap land.  Value investors will start sniffing though eventually.   Below I copied a blurb from Barron's that appropriately excludes cash from P/E calculations.  The huge surplus of excess cash that these guys generate eventually will get noticed by some big, edgy, activist hedge funds.  And they will take them on to encourage distributing more of that cash.

Barron's Excerpt
Tight-fisted technology companies are loosening up a little with dividend policies, but industry payouts generally remain small or nonexistent.
Cisco Systems announced its first dividend on Friday, saying it will pay six cents a share quarterly, while Hewlett-Packard (ticker: HPQ) last week increased its quarterly dividend by 50% to 12 cents a share.

The problem is that neither company's dividend is substantial. Cisco's yield is 1.4%, while HP's is 1.1%. Most techs resist paying the 3%-plus dividends that might attract investors to their depressed stocks, pressured lately by concerns about supply disruptions from the Japanese earthquake and nuclear crisis.

Apple, Google and Dell still pay no dividends. Intel is the most generous among major U.S. techs, with a 3.7% yield, while Microsoft's dividend is 2.6%.

Barron's has argued, most recently in "Time for a Change in Techland" (Feb. 21), that tech companies ought to pay ample dividends. In that story, we highlighted many cash- and earnings-rich techs that could substantially boost payouts. The industry has favored stock buybacks and acquisitions, but that has done little for their shares. Cisco had been a prime offender, buying back more than $69 billion of stock in the past decade while paying no dividend.

Generous dividends could boost tech stocks by attracting income-oriented investors. Legg Mason fund manager Bill Miller has written that major techs ought to pay out 70% of profits and that such a move could substantially boost their stocks. We've argued a 40% payout ratio is justified and more realistic.

Techland Tightwads

These companies' price/earnings ratios are generally low, and higher dividends would probably help.

		2011 E			Net Cash
	Recent			P/E ex	Total	Per	% Of Shr	Div
Company/Ticker	Price	EPS	P/E	Net Cash	(bil)	Share	Price	Yld
Apple / AAPL1	$334.64	$22.98	14.6	11.8	$59.7	$63.98	19%	0.0%
Microsoft / MSFT2	24.78	2.55	9.7	8.3	31.6	3.69	15	2.6
Google / GOOG	561.36	34.54	16.3	13.4	31.5	97.80	17	0.0
Cisco / CSCO3	17.00	1.59	10.7	7.9	25.0	4.46	26	1.4
Intel / INTC	19.90	2.04	9.8	8.1	19.8	3.47	17	3.7
Dell / DELL	14.11	1.70	8.3	5.8	8.4	4.28	30	0.0
Nokia / NOK	8.02	0.73	11.0	7.2	10.2	2.76	34	6.8
Yahoo! / YHOO	15.86	0.75	21.1	17.5	3.6	2.77	17	0.0

Note: Includes Investments. E=Estimate. 1. Fiscal Year ending in Sept. 2.Fiscal Year ending in June. 3. Fiscal Year ending in July.

Sources: Thomson Reuters; Bloomberg; Company reports

Tech price/earnings ratios generally are low, and many are below 10 when net cash is stripped away. Microsoft, at 25, trades for less than 10 times estimated fiscal 2011 profit of $2.55 a share and has a P/E of just eight when its $3-plus a share in net cash and securities is stripped away. Cisco's P/E drops from about 11 to eight when cash is stripped out. Cisco shares, at 17, are down 16% this year amid growing concerns about its profit outlook.

Based on fiscal 2011 profit, even mighty Apple trades for a P/E of around 12 when its industry-leading cash hoard of almost $60 billion is stripped away.

Analysts still view most major techs as growth companies, but they're being valued as if their businesses are going away. Credit Suisse analyst Philip Winslow wrote last week that Microsoft trades at a 30% discount to the S&P 500, and investors are undervaluing its "sustainable revenue growth and defensive competitive characteristics." He sees $3-plus per share in profit in fiscal 2013 and carries a $36 price target.

Credit Suisse analyst Kulbinder Garcha began coverage of Apple with a $500 price target last week, arguing the company has an additional $10 a share of earnings power above the $23 that it is expected to produce for its September fiscal year.

Hewlett-Packard, at 42, trades for just eight times projected profit of $5.24 for its fiscal year ending in October, and for six times the company's fiscal 2014 goal of $7 a share. One reason HP trades so cheaply is that it pays a miserly dividend equal to less than 10% of its earnings and talks about making more acquisitions—which generally have destroyed value in the tech world.

Tech valuations have rarely been lower. Managements can continue their practices of the past—doing deals and buying back stock—or they can get serious about dividends. Our view is that ample dividends are the correct approach and would play well with yield-starved investors.
-- Andrew Bary

Conclusion
I am just waiting for the Keynesian economists out there to say something like, "This is good for Japan.  Think of all the additional spending that will come from rebuilding their infrastructure."  Sure, spending might go up short term, but the capital has to come from somewhere, and also there is the opportunity cost of spending.  Replacing highways and plants isn't generating new capacity or increasing productivity.  In fact it's displacing a lot of that spending.  It's net net a negative to their economy.  The stock market SHOULD be lower, earnings will be lower in Japan, period. 

Spending, as I have argued in the past, (and contrary to what our country's fiscal and monetary leaders think), isn't a positive in and of itself.  Spending to improve capacity, products, or productivity IS a good use of capital.  Spending without generating return is a waste, as anyone with half a brain knows.

Finally, we are seeing more unrest in the Middle East.  Today Yemen's generals are revolting against their president.  My only general comment is that, contrary to what our Western media is reporting, these revolts aren't necessarily people rising up against evil dictators in hopes of attaining freedom & democracy.  Much of it is that these are countries that have leaders in bed with the US, and they are making a statement about who they want their leaders to align themselves with. 

If this spreads to Saudi Arabia, a country with massive oil production and our best ally in the Middle East, then oil could go up much much more.  Add in Japan's need for oil to rebuild, and the bull case there likely stays intact.  And, with more uncertaintly, I would bet that this enhances the case for QE3, or at least prevents the Fed from raising rates anytime soon.  Keep your commodities, tech still looks very cheap, and perhaps add a little XLU or PCG.

What the Best Investors are Saying Right Now

I admit to being an addict (groupie?) of the smartest investors out there.  From following Buffett to Bill Gross to Marc Faber, I pay attention to the select best.  This is the week that many year end hedge fund letters are being disseminated, and I try to read the good ones. 

Given that this bull market is two years old, I question how much longer the party can continue.  Recent troubling events in the Middle East have pushed oil prices up 27%, just since February 15th!  Valuations aren't cheap, but on the plus side, the economy has shown strong manufacturing activity, employment is improving a little, and margins are back to all-time 2007 highs.  The market is up 5% this year already.  What are the smartest guys doing now? 

So here is what I have read lately by different investors or market cognizants.  These aren't journalists, these are people that "get it" in my opinion.  My conclusions on what I am doing are at the end.

Stephanie Pomboy, MacroMavens

She is "dubious" about the strength and durability of the US recovery.  Stimulus is going away, and higher food and energy costs are hurting the consumer.  Specifically, she points out that wage income has gone up $111 Billion in the last 6 months, but food and energy costs are up $116BB.   Next we'll have a wave of adjustable mortgage rate increases in April, because rates have been moving up.  That will also hurt.  Not to mention that basic fact that we are still barely creating any jobs in this economy. 

QE is creating a bubble in commodities as the dollar continues to be debased by the Fed.  The irony is that now that oil prices have skyrocketed, there is talk of negative impacts to the economy here.  Which means MORE aggressive monetary policy to offset higher prices!  This is an endless cycle that doesn't end well.

Another interesting point she makes is that high food inflation rates have been a huge contributor to instability in the Middle East.  And because of this, countries from Brazil to China are now stockpiling food to avoid instability in their own countries.  This is only further increasing demand for food, and driving food prices and inflation even higher.  Eventually something has to give in this scenario, but until it does break, investors should rotate back into Emerging Market stocks, and out of the US.  These countries have more ability to absorb higher prices than the developed world.  And the US economic recovery is not nearly as durable as people believe.

Small caps have been on fire recently, and now she recommends selling or being underweight these names against large caps.  Her list in order:  own gold, Treasuries.  Short XRT, a retail ETF, or other discretionary retail stocks. 

Seth Klarman, Baupost Group
If you have never heard of Seth Klarman, just know that along with Joel Greenblatt in the 1990s he literally wrote the book on value investing.  Baupost shows great patience in investing, chooses stocks better than anyone, and is happy to sit on piles of cash when markets are irrationally high. 

His letter starts by discussing that the 2008 collapse was the beginning of the way an economy normally heals.  That is, in the Great Depression, thrift, saving your money, living beneath your means became the philosophy of a generation.  This lead to great wealth accumulation for decades after we had recovered.  This time around however, in 2008 after the recession hit, the government saw consumer saving (and less spending) as "cataclysmic" and stepped in to continue our living beyond our means. 

"The imagination of our financial leaders remains so shallow that their response to a crisis caused by overleverage and excess has been to recreate, as nearly as possible, the conditions that fomented it, as if the events of 2008 were a rogue wave of financial woe that can never recur. It is only in Fantasyland that the solution to vastly excessive debt is more debt and the answer to overconsumption is less saving and more spending. Worse still, we have yet to see a serious assessment by policymakers of the causes of the 2008 financial market and economic collapses so that we might take action to ward off a repeat performance. The government’s knee-jerk response to contraction was to prop up economic activity by any and every means possible; the hole in consumer activity had to be materially repaired on the government tab. While Treasury Secretary Timothy Geithner ingenuously professes a belief that the U.S. will never lose its AAA rating, Moody's recently warned that, absent a change, a downgrading could be just around the comer. Or, in the words of David Letterman, "I heard the U.S. debt may now lose its triple-A rating. And I said to myself, well who cares what the auto club thinks."

He goes on to point out that we may have a repeat of what happened to Greece and Ireland if we don't right the ship soon. 

He finishes his diatribe by pointing out that investment success is dependant on a number of factors:  focusing on the long term, making informed decisions, asking the right questions, etc.  Seth points out that the markets in late 2008 offered extremely attractive prices, but by late 2010, he sees "froth" having returned to the markets.  I like his last two paragraphs:

Most investors take comfort from calm, steadily rising markets; roiling markets can drive investor panic. But these conventional reactions are inverted. When all feels calm and prices surge, the markets may feel safe; but, in fact, they are dangerous because few investors are focusing on risk. When one feels in the pit of one's stomach the fear that accompanies plunging market prices, risk-taking becomes considerably less risky, because risk is often priced into an asset's lower market valuation. Investment success requires standing apart from the frenzy – the short-term, relative performance game played by most investors.

Yet another long-term risk confronts investors: the government's fiscal and monetary experiments may go awry, resulting in runaway inflation or currency collapse. Bottom-up value investors would not wish to bet the ranch on a macroeconomic view, but neither would they be wise to ignore the macroeconomy altogether. Disaster hedging – always an important tool for investors – takes on heightened significance in today's unprecedentedly challenging environment. Yet, as this insight is not unique to us, the cost of insurance is high. There are no easy ways to navigate these turbulent waters. But because the greatest risks are of currency debasement and runaway inflation, protection against a currency collapse – such as exposure to gold – and against much higher interest rates seem like necessary hedges to maintain."

 

Bill Gross, PIMCO

The bond king writes that Quantitative Easing, QE's I and II, have been successful in artificially lowering interest rates, pumping up the stock market, forcing money out of negative real interest rate money market accounts and into riskier assets.  The problem is, he believes that our QE program doesn't heal an ailing economy, merely covers up the pain temporarily.  And, what are we going to do once QE II ends this June?  Who will buy US treasuries?  He writes:

"What an unbiased observer must admit is that most of the publically issued $9 trillion of Treasury notes and bonds are now in the hands of foreign sovereigns and the Fed (60%) while private market investors such as bond funds, insurance companies and banks are in the (40%) minority. More striking, however, is the evidence in Chart 2 which points out that nearly 70% of the annualized issuance since the beginning of QE II has been purchased by the Fed, with the balance absorbed by those old standbys – the Chinese, Japanese and other reserve surplus sovereigns. Basically, the recent game plan is as simple as the Ohio State Buckeyes’ “three yards and a cloud of dust” in the 1960s. When applied to the Treasury market it translates to this: The Treasury issues bonds and the Fed buys them. What could be simpler, and who’s to worry? This Sammy Scheme as I’ve described it in recent Outlooks is as foolproof as Ponzi and Madoff until… until… well, until it isn’t. Because like at the end of a typical chain letter, the legitimate corollary question is – Who will buy Treasuries when the Fed doesn’t?"

What I would point out is that Treasury yields are perhaps 150 basis points or 1½% too low when viewed on a historical context and when compared with expected nominal GDP growth of 5%. This conclusion can be validated with numerous examples: (1) 10-year Treasury yields, while volatile, typically mimic nominal GDP growth and by that standard are 150 basis points too low, (2) real 5-year Treasury interest rates over a century’s time have averaged 1½% and now rest at a negative 0.15%! (3) Fed funds policy rates for the past 40 years have averaged 75 basis points less than nominal GDP and now rest at 475 basis points under that historical waterline.

As a counter, one would argue (and I would partially agree) that the U.S. and indeed developed global economies must keep yields artificially low for some time if post Lehman healing is to take place. But that of course is the point. By eliminating QE II, the Fed would be ripping a Band-Aid off a partially healed scab. Ouch!  25 basis point policy rates for an “extended period of time” may not be enough to entice arbitrage Treasury buyers, nor bond fund asset allocators to reenter a Treasury market at today’s artificially low yields. Yields may have to go higher, maybe even much higher to attract buying interest.

Investors should view June 30th, 2011 not as political historians view November 11th, 1918 (Armistice Day – a day of reconciliation and healing) but more like June 6th, 1944 (D-Day – a day fraught with hope for victory, but fueled with immediate uncertainty and fear as to what would happen in the short term). Bond yields and stock prices are resting on an artificial foundation of QE II credit that may or may not lead to a successful private market handoff and stability in currency and financial markets.

Marc Faber, Gloom, Boom & Doom

Faber starts off by writing that it is more likely that tensions in the Middle East will increase than decrease.  It could easily spread to other oil producing countries such as Iran, Saudi Arabia, Nigeria, Angola and Venezuela. "If this nightmare scenario were about to unfold oil prices could really spike up."

He explains also that Walmart's stock has been suffering lately as consumers perhaps are pinched by high oil prices.  It really though a stock that's a proxy for the US economy, and lampoons the statistics published by the US government as propaganda put out by the "Ministry of Truth."

However, it's not just the US that is force feeding easy money on its populace.  His list of countries that are holding interest rates at sub-inflationary levels (ie negative real interest rates) is long:
   -Pakistan
   -Indonesia
   -Thailand
   -New Zealand
   -South Korea,
   -India
   -China
   -Vietnam
   -Singapore

Faber doesn't think that these countries will lift short term rates above inflation rates.  Meaning more price increases and inflation.  And if China or the Global Economy begins to weaken, it is likely they lower rates to stimulate growth.  Either way, money supply growth will remain high under any scenario.  He has chart after chart of money supply growth in Japan, India, China.  They all look like the price chart of gold, which he then goes to discuss at length.  (I wont rehash here, but needless to say he's bullish).  However, he does believe that both gold and silver will correct here, and also recommends the gradual accumulation of both.  "As I have said before, I am stilll a buyer and I shall never sell any gold as long as we have powerful fools running our central banks."

He generally thinks EM stocks are a better value now than US stocks, given the recent outperformance in the US.  Overall, EM stocks are now trading at just under 12x earnings, with Russia at the low end at 7x earnings.  He recented tauted Russia on CNBC as one where he thinks the market will bounce by 10%.  Other countries to consider where dividend yields exceed cash & bond yields: Singapore, Thailand, Malaysia, Hong Kong, and Japan. 

Regarding financial stocks in the US, he notes that insider selling is enormous.  The ratio of shares sold in 2010 to shares purchased was 855:1.  Wow!

Overall, Faber is postponing increasing exposure, believing that ALL asset markets could be due for a correction.  Seasonally its a strong period, until late April, but if the S&P has failed to make a new high, then its likely markets have formed a significant top.  Look to short RTH, retail holders ETF with a stop loss of $110.  (It's at $105 today).

 John Mauldin

John wrote a great piece on the delusion of crowds.  First he points out that voters in the US believe that the budget problems here can be fixed by eliminating waste & fraud, and that they also wrongly believe that the government spends more on defense & foreign aid than Medicare and Social Security.  (These last 2 account for almost 50% of spending today with interest, going to over 100% in 20 years).  Congress right now attempting to wring $61BB in savings is ridiculous, our budget deficit is $1.6 Trillion!  Yet voters believe this $61BB is meaningful.

He highlights also that stock market performance isn't really correlated with economic performance.  (great, that sends me back to the drawing board.).  Growth leads to higher inflation, and tighter central bank liquidity.  Which is bad for markets.  So, while the economic cycle seems good right now, he points out that oil spikes almost always lead to recessions.  The chart below shows high oil, almost always followed by a shaded region, meaning recession.

He quotes his freind,

“Here [in the charts below] is PMI vs. Dow 1966-1982 and 2000-today. Also, what worries me is that corporate profit margins are approaching pre-2007-crisis highs (see the third chart). A small slowdown in the economy, or just stagnation, will send profit margins down. Hopefully this helps. Also, as you normalize PEs for high profit margins (i.e., look at 10-year trailing PEs), the market is trading 30%+ above average PE – secular bull markets just don’t start at these types of valuations. In addition, the market did not spend enough time at below-average PE for this move to be the new secular bull market (in the 1966-1982 sideways market, PE was below-average half the time)."

He believes that stocks are priced to perfection today, in an imperfect world.  The problem also is that we are not in the midst of a normal cycle, but a debt supercycle.  This will inevitably lead to a correction in the market.  Here is his post:

http://seekingalpha.com/article/256616-are-booming-economies-good-for-the-markets?source=email_watchlist

Conclusion

That is a lot to digest, but generally feels bearish.  We might run til June when QE II expires, that has been my expectation for this year.  Barron's points out that the 3rd year of a bull market returns an average of 3.4%.  Not terribly exciting.  I am taking today's up market to book some profits.  I am taking off Ameritrade.  I swapped some Wintergreen (WGRNX) for some Berkshire Hathaway last week, but am selling more Wintergreen still.  Its my biggest position, even after I reduce it by 35%.  I also added a little BP recently.  I don't know the name terribly well I admit, but am going on the Ready, Shoot, Aim method of investing for now.  I don't want to be completely out of oil if it does spike even more.

Finally I did buy some RBL a week ago.  Its an ETF of Russian equities, and 57% of the ETF is long energy names (mostly Gazprom, and Lukoil).  Its moved up 8% since I bought it, I don't necessarily recommend it here.  But on a pullback it's probably worth adding a little.  I sold NEM today, it's suffering from weak guidance reported on its call.  I question now whether gold miners will work in an inflationary world.  They are inherently short oil, and NEM is seeing $100 per ounce increases to its costs in 2011 compared to last year.  I don't want to be short oil when its spiking.  Long term there is no position to take except to be long it.  I'll keep my GLD and my physical.  Make sure you have 10% of your portfolio in gold and oil, because, as Seth Klarman points out, you cannot ignore the macro picture, you have to insure yourself against hyper-inflation risk and currency debasement risk. 

I will sit on more cash for now, and hopefully wait for the market to stop throwing 90 mile an hour fastballs right down the pike.