Japan: Where Capital Goes to Die

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Ah, Japan: land of the rising sun, homeland of the hot dog-eating champions, and capital-sucking vortex.

"Capital-sucking vortex?" That's a wee bit harsh, no?

No, it's really not
Japan is where capital goes to die, and I have the stats to prove it.

Firing up my super-duper stock screener (not sold in stores), I see 2,371 companies with a primary listing on the Tokyo Stock Exchange. That excludes non-Japanese firms that happen to have local listings, like Dow Chemical (NYSE: DOW) and Aflac (NYSE: AFL). Out of all those businesses, how many do you think managed a greater-than -4% return on equity -- a solid but not stunning result -- over each of the years 2005, 2006, and 2007?

Make sure you don't guess too high, or you'll be disqualified. I'll give you a hint: The answer is less than 800.

The price is wrong!
In fact, only 35 firms hit that mark! Add in the 925 companies on the Jasdaq exchange, plus the stragglers listed on other local exchanges, and the number climbs to ... 36. In total, fewer than 1% of Japanese equities pass this simple test of Capital Allocation 101.

Why does return on equity (ROE) matter to Foolish investors? Here's a primer, but the simple fact is that the "E" in ROE is shareholders' money. If management is retaining earnings to reinvest in the business, one of its basic requirements is to continuously generate an attractive return on the owners' investment. There are plenty of "profitable" companies in Japan, but those wealth-withering single-digit returns on equity just don't cut the wasabi.

Return on equity isn't the end-all and be-all of performance yardsticks, but it's a very handy one, especially if you remember that managers can juice this figure by taking on more debt. Note that I didn't limit my Japanese search to a maximum level of indebtedness. Some of the companies that passed the test only did so by leveraging to the hilt.

Do we avoid the archipelago entirely?
After running this sobering screen, I'll definitely refrain from throwing investment dollars at something like the iShares MSCI Japan Index (NYSE: EWJ), no matter how cheap the broad market looks. However, I'm not going to rule out every single Japanese company. After all, I've got three dozen here that are at least worth a look.

Take Komatsu, for example. This equipment heavyweight is the Japanese version of Deere (NYSE: DE). After checking out the numbers, I'm tempted to say that Komatsu is the superior firm.

These two outfits throw off about the same level of revenue, but Komatsu sports slightly fatter margins. In trying to suss out the difference, one statistic really jumped out at me. On its website, Komatsu lists 39,267 employees on a consolidated basis, whereas Deere recently claimed 56,700 full-timers. The resulting revenue-per-employee figure suggests that Komatsu's operations are a good deal more efficient.

I would also note that Komatsu has managed to post good returns on equity without employing nearly as much balance-sheet leverage as Deere.

Another interesting group of firms are the so-called sogo shosha, or general trading companies. Mitsubishi, Mitsui (Nasdaq: MITSY), Itochu, and Marubeni all passed my simple return-on-equity screen.

What do these firms trade, exactly? Well, pretty much everything, from textiles to food products to petroleum. Some of these companies date back centuries; they seem like a natural outgrowth of the nation's limited resource endowment.

I've run across several of these firms in my energy-sector coverage, from Mitsui's profitable Petrobras (NYSE: PBR) partnership to Itochu's dinged deepwater venture. They're interesting businesses, but I find them nearly impossible to analyze. If you're a fan of conglomerates like General Electric (NYSE: GE), then the Japanese trading houses may be right up your alley.

A Foolish final word
I'm still parsing this list of Japanese firms, but here's a preliminary observation. Of the 36 firms, only six have a market capitalization north of $10 billion. In other words, the big boys are blowing it. That should make you even more wary of taking an index-based approach to your Japan exposure, unless you pick up one of the small-cap ETFs.

In Japan, just as we've discovered here at home, the market's best stocks are ignored, obscure, and small.