FOOL ON THE HILL
Lessons From Japan?

At the end of this month, Japanese banks for the first time will have to report their stock holdings at market value, rather than purchase value. Trouble is, many of these securities have been worthless for years, and so the banks are currently selling them as quickly as possible now that there is no benefit to holding them. Japan's stock market recently bounced off a 16-year low, and with the U.S. economy stalling and the Nasdaq falling the two are commonly compared. Bill Mann reports that the differences are enormous.

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By Bill Mann (TMF Otter)
March 28, 2001

We Fools enjoy harping on one of the tried and true statistics about investing: that the U.S. market, represented by the S&P 500, has returned, on average, about 11% per year over the last half century. The fact that investing in equities has provided the best long-term generator of wealth for our future has become axiomatic.

In the last year, for the first time in our history, the number of American households invested in common stocks surpassed 50%. Unfortunately, this landmark coincided with one of the worst drops in stock market history -- though this is likely no coincidence). The recent swoon, however, has done little to cloud the big picture: The U.S. stock market offers the opportunity for superior long-term gains.

To this, the average Japanese investor says: "Are you mental?"

Earlier this month, Japan's Nikkei 225 index, its equivalent of the S&P 500, hit 11,819 -- its lowest level in more than 16 years. (The Nikkei remains more than 65% below its all time high, recorded in the first week of 1990.) Imagine this for a second: The stock market in Japan is at the same level that is was when Ronald Reagan was president. Americans are crying in pain due to a falling stock market that has now lasted slightly longer than one year. Expand this out to 16 years, with no sign of recovery.

Clearly, the United States markets are going through some turmoil right now, but consider recent history in Japan: Not only are investors there losing money, but the length of the downdraft means they've lost a significant amount of opportunity cost as their money has essentially done nothing for more than a decade and a half. Take your investing assumptions and extrapolate out to 2017 -- then imagine that when that day rolls around, you've got the same amount of money as you do today.

Fortunately, the majority of Japanese citizens ran long ago from their stock market like scalded dogs. Unfortunately, they have instead chosen to hoard their money in savings accounts offering interest rates that are effectively zero. In other words, the average Japanese has abandoned the concept of compounding to assist him in saving for retirement, choosing instead to put his current earnings in what amounts to a piggy bank. 

The Japanese government has sought to compensate for the lack of individual and corporate investment by instituting huge federal spending projects, all the while lacking the political will to institute needed reforms to "fix" the commercial and banking sectors. For a decade Japanese banks have teetered on the verge of insolvency, the government has taken on a boatload of debt, and individuals are still resistant to spending or investing. Why should they put their money into something that has been such a resounding destructor of wealth?

We often discuss the idea that stock prices will eventually track the performance of their underlying companies. If true, this must mean Japan's companies are, for lack of a more delicate term, big freaking disasters. As it turns out, they are: According to noted economist Martin Wolf, in 1998 the accounting book value for public Japanese companies was 6.5 times higher than their aggregate market values. To translate, the market treats companies in Japan as if they are mass destructors of capital, not creators.

The insularity and limited disclosure requirements upon Japanese companies, meanwhile, shield them from any real accountability to shareholders. Essentially, the lack of disclosure or shareholder protection in Japan -- while allowing the scions of industry to maintain face -- has dissuaded much investment in Japanese markets from foreign or domestic sources.

The yen stops here
Japan's banks have been selling off their stock market assets in advance of the end of the fiscal year, at which time -- for the first time -- their equity holdings will be carried at their market value. This will pull just one of the myriad veils away from Japanese corporate accounting: Investors will see the devastating losses in principal these banks have endured and how many walking-dead companies' stocks the banks have relied upon in order to make their balance sheets seem less like a train wreck. At least one big company, Toyota Motor (NYSE: TM) is using this opportunity to buy back more than $2 billion of its stock from banks, a good move for its shareholders.

Different as night and day
Although pundits like equating the danger to the U.S. economy caused by the pop in the Nasdaq to the pop of the Japanese bubble and its effects on Japan, the reality is that these events are as different as night and day. (For another look at how the U.S. might see Japan's problems, please re-read Tom Jacobs' column of last week.) 

Where Japanese investors have been convinced by past corporate performance and a deflationary environment that they are better off hoarding their money in interest-free vehicles, the U.S. has too little savings among individuals and over-borrowing by companies that now must service these debts. Japan's companies must do something to increase investor confidence in their ability to create capital above the rate of inflation (of which there is none). In the U.S., on the other hand, we're feeling the effects of over-dependence on the stock market to provide us with sufficient gains, forsaking our need to save.

NEC (Nasdaq: NIPNY) has long reported its earnings using U.S. accounting conventions in order to attract investors from outside Japan. Other Japanese companies would be well-served to follow NEC's lead, for while Japanese law allows companies to operate without much accountability to shareholders, it is accountability that attracts foreign investment to the U.S. and European markets. In the U.S. market, it is estimated that more than $1 trillion, or 10%, of the risk capital comes from overseas sources, compared with a minuscule percentage in Japan.

Lack of accountability has allowed Japanese companies to continue to invest their retained earnings -- which represent only 7% of the operating surplus in Japan, as opposed to 33% for U.S. companies -- into low-return investments rather than paying it back to shareholders in the form of a dividend. This is a problem that today exists only for the worst of American companies, many of which have developed the debt problems of their Japanese counterparts yet have continued to provide returns on retained capital.

In fact, the mere danger of this last point, particularly with the capital-intensive telecom industry, is what has caused a fair portion of the current swoon in U.S. equities in the first place. Fortunately, U.S. central bankers and corporate executives have both the tools and the motivation to respond quickly to this risk. Those companies that destroy capital will be cut off by both the equity and the debt markets and will be replaced.

Japan's longtime habit of propping up these companies has gotten it into the crisis it has before it now, but it is simply -- and unfortunately -- too late to let them fail en masse. While there is nothing actually preventing the U.S. from falling into a long, Japan-style recession, our capital markets' tendency toward allowing companies to sink or swim on their own merits, while unforgiving, helps us avoid the greater evil of having to throw good money after bad to prop up companies that need nothing more than to be allowed to die.

Fiat Fool!

Bill Mann, TMFOtter on the Fool Discussion boards

Bill Mann guarantees that his articles will shave two to three strokes off of your game. At the time of publication, Bill owned none of the companies mentioned in this article, though he does own a sweet Elvis bust, which may or may not have been made by NEC. To view his holdings, please visit his profile.