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Welcome back to Business Breakdowns.
This is Matt Russell.
Today, we are covering what might be the most interesting investment strategy that I've come across in a long time, and that is activism in Japan.
My conversation in this episode is with Musimi Nishida, partner in Dalton Investments.
But as part of this intro, I brought on a special guest and the catalyst for this episode, and that is Nick Bartolo.
Nick is founder of Essential Partners.
He was previously at International Value Advisors, TCW Capital Group.
So Nick, welcome. You've spent a good deal of time in the markets.
When did you first come across this opportunity that you so graciously served up to me?
I'll even take it back a bit further or give a little more context, in that Matt and I first talked about this opportunity at the first founders event in Austin.
I think that was back in March.
And the reason I brought it up is because it is such a odd, yet compelling opportunity.
And so when I first thought about Japan, 2008, 2009 were some of the first businesses and companies that I started studying in Japan right after the global financial crisis.
And what really struck me like it does most people who first look at Japan is the fact that the valuations are dirt cheap.
So finding companies, especially on an enterprise value basis where they might be a negative enterprise value, or two, three, four times enterprise value to EBITDA is quite common in Japan.
And so I can imagine there would be collective groans because everybody knows Japan's cheap and will often have the refrain that Japan's just a value trap.
And I don't disagree with that.
But back then, if you could actually find businesses that were not value traps, and essentially as an investment analyst working in that market, that was my job.
Back then though, you could find companies that had a controlling shareholder that was an owner operator who actually had more of an internal activist mentality in that they were enacting pro shareholder actions such as increasing dividends or god forbid, companies actually did repurchase shares back
then, which was quite unique.
And if you found those companies that took those actions and actually had a stable business that was growing, it was easy to outperform the overall Japanese stock market and even the S &P.
And so really that was the strategy that my old firm pursued for a long period of time and investing in Japan.
To add on to that, once former Prime Minister Shinzo Abe came into power back in, I believe it was 2012, 2013, and really started to very slowly implement some of these reforms across the various regulatory agencies to create a more pro shareholder culture.
That's when the opportunity evolved.
I think you laid it out so well there.
It's the valuation that has kind of always stood out, but maybe is a particularly known story.
At the same time, the opportunity to be involved, be activist, that can change a lot of things.
Once you have your hands on potentially deciding capital allocation that completely changes the game in terms of the investment opportunity, when you just think about where we are today versus where we are when you first started looking at that opportunity.
And I know we can look at it in the midst of the moment and what has happened in Japan over the past couple of months, but even maybe a level broader over the years.
How do you think about the opportunity today versus when you first started looking at it?
The way I think about it is that at the surface level, people look at Japan and the performance of the Japanese stock market has actually been quite good over the last number of years.
Let's call it four years.
If you look at Japan on an unhedged basis, it's actually outperformed the S &P 500.
It's up, I think around 120%, and the S &P is up 90 % to 100 % right around there.
So on that surface level, you would think this opportunity is over.
Japan's actually recovered.
It's picked over. But if you take it a step deeper, what you'll see is that actually smaller companies in Japan have lagged by probably 50 % relative to large.
And then in looking at the actual valuation of these smaller businesses, under a $3 billion US market cap, there's still over 600 companies that trade on Japan at less than six times EV to EBITDA.
So that's still a very cheap valuation.
As a public market equity investor, I always thought of four dimensions of risk.
And this is oversimplified, but the first being the balance sheet.
Assessing this opportunity to go forward, I go back to my risk model.
The balance sheet is the first one.
So clearly, you don't have a balance sheet risk when these companies are overstuffed with cash.
So take that off the table.
The second dimension of risk that I always looked at was business quality.
Japan, actually, a lot of their industries are far more stable in terms of just the industry structure relative to companies in the US or around the globe.
And despite a deflationary environment for much of the last 30 -plus years, there's actually a lot of companies in Japan that are growing.
They're not growing at eye -popping tech rates, but they do have growth oftentimes overseas.
So the business quality, you can't find businesses that are growing.
If not, this doesn't really work.
The third dimension of risk is valuation.
We talked about that.
Japan's always been cheap, and there remains a large opportunity set of companies that are cheap.
But the fourth and critical risk feature is capital allocation.
If you give me a business in Japan that has all of the other dimensions of risk covered and off the table, but they have poor, lazy, Japanese -like capital allocation, forget it.
I wouldn't be interested.
But if you do have an activist involved, then it can completely change that paradigm and turn that risk into a positive, which in my opinion can lead to these idiosyncratic return opportunities.
And the last question I have for you before we shift over to the episode is, you are a fellow Westerner like myself, and that is and can be a meaningful difference when thinking about activism and where you're going activist.
So just from your perspective in terms of implementing this strategy and the potential to have success in the strategy, how important is that?
We've seen some of the bigger US activists go after some of the bigger Japanese companies, but what we talk about with Musimi is a much smaller set of companies.
So how important do you think that is in terms of seeing success with this type of strategy?
Being boots on the ground there, potentially thinking about the cultural dynamics, can an American have quite as much success in the Japanese markets if they're going activist?
I think it has proven to be very difficult to not have boots on the ground, but yet be an effective activist in Japan.
Although there are certainly US American firms that have done it, Value Act, Elliott, et cetera.
Culturally, I still don't think Japan is actually ready for it.
I think that the smaller companies and just overall culturally in Japan, I don't think they're necessarily ready for that.
And hopefully Musimi will shed some light on that.
But I do think that if they can avoid the public shaming and take actions on their own behalf without necessarily addressing the activist in the room, then they can actually enact these changes on their own terms to the benefit of shareholders.
It's a different structure and it's a different communication style, but it can still be effective.
Absolutely, yeah. The idea of saving face in any type of work or job or investment or anything plays true no matter what culture it is, but particularly here.
Thank you again, Nick, for bringing this to my attention than to the audience.
Again, it was one of the most enjoyable conversations that I've had in a long time.
So I appreciate you doing that.
Oh, absolutely, happy to do it.
All right, Musimi, I'm excited to have you here today to talk about something thematic, a strategy that you are heavily involved in.
And that is activism in Japan.
It's a market that I'm personally fascinated with.
And thinking about how to structure this conversation, I thought we'll start at the top with just an overview of the opportunity, some of the thematic trends that are present today that make this something investable.
And then we can get into the case studies later in the conversation, get more into the weeds.
But maybe just to start, how would you frame the opportunity set, what makes it investable?
And then we could take it from there.
So in Japan, as you may have heard, Japan is changing in a lot of fronts.
At the base of it, the Japanese equity market is extremely cheap.
So if you work in equities, one metrics you could look at is price to book.
At the start of the year, roughly 40 % of the market was trading at, say, 40 % of the listed companies in Japan.
There's roughly about 3 ,500.
It was trading price to book ratio below 1 .0.
And then if you worked in credit, maybe EV to EBITDA is more familiar.
But roughly, again, 45 % to 50 % of the companies traded in Japan trade below six times EV to EBITDA.
So from any valuation metric, the Japanese market is cheap.
But you consistently hear Japan is a value trap.
It's very difficult to extract value in Japan.
It's very difficult.
The market might move out because of urbanomics.
It might be a one -time thing, but not maybe persistent.
But I think in the market today, the combination of cheap valuations and the government really pushing their agenda in improving the market, I think, has compelling opportunities set for anyone that has some interest in Japanese equities.
The undervalued point definitely stands out.
And the value trap theme, I think, has been in place for a long period of time, for as long as I can remember hearing about Japanese equities.
That's been a categorization that's been attached to them.
One of the dynamics that stands out, and you can share a bit more just about the cultural dynamics here as well, is there's substantial cash on the balance sheets.
When I think of the US, I do tend to think of more leverage, more risk, more willingness to be creative with financial engineering, whatever it might be.
And in Japan, I am saying this very much far away from the cheap seats, but it feels like a much more conservative culture, much more cash on the balance sheets.
So can you talk a little bit about those dynamics, how much that plays into the valuation gap in terms of where it would trade on book value?
I think that could play a role there, but a little bit about the history there and whether you're seeing changes in that conservatism as it relates to management and capital allocation.
So in Japan, Japan has historically been in a deflationary environment.
So we've had no inflation for maybe 20 years, 25 years.
So it was easier for the companies to actually stash the cash away on the balance sheet than actually spend in the form of CapEx.
Because if there's no growth perspective in a deflationary environment, there's no point in making any aggressive capital expenditure.
So as a result, Japan through the 20 years of deflationary environment has stacked up so much cash on the balance sheet, which makes Japanese companies look cheaper, even compared to say five years ago, 10 years ago, 20 years ago, even when Nikkei is trading at say, 20 to 25 year highs.
Japanese companies because of the deflationary environment, they're conservative.
But I think above all, after working in Japan for three years and having spent my entire career in say US brokerage, is that the understanding or the amount of financial literacy of Japanese management is extremely poor.
Previous to the TSE reform, which we can jump into later, Japanese company management, well, first of all, they have no incentive to look at the share price because they don't receive shares in the form of compensation.
But in addition to that, they don't understand, optimizing the balance sheet.
So in the US, every company optimizes the balance sheet, minimize the equity component so you can increase return on equity.
And that's used through leverage.
Japan is the opposite to that.
There is no leverage in the system, despite the fact that rates in Japan trades on the short end at zero to negative rates.
And even when say 10 year JGV is trading at say 1 % today, at the start of the year, obviously it was trading at 30, 40 basis points.
But because of the deflation environment and because of the lack of incentives to do any financial engineering, the Japanese companies typically are under optimized in terms of its balance sheet.
There is a lot of cash on the balance sheet.
There's a lot of cross shareholdings on the balance sheet, which we can talk about later.
And as a result, return on equity, ROE, is extremely low for a lot of these companies.
And when return on equity is low, the stock price is also low.
Yeah, really attaches to that price to book valuation gap that you were mentioning earlier as well.
Yeah, so there's a lot of things that you can do as an activist, or there's a lot of things that you can ask for, especially with Japanese company management.
And first and foremost, because there's so much cash, there's a lot of opportunities to improve the balance sheet.
And you can only improve the balance sheet in a few ways.
If you have so much equity on the balance sheet, you can maybe spend.
So spend more on factories, especially try to spend more on growth CapEx.
But if there's not that opportunity, then there's only two other options, buying back stock, or increasing the dividends.
So improving the capital allocation of the company at the market today.
You mentioned the management teams are not incentivized because of lack of equity compensation, which is a really interesting point that you're making there.
Can you talk through the history of that dynamic?
It is so common now in the US and to the point where it's probably an overused phrase that incentives are everything, but that would really seem to tie things together here.
Is that historically always been part of the culture where equity is not granted?
Where does the equity sit?
Is it still the founders and the founding families that owned the majority of the equity and anything else that comes into play, whether there's a shift happening or not?
So if you eliminate the true global Japanese companies, so if you eliminate, you can think about Sony, SoftBank, Toyota.
So for those companies, because they have to hire global talent, the compensation structure is much more global.
But for any other Japanese company that is not as global as the companies that you often hear about, most of the company management, unless it's a founding family, have practically no equity.
So I've seen listed companies, maybe 200 million market cap to say 2 billion, 3 billion, a CEO could own anywhere between say $50 ,000 in equity in that company to maybe $500 ,000.
In the form of compensation, equity, comp has historically not been a favorable form of comp because of tax reasons.
That's finally changed in the last few years.
But I think the conservative culture, the lack of management caring about the equity price, and because of the tax schemes, I think management didn't really want equity compensation.
So it's really surprising.
Sometimes I look at some of these CEOs and they own PA, personal trading worth of stock.
And we often tell them, you can own a little bit more than what you own.
So we often do shareholder proposals so that we try to give more equity to management.
It seems like it would tie into maybe the lack of dividends and repurchases as well, given those are directly going to shareholders.
And if you're not a large shareholder, as a management member, I could see why you might not push for that.
The thing you referenced earlier was this corporate governance reform that's happening.
Can you walk through the overview of that in terms of what's going on in Japan with corporate governance?
So corporate governance reform really kicked off in 2015.
So that basically laid the foundation, including trying to have more say independent directors.
So now TSE, Tokyo Stock Exchange, it started by asking for one independent director.
Now they ask for a third.
So that compares to the US where if you want to be a listed company in the US, you have to have majority independent directors.
So corporate governance reform has been improving over the years.
But now we think it's accelerating.
We think it's accelerating because the Japanese government through GPIF and Bank of Japan, BOJ, now earned say 13 % of the total Japanese market.
So as a result, equity of the total Japanese equity market.
So as a result, they're more incentivized to make continuous improvements.
And Japan historically lacked that governance.
And because of that, we've had really poor cases, whether it's say Olympus, where they did fraudulent accounting, or whether it's Toshiba, where they lost billions of dollars through fraudulent accounting and also underwriting a bad deal like Westinghouse.
So that's continuously improving, but it's still a work in progress.
Corporate governance reform is one thing, but I think what's really changing the market is the TSE reform.
So TSE reform comes in a two step process.
The first step came in a couple years ago, where TSE changed from section one, section two listing to say we now have prime and standard.
So within that process, what the TSE did was that if it finally decided that they have too many inefficient companies that don't trade effectively, they basically put a structure where they can eliminate companies that basically, A, don't trade.
So if it trades less than say $200 ,000 market cap, it can be delisted.
And if there's a lack of flow, then that can be delisted as well.
So that was the first step of the TSE reform.
It's basically based on size, so market cap, and then liquidity volume that's trading.
Those are the two measures that make sense.
The second step of the TSE reform is what's called the TSE request.
And the TSE request is basically the TSE becoming Japan's number one activist.
And they've requested all companies on the TSE to think about return on equity, return on invested capital, the price double ratio, PBR, and weighted average cost of capital, whack.
This is the TSE request.
So historically, when you engage with Japanese company management, they would often talk to you about the mid -term plan, how they think about increasing revenue, how they think about improving margins.
But if you ask Japanese company management, what do you think about the stock price?
You often get the answer, stock price is not part of my mandate, period.
They say it's supply and demand of the market.
So with TSE reform and with the Turkish stock exchange, asking every lists company to do a self analysis on return on equity, return on invested capital, price to book, we can finally have a common ground in talking with Japanese company management about its stock price and maybe steps in how they can improve
the stock price. It's so different from when I joined the company three years ago.
It's very, very interesting to hear that.
I feel like since I came into the market, one of the first things I feel I learned about the stock market, even as a teenager, was CEOs have this fiduciary duty to enhance shareholder value.
And that is certainly a US thing which can be taken to the extreme.
But it's so interesting to hear how different it is versus what's happening in Japan.
Talking about how that shift or adjustment in views is happening, can you talk a little bit about what's driving the willingness to change?
And even just generally, you had the distress background in the US, which meant you can have contentious conversations with many different parties involved in a US distressed environment.
That oftentimes is the case in activism as well.
What is it like in Japan coming in with proposals, reform proposals, whatever it might be?
So I think Japanese companies are different to US companies in two ways.
The first way is that you can ignore shareholders.
You can absolutely ignore shareholders if they wanted to.
Some US companies do that as well, but I hear you.
Maybe it's a little more common over there.
But it's different in the sense that in Japan, historically, Japanese companies have been protected by cross -share holdings.
So cross -share holdings basically means that one company, one listed company would be also owned by another listed company.
So Toyota might be owned by another, say, Toyota Industries, or maybe Stanley Electric, or maybe any one of their vendors.
Does this extend beyond the trading houses where you have these conglomerates and so many different things that may or may not be related?
You're suggesting it goes beyond that, where it can just be independent businesses, but cross ownership amongst themselves?
So any company where price of book ratio trades below, say, 1 .0, after doing extensive research, I think most of these companies have, say, 40 % to 50 % cross -share holdings.
So cross -share holdings including their vendors, other listed companies, financial institutions, including insurance companies, could be lifers, casualty insurers, and also banks.
So if you have so much of the, say, cross -share holders as a block, even if we submit a shareholder proposal, it doesn't really get you that far, because on a proxy, there's 40 % to 50 % against votes already before you do anything.
So that's the first step.
As a minority shareholder in Japan, it is so much easier to be ignored than US companies because of the fact that there's a lot of cross -share holdings.
This cross -share holdings is going down, and we can talk about that later, but it's a big issue, and it's also a big reason why Japanese equities is cheap.
The second part is that historically, there is no such thing as hostile bids in Japan.
So it was frowned upon.
Not only was it frowned upon, but Japanese banks would not lend.
They would not provide financing to a hostile bid.
So without any financing, you can't do an aggressive leverage buyout.
Private equity could do none of that.
Because historically in Japan, if you can't do an aggressive bid against a publicly traded market, there is no such thing as market for control, which is not what the US market is today.
Japan today is basically what the US market was in the 1980s, but now the Japanese government has changed what's called the M &A guideline, and that changed last summer, and now we can actually do hostile takeovers.
These two components, no market for control, and large blocking stakes through cross -share holdings basically made the Japanese companies cheap.
As a result, as activists, as an engagement fund, even if we submit these shareholder proposals, we're going there knowing that we won't win.
But that's part of the process for us in engaging with companies.
The government changes.
Has that actually played out with now banks are willing to underwrite hostile bids or some other reception in terms of what management or the existing shareholders are willing to listen to?
Sometimes you can hear these announcements, but they never actually trickle down into practice.
But has there been a noticeable change in terms of what's going on?
So previous to the change in M &A guideline last year, maybe there was one hostile TOB per year throughout the whole market.
Already this year, since the M &A guideline was put in place since the summer of last year, there's probably been five to six hostile TOBs.
And we've also seen cases where listed companies are bidding on top of each other, which is being unheard of in Japan, believe it or not.
If someone went to bid for a company in Japan, if you bid for a company, the targeted company, the Targetee, the board of directors will get together and they will come up with an opinion, whether they endorse or not endorse the takeover bid or not.
And if it doesn't receive the blessing from the board of directors, then most tender offer bids, no matter how good the price is, wouldn't go through because it goes back to the cross shareholders, which they could own 40 to 50 % of the company.
There was a case I think last year where a supermarket chain was bidding for another supermarket chain.
So the initial bid was 1400 yen and the bid that came over was 2200 yen.
So substantial premium to the initial bidder, but that didn't go through because they made some rubbish excuse about there's no synergies or whatever.
But that's finally going to change in Japan.
Very interesting compared to the US where I think you have many management teams where there's one lifeboat left on the Titanic, they would be taking that and leaving their parents and their children behind.
So to see the disparity just in terms of self -interests and what's going on, it's quite noticeable.
As it relates to the activism side of things, when you are looking for potential engagements, is this where the small caps really come into play?
Is there less cross ownership there?
Is there more opportunity to actually have an impact?
What's the dynamic there in your ability to actually have a successful outcome with all these changes happening?
So the small to mid cap in Japan, market capitalists than say billion is probably where companies trade the cheapest.
So you can find companies trading at two to four times, EV to EBITDA.
And there's probably about maybe 30 companies that actually trade at negative enterprise value because the companies hold so much cash.
So the small cap opportunity, small to mid cap opportunity set is extremely compelling.
First of all, from a valuation perspective, and second of all, the Tokyo Stock Exchange wants to eliminate these companies that basically don't trade.
So they want to consolidate the market.
And that's why they came up with the newer M &A guidelines.
So the new M &A guidelines is interesting because previous to the M &A guidelines that came out in the summer, if any Japanese company, if management received a bid, external bid, they could look at that bidding letter, read it and just throw it in the bin.
And there was no repercussions.
Zero. But now they have a process.
So the process is if you receive a bid, and if the bid seems real, including maybe financing a letter of intent that the deal would be financed, then they'll have to form an independent committee that would actually consider the bid and actually seek maybe another buyer if they don't see the bid being
good enough. So this is actually quite a big step.
Because again, without mark of control, then it's really easy for you to step into these Japanese company value traps, because you think that they're trading a negative enterprise value.
But if there's 40 to 50 % of crochet holders blocking anything that you tried to do, then it's very easy to lose money on these negative enterprise value companies.
But with M &A guidelines changing, then there is potential that there could be another buyer on the company that maybe you are buying.
So I think that's where it's most interesting.
And previous to that, there are other components, including Japanese financing environment is very attractive compared to the US.
So if you tried to do leverage buyout in the US, you have to pay, what, 10 %?
In Japan, you can finance LBO debt at say 3%.
So the combination of cheap valuation and cheap financing can get you a long way in terms of risk reward.
And as you're thinking about some of the outcomes and the potential best case scenarios, it's a shift in capital allocation is one of the major things.
When you do have an engagement with the management team, assume the board of directors is involved here, if there is a lack of equity ownership, then some of those changes are really not that enticing to the management team.
Issuing more dividends, buying back shares does not really move the needle much in terms of their own lives.
So I assume there's something broader in terms of proposal that will include other things to also entice them.
But what is gaining reception from them?
What is attracting them to listen to your proposals and to make changes based on what you're suggesting?
At Dalton, we basically make or at our firm, we make three proposals at the AGM.
So unlike the US, in the US market, you can only ask for a change of board of directors.
But according to company law in Japan at the AGM, you can actually change the way the company allocates capital.
So you can actually set how much buybacks the company does in that given year.
And you can also set how much dividends the company pays in the AGM.
And that will be voted in the AGM.
So it's quite interesting in Japan, because you can actually make changes in capital allocation through the AGM process, which is very different to the US.
But back to your question, does Japanese company management actually do anything to your proposal?
The short answer is, they will not do anything that you propose, period.
But then you might ask, why are we doing this?
So we've made three proposals.
Some participants call us copy and paste proposals, because we basically make the same proposals to all these companies, or maybe a cookie cutter proposal.
But we have three proposals.
The first proposal is company management to earn more stock.
So we asked Japanese company management to earn more equity through restricted stock, RSU's.
It's actually a good deal for company management, but because it's proposed by shareholders, they would say no to this.
The second thing is majority independent directors.
In the US, it's basically standard.
But in Japan, you might have two to three independent directors out of 10 directors.
Just to give you a start, only say 12 % of companies listed in Japan have majority independent directors.
So there's a long way to go in trying to improve governance.
On the independent directors point, you need those independent directors to take the job seriously.
So how do you go about enacting, how important is it in terms of who's being picked as independent directors?
That's a really good question.
So as independent directors, or any director, including the CEO, they earn a fiduciary duty.
But I think in most cases in Japan, to be honest, I think they are underqualified from the perspective of a shareholder.
And I think it's because in Japan, there is a culture where to become the CEO of a company, you have to work 30, 40 years and basically climb up the corporate ladder to get where you are.
So then you basically got to your seat because you did such a good job in managing internal politics, I think.
And then the first thing you do is you surround yourself with people that listen to what you try to do.
And that would also include independent directors as well.
So independent directors in Japan is often accountants, university professors, lawyers, but you don't see anyone that worked at, say, Bank of America, Morgan Stanley, Goldman Sachs, or any of the brokerage houses.
It's actually quite interesting.
The board consists of people that actually don't understand the equity market.
Also, in Japan, there is a word called hiratori.
And hiratori basically means that you're a first year board member.
Which means your opinion is valued a little bit lower, I'm guessing.
It also basically means that there is hierarchy, even at the board level.
So if you're a hiratori, you're a first year board member, although you have the same amount of votes at the board, you feel like you're a junior analyst at a sell side show, for example.
So that is something that the TSE is actually trying to change as well.
They're trying to really make the board a better place.
But to do that, they have to just increase the amount of independent directors, so that the CEO and the chairman is not surrounded by his friends with people that actually don't understand the equity market.
Yeah, it's interesting to see what type of cultural DNA that you would have to untangle with some of this stuff is just fascinating to me.
But it makes a lot of sense.
Yeah, and I'm actually compelled to do this job because I feel that there needs to be more better governance in Japan.
I touched on this before, but going back to Toshiba.
So Toshiba, they lost $10 billion through fraudulent county and then they lost another $10 billion through Westinghouse.
So combined, they lost about $20 billion.
And in my previous job, when I worked at we bought Westinghouse claims from Toshiba at $0 .30 on the dollar.
So during that process, I saw someone working on the desk getting involved in a very profitable trade.
It was great. But inside, I'm thinking the Japanese institution lost $67 billion because of poor judgment, because some CEO or the Toshiba CEO at the time decided to underwrite an APC contract, engineering, procurement and construction contract that was fixed revenue, floating cost, infinite downside
if something went wrong.
I wasn't there on the Toshiba board, obviously, but I question whether there was appropriate discussions made in making such a horrendous decision.
And for my job, I think today as an activist, and why I'm doing this with passion is because I actually want to eliminate or reduce the amount of Japanese company lose so much money through poor governance and M &A decision making.
Where do the claims recover?
So about both bought most of the claims, and they probably doubled their money in 12 months.
So there's the initial decision and then the unwinding of the decision to where you can feel it on both sides of it.
So you have the proposal of management owning more stock, majority independent directors, and then I cut you off from sharing the third point in the proposals.
Yeah, the third point is changing capital allocation.
So again, in Japanese company law, you can determine the amount of shares to buy back or the dividends paid in that given year through the AGM.
But it's quite interesting.
So even if we propose a 10 % share buyback program, we might only get 20 to max 30 % of support from other shareholders.
So we go in there thinking restricted stock for management to increase alignment of interest is something that all shareholders want.
We go in there thinking majority independent directors, something that all shareholders want.
We go in there thinking huge buyback, that's something where all shareholders want, but in reality, we don't get that much support.
And that's basically because of cross shareholders.
But in Japan, so if you submit an AGM proposal, the company would actually take that AGM proposal, discuss it among themselves within the board.
And then once they make a decision, whether to endorse or not endorse the AGM proposal itself, then they will have to make that opinion public and give other shareholders a reason why they feel compelled to oppose a 10 % buyback.
And the reasoning behind why they don't want to do a share buyback is like someone in grade six not doing their homework.
The reasoning is so BS.
So it's actually very interesting to read.
But we also find that because we make these shareholder proposals public, and because company opinion, and whether to endorse or not endorse the AGM proposal itself is public, then it actually provides more firepower to other minority shareholders as well.
So we go into AGM expecting not to win on a proxy basis, not going in there thinking we're going to win majority.
But we go in there as part of our engagement process and put more pressure on the company to do things where all shareholders basically won.
And we can start to transition into some of the individual cases, because I think it'll bring all this to life.
But the last thing that I wanted to hit on was the outcome of management buyouts, and taking these businesses private.
I think I understand now some of the dynamics here where you are, as a result, getting more management ownership in the business.
But can you talk through how all of this upfront work, these upfront proposals, eventually leads to that, and why that is the optimal outcome, at least for a significant percentage of these businesses, when in the US, you see it from time to time.
I can think of a few instances of MBOs, and then particularly years back, it was way more common, but something that you don't hear as much anymore in the US.
So just curious about the driver of that specifically in the MBOs.
We have a process. So first of all, we submit our shareholder proposals, gauge the willingness of the company, whether they want to do share buybacks or do any of the things that we ask the company to do.
In most cases, the company would not do any of our proposals.
That's fine. But sometimes we proceed and tell the company, well, you're a listed company, but you don't want to give anything back to the shareholders.
Why don't you go private?
Because you don't raise equity capital, what's the point of remaining listed?
It's probably more of a nuisance of having the IR department saying no to everything to what shareholders want.
So we did exactly that to a company called Ihara Science.
It was a small company, market cap, maybe 200 million.
Good business. They make pipes that go into semiconductors, but they do such a good job with absolute efficiency that it was a 25 % EBITDA margin business.
It was trading at the time, maybe three times EBITDA.
So very cheap. We went to 85 -year -old chairman of the company and we told them exactly that.
You do such a good job in managing your business.
Operation is excellent.
Margin is excellent.
But it really seems to us that you don't want to give anything back to your shareholders.
So we basically told them you should just give control back to yourself because you already are in 10 % and to the other employees because they are the blood, sweat and tears of this company.
You don't have to give money back to us if you don't want to, but you shouldn't be listed.
So you should just take yourself private.
I worked in credit for doing Japanese equities.
So I have a pretty good understanding of financing and I have relationships with banks.
So I told them you can actually take this company private at six times EBITDA without you having to put a dime in equity.
Yeah, talk through a bit about that financing because you have the cash on the balance sheet.
Obviously, that plays a role in the market cap and the debt.
These all play a role in the EV, but the enterprise values in Japan look way different in terms of those compositions versus what you have in the U .S.
So I am curious what it looks like from a leverage perspective when this is happening.
So Japanese banks will be willing to leverage buyout or managing buyout debt at 3 % up to six times net debt to EBITDA.
Wow, 3 % up to six times?
Yeah, no problem. I got to move to Japan.
And on top of that, zero equity.
So not this company, but there was another company called Sakaya Ovex where the CEO bought the company $200 million with $500 ,000 of equity.
So the deal structure was the following $200 million deal financed through $180 million of debt from Mizuho bank and another regional bank, $20 million of pref equity from the same lenders.
So Mizuho and the regional bank, and the CEO putting down $500 ,000 U .S.
dollars to buy $200 million company.
I told Mizuho, sign me up.
What did the CEO own in terms of that equity after that transaction?
I'm assuming you're taking out the shareholders.
Is he keeping the substantial percentage of that?
He earned 100 % of the company $500 ,000.
Wow. This is a very interesting dynamic here because in some ways, you're coming off of an extreme where there's barely any leverage.
There's a ton of cash on the balance sheet.
And while it sounds outrageous in some ways to be able to do that, put $500 ,000 in for a $200 million company, and that's the only equity, when you start at such a far extreme, it allows you to go to that other extreme.
You're skipping a few steps in between where maybe you do it slightly more conservatively, but six times EBITDA is not an outrageous number in terms of net leverage.
In the U .S., it's certainly something, maybe not at 3%, but that's just fascinating.
Well, in Japan, just to give you a better picture, major banks and most financial institutions lend an average duration of less than five years at 1%.
So if they can get 200 basis points yield enhancements through LBO debt, it's a home run for them because there's just so much cash lying around.
So financing is basically very cheap.
And that's why management, first of all, they don't really have to put equity down if they don't want to do a management buyout.
And previously, before the M &A guideline, if you actually had endorsements, or if you have the blessing from the board of directors, then no one can really block that deal despite the price.
It goes back to cross -share holdings, no majority independent directors on the board could really push that deal through.
So there is a risk that management could maybe steal the company at six times when you buy these discounted companies.
But I think in today's M &A guideline, where if management tries to buy out a company on the cheap side, there could be someone else that could actually outbid management themselves.
It opens up the market with the change in reform.
Maybe we could bring it into some of the cases, Mitsuboshi belting being one that I would highlight a rubber and plastics business.
Can you just talk generally about what attracted you to this situation?
And whether this was somewhat cookie cutter in terms of the opportunity set that we've just been describing, or if there was anything unique that you would point to here?
So Mitsuboshi belting is a rubber belt company.
They make engine belts.
So engine belts, if you have internal combustion engine, if you open the hood in a car, it's the thing that rotates within the engine.
Matt, I'm sure you have a Tesla, so you probably have no idea what an internal combustion engine is.
Nope. I am a Japanese car guy.
Okay. Perfect. They make them very differently over there.
They make them here.
Perfect. Yeah. So they make engine belts.
Very good business.
It was traded two times EV EBITDA when it was doing 12 to 15 % EBITDA margin.
No CapEx. Good product, because if you actually sell engine belts, the product, the buyer would only change every five years unless there's a major model change.
But replacement parts is basically where they make most of the money.
So effectively, we saw this as a great product, but high margin business, a 15 year product trading at two times EVT EBITDA.
So we're compelled to earn this company.
So we bought 5 % of the company.
And then we proceeded to do a shareholder proposal.
Basically the shareholder proposal that we just discussed, including a 10 % share buyback program, the company said no to our proposal, but four to five weeks later, the company decided to do 100 % dividend payout ratio, which basically meant 220 yen dividend for three years when it was trading at 2000
yen. So basically we became a 10 % dividend stock overnight.
The shares of trade here say 4 ,500 today.
So it was a great trade for us.
But we were actually really surprised because we went to ask for a 10 % buyback program, not a 10 % dividend yield.
So we went back to the companies in Colbert and we asked the management, why did you do something so aggressive?
And the answer to that was, they had actually been thinking about how to improve their return on equity.
They actually wanted to make return on equity 8%.
But they knew that because they run such a good business, that their ROE was going to go down with time.
Because if you don't have that much CapEx, and you have good cash flow, cash flow just sits on the balance sheet if you don't spend it, CapEx or dividends or buybacks.
So your ROE is going to go down every single year, because equity accumulates on the balance sheet.
You have this increase in shareholder equity when it sits there on the balance sheet.
So they basically took our shareholder proposal, and they convinced because this is a 100 year old company, they actually convinced the internal, the old guards essentially, and saying, this is what shareholders want.
And they actually went to check other shareholders whether our idea was a good thing.
And their response was, well, it's actually something what all shareholders want.
And they responded with basically 100 % dividend payout ratio program.
And they really did fix the return on equity, but they also really fixed the stock price.
And that was through change in capital allocation.
That was basically a double in stock price?
Yeah, it was a double in stock price.
Roughly. And one question I didn't ask, in the US, there is this gap in terms of tax treatment on dividends versus buybacks.
So there's generally a push from investors for buybacks over dividends, I think in Europe and certain companies in the US, there's cultural dynamic to dividends and receiving cash on the account.
Is there anything unique in Japan, whether it's tax treatment or general cultural preference for dividends versus buybacks?
If you want to increase the stock price, it's better through increasing the dividends because a lot of these Japanese investors, they're quite sensitive to dividend yield, because they've been living in their interest rate environment for such a long period of time.
If you increase dividends to a 5 % dividend yield, then naturally, the stock price will adjust so that it will become 3 % dividend yield stock.
So there is a preference from retail investors to have dividends, but for institutional investors, we tend to ask for stock buybacks, company might respond with more dividends, but stock buybacks generally don't move the market.
Interesting dynamic.
And you mentioned they turn down your buyback proposal, I think you alluded to before, they have to actually explain why they're turning it down.
Was there anything unique in the response about why they decided to turn that down?
Yeah, they said they turned down the 10 % buyback program because they said our stocks don't trade enough to buy back 10 % in the market.
Okay, that actually feels like a tangible reason that I can give them credit for when it's a low liquidity name that could be a tricky situation, especially if it's telegraphed to the market in the way that has to be there.
So that's an interesting dynamic that I wasn't thinking about with some of these proposals, when you have to put it into writing that this is going to be the capital allocation policy that can move things before you can actually implement the buyback, so interesting.
But in most cases, because it goes back to a lot of cross share holdings, so a lot of Japanese companies, there's such substantial amount of equity owned by say the banks or other financial institutions and other listed companies that they can do this thing called a TOSnet program where they can actually
buy 10 % of the company in the following morning before the stock market opens at a price and all shareholders can tend to that.
So it's not impossible, but they don't even consider that they would just say, you can't do that in the market.
Want to transition to another case here, Ahara Science, which I believe is a Valve producer.
This situation ended differently with a proposed management buyout, as we were discussing before.
So walk us through in a similar fashion, the opportunity set that you saw there in Ahara Science and some of the dynamics that resulted in the MBO playing out.
So Ahara Science is a company where they make valves and pipes that basically go into semiconductor fabs.
And again, this is a very good business, no capex, 25 % EBITDA margin business traded three times EBITDA, or maybe less, maybe two to three times EBT EBITDA when we started buying the company, we accumulated 10 % of the outstanding stock.
This is a case where we again made shareholder proposals, but effectively company management said, no, they don't want to do share buybacks, have more independent directors or anything else.
So we went ahead and met with company management after we own 10 % of the stock.
And we told them, if you want to continue to ignore us and other shareholders, it's fine.
You can do that. But there's really no reason why you should remain listed in the stock market because you don't want to give anything back to shareholders.
So we said to the company, maybe you should take yourselves private.
And we told them we can introduce you to maybe three potential banks that will be willing to lend six times net debt to EBITDA at 3 % interest.
So 85 year old chairman, I think he was interested.
You can't tell with these things, but I think we interested him enough.
And then it's in the public documents when he actually took the company private, but he basically decided the following week to actually have the board consider the Go private deal.
He basically appointed SMBC Nico as financial advisors the following month.
He also got financing the month after and then they launched a management buyout in three months after we made the proposal.
We were actually quite surprised because we're going to make these management buyout proposals thinking maybe they'll do it, maybe not, but no one knows.
So we were actually pleasantly surprised when he did the deal.
We proposed that he should do it at 3000 yen.
He came in bidding 2950.
So it was a deal that really worked for us.
And we actually went in and supported the deal.
So we actually signed a shareholders agreement to actually tend our shares before the tender offer bid closed, which ensured that he would succeed in the management buyout.
The alternative to a tender offer, do you have the opportunity to roll your shares or what would be the alternative versus tendering your shares?
So the shares were trading in 2000 yen at the time, and we are in 10%.
And he bid for almost 3000 yen.
So we had the choice of either buying more and maybe blocking his management buyout deal.
Or it is something that we actually proposed to him three months ago, so actually support him.
And we decided that we would support his deal.
And again, we thought that as part of our proposal, we actually told them, you do such a good job in running your business.
This business does 20 to 25 % EBITDA margin and grows say 10, 15 % every year.
Strong growth, strong margin, no CapEx.
Grading at two to three times EBITDA.
Unbelievable. So we told them you should really give back the keys to yourself and also the blood, sweat, and tears of the company, which is basically an employee's.
And he did exactly that.
We tried to go private with him in the SPC, but it didn't work out.
But there are other deals where we were able to.
Very, very interesting.
I think in this case, as I was reading some of the research and the headlines, it seemed like there was some shareholder pushback on the price and maybe a desire to get more.
It was still below intrinsic value.
Is that something that you commonly see when you're doing these proposals?
If it is a management buyout, that there's some pushback from other shareholders desiring a higher price?
So there was other activists involved as well, which publicly said that the deal should demand a higher price.
There was a chance we can maybe push the company to pay a little bit more, maybe one or two turns of EBITDA.
So maybe not six times, but maybe try to get them to pay seven to eight.
But we stuck to our words and supported him through the price that we actually proposed at.
But it's not often where there's other activists publicly condemning the price.
Maybe there's one in three that would do that.
But with the new M &A guidelines since last summer, there's massive repricing that's going into the market, especially with go private with transactions.
When companies get taken private, we're finally trading at say global comparables, which is say 15 times.
So it's actually quite interesting.
You can maybe buy these companies at four to six times.
And if it's a management buyout, it's maybe six to eight.
And if it's a private equity coming in, because they have so much dry powder, they're really quite desperate to do deals.
And some of these deals trade at 12 to 15, 18 times EBITDA.
So it's very interesting at the moment.
This has been an excellent conversation.
And I love just at the highest of level and then getting into some of these individual cases.
Just to close it out, you alluded to before your boss making this comparison to the 80s in terms of what's going on in the market.
And I will say when you're describing some of these situations where it's trading at two to three times EBITDA, and there's this ability to add leverage at extremely low rates, it often reminds me of when I listen to people telling stories about the 70s and the 80s and the 90s and search funds and PE.
And I think to myself, well, that was then this is now it's completely different.
But maybe not. Maybe there are opportunities that maybe this is it.
Where do you feel like we are in terms of the innings of this, in terms of how much competition there is to implement this strategy and the potential runway to keep going?
Is it still early days?
Is it becoming more and more difficult?
Where do we stand? So I think in terms of valuations, we've seen some rework.
It's actually more difficult to find two times EBITDA companies.
They're trading now say four times EBITDA.
Got a ways to go before it gets to anywhere near the US.
Exactly. So there's been some rework, and that's reflected in the Nikkei index.
So there's been a rework through the two things that we discussed, TSC reform, where it gives more ability for investors to talk about the share price through return on equity, return investments, essentially balance sheet management.
And the second part is market for control.
I personally think that we're in maybe second inning of this market.
And I think that there's a long way to go.
I might have a bias because I lived in New York and I came to Japan three years ago.
So I want this to be my career, not evident in one or two years.
So I'm actually quite fearful, to be honest, that the market doesn't accelerate quicker than I wanted to.
But I do think it's, for me, the right place at the right time.
And considering where the market is, I think that's a lot of opportunities.
And I often compare it to my last job, US Distress, there's probably, I don't know, 200 funds, looking at 10 opportunities, and everyone's talking about the same.
Five of them aren't even really distressed.
Yeah, the high yield paper, but it's the complete opposite in Japan.
It's maybe five guys, there's 100 plus companies where we think it's the cheapest.
But there's still another 300 companies that we can actually do the same thing, just that we don't have the time and capacity.
There's definitely a language barrier, which is maybe a market deterrent.
But we've also seen other activists, whether it's Alia coming in to do SoftBank or Value Act coming in to do maybe 7 -11 or 7 -9.
So you can choose your poison.
We choose to do small to mid cap because we think it makes the most sense.
It's also a function of maybe AUM as well.
But it goes back comparing to the US Distress Market, I think it's half the risk, double the upside.
Excellent. Well, Missumi, this has been a lot of fun, personally.
I find this very, very fascinating from a wide variety of variables.
I appreciate you joining us and sharing the knowledge.
No problem. Happy to chat.
We'll have to do a check in.
Check back in 12 months.
Exactly. Excellent.
Thank you again. All right.
Cheers. Thank you. To find more episodes of Breakdowns ranging from Costco to Visa to Moderna or to sign up for our weekly summary, check out joincolossus .com.
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