In assessing China, I think it’s important to distinguish carefully between the course of the mainland Chinese economy and the fortunes of China-related stocks.

the economy

background

The foremost goal of the Beijing government is to keep the ruling Communist Party in power.  This translates into the economic objective of avoiding possible social unrest by keeping employment high and unemployment low.  That’s quite a trick when you’re managing the transition from a rural, agriculture-based society to a more urban and manufacturing-oriented one.

In addition, China dedicated itself to creating a Western-style market-based economy in the late 1970s when it realized the country was too complex for central planning to work.  Again, hard to do when three-quarters of your industrial base was zombie-like state-owned corporations, when being a businessman was a felony and where citizens preferred to bury chuk kam gold trinkets in the back yard rather than use banks.

Complicating the situation further is the fact that high corporate or local/national government officials are Party officials whose chances for personal promotion are directly related to aggressively growing the areas they control, whether doing so makes long-term economic sense or not.

results

At the same time, all the mid-level national economic officials I’ve met–who actually implement policy–have been highly sophisticated, well-trained (mostly from the US or UK), competent and dedicated to creating healthy and balanced growth.

Given the large size of the Chinese economy and the paucity of tools to make economic policy, the best they’ve been able to do is to lurch between two extremes, overheating and stalling (the latter meaning unemployment is rising–a combination of new entrants to the labor force and layoffs)–and gradually lessen the amplitude of the cyclical swings.

where we are now

When the developed world appeared to be coming apart at the seams in 2008, China allowed a particularly strong domestic lurch to the upside.  For the past two years or so, Beijing has been trying to force an economic slowdown to rein in that expansionary impulse.

Policymakers have most recently been signalling their belief that slowdown has gone far enough and it’s time for faster expansion again.

China stocks

By and large, non-citizens can’t buy or sell stocks in the domestic market.  I’m not sure it makes much economic difference whether the local bourses go up or down.

Hong Kong is the natural market where the best and brightest of the mainland list their shares.

Over the past six months, Hong Kong stocks have sold off much more heavily than, say, the S&P 500, in response to worries about the Eurozone and potential global economic slowdown.  Since bottoming in early October, they’ve only rallied back in line with the S&P.  As I see it, so far there’s no anticipation of a better mainland economy this year in Hong Kong stock prices.  Many stocks there look cheap to me.

what to do

Personally, I think it’s important for all but the most risk-averse investors to have some exposure to the Chinese economy.

The most conservative way to do so is to hold companies listed in the US or Europe that have significant businesses in China.  Luxury goods retailers like LVMH, Tiffany or Coach are possibilities.  Casino companies like Wynn and Las Vegas Sands make all their money in Asia.

Discount brokers like Fidelity offer international trading services that allow foreigners to buy stocks in Hong Kong directly and cheaply.  Most investors will likely find it easier not to do research themselves, however, and buy an ETF or an actively managed mutual fund that specializes in Hong Kong or Greater China.

Price action in December and early January is often hard to read because of tax-related selling–losers in December, winners in early January.  Still, I’ve been a bit surprised that Hong Kong stocks haven’t done better than they have, given that the most recent economic news out of China, the EU and the US has virtually all been positive.

I don’t think this means that the positive case for the Chinese economy and for Hong Kong stocks is incorrect.  It may just take more time for negative emotion–from investors located in Europe, I think–to exhaust itself.  I’ve always thought that “buy on weakness” is pretty lame advice.  But it’s probably the right approach in this case.

During the summer, the newly appointed CEO of Olympus, Michael Woodford, followed up on an account in a Japanese magazine of severe financial irregularities at Olympus (TYO: 7733).  He discovered a number of failed M&A transactions involving gigantic payments to obscure companies that disappeared from existence soon after receiving the money.

He was fired for his pains.  He promptly left Japan, saying he feared for his personal safety.  Once in the UK, he disclosed everything to the world financial press.

An independent panel was appointed by the Olympus board of directors to investigate the situation.  The panel determined that Olympus had engaged in speculative “financial engineering (zaitech)“, presumably arranged for it by its investment bankers, starting in the late 1980s.  Like virtually everyone else who did this in Japan, Olympus lost its shirt.  It covered the losses up, again presumably using a service (tobashi) provided by its brokers.  This generated a cycle of progressively larger cover-ups and money-losing speculations that lasted over two decades.  The fake M&A was an attempt to get money to pay off creditors and end the cycle once and for all.

what’s new

Olympus has avoided delisting by providing the Tokyo Stock Exchange with accurate accounting statements by a mid-December deadline.  The “new” Olympus has book value of about a third of what it had previously claimed.

The stock lost about 60% of its value since the Woodford firing.

Two American funds managers appear to have held close to 10% of the company’s stock at the time the scandal broke.

The newest chairman of Olympus appears to me to be proposing that:

–the company’s board needs only a symbolic shakeup (where one or two members make a ritual expression of regret and resign), and

–Olympus should recapitalize by issuing stock to other members of the Fuji group, like Canon or Fuji Film.

my thoughts

Olympus is a typical Japanese technology-related company.  It’s torn between the need for constant innovation to keep up in  an increasingly complex and rapidly evolving world and its presence in a social/cultural environment where preserving the status quo is acknowledged as perhaps the highest goal.

Current management seems to be in the process of arranging a “traditional” solution to Olympus’s problems–one that doesn’t probe too deeply and where a new corporate direction launched by change of management is completely out of the question.  It sounds like other Fuji companies are willing to help this happen.

In other words, business as usual in Japan.

My guess is that this is the most likely outcome.  After all, except for what I think of as counter-culture companies run by younger Japanese, this has been standard operating procedure when companies get into trouble for the twenty-five years I’ve been watching the Japanese stock market.

Any signs that this time will be different should be studied carefully for potential to be a bellwether of change. (I’m not optimistic, though.)

I’m most curious about the foreign professional investors who  held large positions in Olympus.  Didn’t they know anything about Japan?  Did they really think that buying companies with low price to book or price to cash flow ratios would bring the same kind of success it does in the US?  Didn’t they see that this approach has failed time after time in Japan?

Apparently not.

I believe the qualitative story

To recap:  The qualitative argument the consultant makes starts with the idea (which I think is correct) that stock markets in almost all emerging nations are hazardous to investors’ wealth.  The companies listed may be the politically connected dregs of the local economy, not the stars.  Financial statements may not be reliable.  Corporate management may not have shareholder welfare as a primary goal.  The regulatory playing field is probably heavily tilted toward insiders.  It’s ugly out there.

Firms may not find it easy to raise money under these conditions.  Foreigners are unlikely to help, either, since in the developed world an aging investor base isn’t likely to have risk assets to spare.

Therefore, emerging economies will only fill the potential we all believe they have if their governments make substantial changes in their stock markets.  Otherwise, companies in these countries will come up $12.3 trillion short of their equity funding needs by 2020.

This is a problem, not only for these countries but also for any investors who have bought emerging markets index funds or ETFs banking on emerging economies to flower fully.

I agree.

…the quantitative?

It’s the quantitative stuff that I have problems with.  Specifically,

1.  starting with a quibble…

McKinsey projects that global financial assets will be worth $371 trillion in 2020.  It’s not $370 trillion.  It isn’t $372 trillion, either.  The precision of the figures implies that McKinsey can forecast the state of financial markets almost a decade ahead with an accuracy of +/- .25%.  All the empirical evidence is that no one can forecast with this degree of accuracy even one year ahead.  Stock market participants know the limitations of forecasts, because the real world beats them over the head with their misses every day.  Why isn’t McKinsey aware?

…or maybe not

The “equity gap” McKinsey forecasts amounts to $12.3 trillion (not $12.2 trillion…).  That’s 3.3% of projected financial assets in 2020.  How much of the “gap” would remain if McKinsey didn’t stick with overly precise point forecasts?

2. using local GDP to forecast corporate profits

McKinsey assumes that the profits of publicly listed companies in a given country will rise in line with nominal GDP.  Three reasons why I think this is a mistake:

–many parts of the local economy may not be represented in the stock market.  On Wall Street, for example, autos, housing and real estate–all pretty sick sectors at the moment–have virtually no stock market representation

–in the US and UK, at least, publicly listed firms tend to represent the best and the brightest of the local economy.  Private equity and trade acquisitions winnow the elderly and the infirm from the herd.

–in the developed world, foreign sales and profits make up a considerable portion of the stock market’s total.  In the UK, for instance, maybe 75% of the earnings of the FTSE 100 come from outside that country–explaining its dominant stock market size in the EU, despite not being the largest economy.  In the US, the best guess of S&P is that foreign earnings make up about half the total.  The figure is rising.

My conclusion(s):  the method McKinsey uses will understate corporate profits, and thereby the size of future equity market.  This is not new news.  Wall Street has been actively discussing the increasingly non-US nature of S&P profits for the past two decades.  In other markets, it’s been a key subject for much longer.

3.  we live in a post-internet world

It isn’t just the internet, either.  Other key factors as well have conspired over the past couple of decades to substantially decrease the capital intensity of business. 

–development of sophisticated supply chain control software, combined with internet communication and the rise of specialized logistics/transport firms, means everyone holds smaller inventories

–for many industries, today’s capital spending = servers and software, not machine tools and buildings.  The rise of technology rental, software-as-a-service, for example, means decreasing capital intensity

–e-commerce has vastly decreased the requirement for repeated expensive advertising campaigns and ownership of physical retail outlets as tools to make potential customers aware of a product or service. 

–the separation of design and manufacture that the internet allows means that companies use less capital intensive processes to make products in low labor-cost countries

in developing economies, too

There’s no doubt that emerging nations will still need a lot of development in capital intensive areas, like power generation, chemicals, water, roads, ports and related infrastructure.  But there’s no reason to believe that these economies won’t also avail themselves of the same capital-saving devices in other areas that developed nations now do.  For instance, eastern China is already outsourcing some manufacturing operations to lower labor-cost countries.

My point:  in projecting the future capital needs of publicly trade firms the McKinsey assumption that companies will be as capital intensive as they have been in the past is the simplest one.   I don’t think it’s right, though.  In fact, the more I think about it, the odder it sounds.

A final thought on this subject:  as prices change, behavior adjusts.  If the cost of equity capital were to begin to rise, companies will rethink their spending plans and economize/substitute.

Asian stock markets sold off on the news.  That was on the worry, I think, that the North Korean government would stage a military provocation to “demonstrate” Kim Jong-il’s leadership ability–as it did when he was being introduced as heir.

investment implications

Other than in national intelligence agencies (which don’t share their information), the outside world knows very little about North Korea.  It’s an unruly client state of China, formed artificially at the end of the Korean War–separation along social and cultural lines would have been east vs. west.  It’s very poor.  It has big armed forces, but little industry.  It has nuclear weapons–and missiles capable of delivering them at least as far as Tokyo.

I think the most likely outcome from the leadership transition–temporary saber-rattling aside–is continuation of the status quo.

It is possible, however, that the absence of a dictator fully in control of the country will prompt a push in North Korea for reunification with South Korea.  This is something that both sides have talked about, off and on, for twenty years.  And there would be some pressure in the South for reuniting communities that have been apart for half a century.  Having seen the decade of economic stagnation that followed the reunification of the former East and West Germanies, however, I think Seoul would regard this as at best a mixed blessing, or as the best of a number of unfavorable choices.

This is the only outcome from Kim Jong-il’s death that I can see as having major investment implications.

I’ve always found South Korea a difficult place to invest in.  Lots of local quirks, including sprawling family-owned conglomerates (chaebols) with opaque operating procedures, and unpredictable (to me, anyway) intrusions of government into company operations.  So I’ve only occasionally owned companies like Samsung Electronics or Hyundai Motor, despite the excellence of their products.

I don’t think reunification would change government or corporate behavior at all.  Nevertheless, it would likely spawn enormous construction projects in the North, as well as the shifting of labor-intensive industrial production away from the South and the expansion of low-end Southern retail concepts there.  These moves could generate huge profits for the companies involved and would last a long time.

This prospect would most likely merit making the research effort to identify the beneficiaries.  In fact, the economic positives of reconstruction would probably be so powerful that a less-than-level playing field for foreigners might not matter that much.

I didn’t know until I was reading the Wall Street Journal this morning that Hong Kong had depository receipts (DRs).  But COH just issued one.

Sure enough, checking with the Hong Kong Stock Exchange website, HDRs have been permitted in that market since mid-2008.  Not many takers so far, however.  The HKSE lists Vale, the Brazilian iron ore company, with two HDRs; SBI, a Japanese internet-based financial, has one.  And now there’s COH (6388 is the Hong Kong ticker symbol).

what they are

The basic idea behind a DR is to provide a simple way for a domestic investor to buy a foreign stock without having to set up a brokerage account in the foreign country or to deal with foreign exchange, either in buying and selling or in receiving dividends.

The buyer doesn’t actually get a share of stock, however.  Instead, he gets an IOU (the receipt) from some financial entity, usually a bank, that holds the real shares in a depository account.  The bank handles all the necessary administrative details, like foreign exchange and the sometimes messy business of meeting the foreign country’s securities and tax regulations.

ADRs

The company whose stock underlies the DR may use the DR issuance to raise capital in a new market, where investors may well pay a higher multiple for shares than would be possible in the home market.  In the biggest DR market, the US, I’ve found this often the case–and regard it as a bad sign.  In my experience, seeing a mature company launch an ADR means it has lost its allure for more knowledgeable home market investors.  (Another important factor in ADR issuance in particular is that it circumvents the more stringent disclosure and reporting requirements that the SEC has for US-based companies.)

In the COH case, however, the firm has not created 6388 to raise new funds–after all, operations are generating $1 billion in annual net cash.  It has created a DR to raise its public profile in Greater China.

their Achilles heel

The bane of DRs, in my opinion, is low trading volume and potentially Grand Canyon-wide bid-asked spreads.  I’ve found the problem especially acute in cases, like this one, where the operating hours of the home and DR exchanges don’t overlap.  According to the HKSE website, trading in 6388 over the past five days has only totaled about US$11,000.  The bid-asked spread shown is about 2% (my experience in the US is that the spread for a stock like this could be more like 10%).  December is usually a dreary month for investors, so January will probably give a better read on volume.

worth watching

Nevertheless, COH has probably gotten more publicity in China through the HDR listing than it would have been able to buy with the money it spent to create its HDR.  The phenomenon itself it worth watching, as well.   Two reasons:

–we may ultimately reach a tipping point where having a HDR acquires a cachet that exerts a positive influence on the home market security price, and

–pioneers like COH may have a leg up on obtaining an eventual listing on a mainland exchange.

Macau gaming stocks began a late-August swoon when Karen Tang of Deutsche Bank, an influential securities analyst in the Hong Kong market, published a report on the casino stocks there.  In it, she predicted that a sharp and protracted slowdown in spending by high-rollers in the Macau gambling market would soon begin.  According to Reuters, she said that revenue growth would slow to +34% year on year in October 2011, +32% in November and +20% in December. Growth might shrink to as little as +10% during 2012.

her reasoning?

Affluent Chinese were no longer spending on European-made luxury cars.  She and the DB economics department felt that this was the harbinger of a widespread pullback in consumption by the wealthy.  Finally, they thought, the affluent were succumbing to the Beijing government’s attempts to rein in economic growth on the mainland.

does the argument make sense? 

In my opinion, no.   There’s been no sign of falloff in any other area of Chinese luxury spending.  Maybe the new cars were ugly, or the potential buyers had no garage space left.  I’m not saying that Chinese gamblers aren’t going to spend less in Macau in the coming months.  That could happen.  I’m only observing that I don’t think the luxury car situation is evidence in favor of this conclusion.

I think Ms. Tang would have been better off arguing that the Macau casino stocks were fully priced for the best possible outcome and therefore had no near-term upside.  That would mean that they could only go sideways or down–reason enough to take some profit in the sector.

Nevertheless, the Tang report was enough to drive the sector down very sharply in late August and throughout September.  At one point, some stocks had lost close to half their value before beginning to rebound.  …and then the Europe-related selling began.

what does all this mean for us today?

Well, the November Macau gambling market results were posted on the website of the Macau Gaming Inspection and Coordination Bureau on the afternoon of December 1st.  Here they are:

Source: Macau DICJ

As you can see from the bold figures, after being wildly wrong about October growth prospects, Ms. Tang seems to have predicted the November results reasonably accurately.

Is there any significance to the November prediction?  My guess is that there isn’t much meaning for the stock market, even if this turns out to be more than a lucky guess.  For one thing, the stocks are much cheaper today than they were when the original report came out.  For another, Beijing has just publicly signaled that it is reversing its money policy to favor GDP growth.  So stocks should now be beginning to discount a reacceleration of the gambling business in Macau–not a slowdown.

It will be interesting to see how the Hong Kong market evaluates this situation.  My hunch is that the mid-November lows will hold, but that the market will want to see at least the December market results before becoming more bullish.

TIF reported its 3Q11 (ended October 31st) earnings results before the start of New York trading yesterday morning.  For the three months, the company took in revenue of $821.8 million.  It earned $89.7 million, or $.70 per share.  This represents a 52% increase over the $.46 a share the company earned in 3Q10.  The 3Q11 figure handily beat the Wall Street consensus of $.60 a share, even exceeding the most optimistic estimate, which was $.67.

TIF also continues to buy back stock at around the $65-$66 level.

the guidance

TIF says it expects 4Q11 earnings to come in between $1.48-$1.58 per share.  This represents a (mere) 6.3% increase over the $1.44 per share the company posted for 4Q10.  This guidance falls near the bottom of the 4Q Wall Street analysts’ estimate range of $1.51 – $1.69.  The median estimate, which  may be revised down, has been $1.64.

Just for reference, a year ago TIF guided to eps of $1.29 and reported $1.44.  If we adjust management guidance for possible lowballing of the same magnitude, we arrive at a figure around $1.65.  That would be a year on year gain of 15% or so.

the details

3Q11 business was stellar.  By areas:

–the Americas, 47.9% of TIF’s sales (49.7% a year ago), rose by 17% yoy.

–Asia Pacific, 22.6% (19.6%), was up by 44%

–Japan, 18.1% (19.1), rose by 12%

–Europe, 11.4% (11.6%), was up by 19%.

Strength was in high-end merchandise.

Where’s the problem?

In its guidance, TIF alluded to “recent sales weaknesses” it has noticed in Europe (no surprise there–and it’s still a tiny part of TIF’s overall business) and in the eastern US.  In its conference call, the company said the western US remains strong and buying by foreign tourists continues to be a significant positive.  But it has noticed a slowdown in purchases by domestic customers in the Northeast and Mid-Atlantic states.  That’s the reason for its relative caution.

my thoughts

On the surface, the Boston-Washington corridor slowdown seems odd.  The just-released National Retail Federation survey (see my post) highlights the Northeast as an area where holiday spending is surging.  However, I’d already heard the same story as TIF’s from another (privately held) luxury retailer doing business along the East Coast.  I’d attributed that to company-specific problems, but it’s sounding like I’m wrong.

What could be the cause?  …pent-up demand from the recession being satisfied over the past year?  …lower bonuses on Wall Street?  …Newt Gingrich taking a lower spending profile (a joke)?

TIF is still projecting sales in the Americas to be up by 15%-20% yoy in 4Q11, but is now expecting the lion’s share of the sales growth to come from buying by foreign tourists.  This contrasts with the 50-50 split the company has seen in sales growth  between locals and foreigners during recent quarters.

TIF is currently earning at a $4 per share annual rate.  This means it’s now trading at a bit over 15x earnings.  That’s an unusually low multiple by historic standards.  It’s also where the TIF management sees considerable value, as evidenced by its stock buybacks.  In addition, Asia Pacific sales probably amount to about a third of revenues, if we factor in sales to tourists in the US and Europe.  Those sales alone seem to me to be enough to grow the entire company’s profits by at least 10% per year.

On the other hand, if US sales of luxury goods to domestic buyers are beginning to flatten out after an extraordinary burst of buying over the past year–and continue flat for a while–then earnings comparisons for TIF over the next few quarters will likely be lackluster.  Any potential bids from European luxury goods firms (I’ve regarded this possibility as very small, in any event) will likely stay on the shelf until the EU’s economic future is less cloudy.

All in all, I’m content myself to wait before adding to my holding.  If I owned no TIF at all, however, I’d be tempted to buy a small amount now and await further developments.

Today’s ft.com contains a commentary from Lou Jiwei, chairman of the mainland sovereign wealth fund, China Investment Corporation.  In it, Mr. Lou argues that global economic recovery can’t come from developing countries alone.  Developed nations must expand as well.  To help this latter effort along, the CIC is preparing to participate in Western infrastructure projects as  “investor, developer, operator and contractor.”  Projects could be in “energy, water, transport, digital communication, waste disposal…”  The CIC’s first stop will be the UK.

In a companion article, the FT says that a proposed high-speed rail line between London and northern England has caught China’s eye.

Why?

Why do this?  …and why the UK, of all places?  After all, it isn’t that long ago that China was demonizing the UK for invading China in the mid-eighteenth century to force the mainland to accept opium imports from British colony, India.

I can see several reasons for the CIC proposal, aside from the salutory effect infrastructure spending may have on Western economies:

–infrastructure projects can provide higher returns for China’s massive foreign currency holdings than government bonds will.  China is such a super-size investor that liquidity may not be that different,

–successful infrastructure upgrades can buy public goodwill and political influence,

–reversal of the “normal” flow of equity investment funds from developed to developing is a sign of China’s increasing importance in the world economy,

–Chinese industrial and service companies may have a greater chance to win contracts for such projects than they might otherwise,

–the UK is small enough that Chinese spending can have a significant, highly visible impact,

–the UK may be a showpiece.  It could provide entrée into the Eurozone and ultimately to the US,

–the UK is apparently willing to accept Chinese money and not raise spurious “national security” objections to prevent mainland investment.

investment considerations

CIC-backed projects could provide a mild–mostly psychological–boost to the UK.  It’s possible that private investors may be allowed to invest side-by-side with the CIC, as well.

Better transport… alternatives could take business away from direct competitors.  Better rail links, for example, might be bad for commuter airlines or for delivery trucks.

On the other hand, better overall infrastructure support could lure industrial or service businesses from elsewhere in the EU.

So far, however, we don’t have enough information to act on.

“Brain drain” is a term coined in the UK after WWII to describe the outflow of human intellectual/scientific/economic talent from a country.  Motivation for the outflow can sometimes be religious or ethnic persecution in the home country.  More benignly, brain drain is more likely motivated by economic prospects that are perceived to be significantly better away from the home country.  According to Wikipedia, the term may have been initially used to describe the movement of British citizens to the US, or to the inflow into the UK of citizens of India.

where is it happening today?

What forms of brain drain can be seen in today’s world?

the Eurozone

–I think we should watch the EU carefully, especially southern Europe.  On the one hand, government finances in Italy, Greece… can’t be fixed by raising taxes.  People will move into other parts of the Eurozone, for one thing,  History also shows that higher tax rates invariably trigger increased tax evasion.  So higher rates can end up generating lower revenue.  (This isn’t just a European phenomenon:  New Jersey has just released an economic study showing the state is suffering a net loss of $150 million in annual tax revenues as a consequence of two income tax rate hikes early in the last decade).

Even though cost-cutting will be the main tool European governments will use to balance heir budgets, the economic stagnation that austerity measures will produce may cause an outflow of intellectual talent from southern Europe to France or Germany, or outside the Eurozone to the UK.

the US

–Anecdotal evidence suggests there’s a budding trend toward emigration from the US to China, because of the latter’s superior economic prospects.  There’s also a movement on the Northeast to create publicly funded schools that emphasize Asian culture and history–and where instruction might be in Mandarin.

–a combination of high taxes, lack of home-grown engineering graduates and immigration restrictions that severely limit the number of Indian and Chinese engineers able to work in the US has meant a continual outflow of technology manufacturing away from the US.

China

–To my mind, the most curious case of potential brain drain is that recently reported by the Wall Street Journal.  It’s the potential outflow of wealthy Chinese from the mainland.  They’re not seeking political or economic freedom, or at least not simply that.  What’s prompting them to consider emigration–overwhelmingly to either the US or Canada–are social concerns, including:

–poor schools

–bad medical treatment

–pollution

in that order.  Also:

–unsafe food (local municipal authorities sometimes offer industrial waste disposal sites for lease as agricultural land), and

–the one-child policy.

investment implications

At this point, these developments are more curiosities than anything else.  But events in southern Europe bear close watching.  That’s the place where emigration has the most potential for economic disruption, in my opinion.

In an earlier post, I’ve written about the events that led up to the firing of Olympus’s newly-appointed CEO Michael Woodford.

On Halloween, according to the Wall Street Journal, long-time Olympus executive Hisashi Mori revealed to replacement CEO Shuichi Takayama–who had been defending Olympus vigorously against Woodford’s accusations–the truth about the situation.

That is, the apparently bizarre investment banking activity Olympus had engaged in was a sham.  The excessive payments, the shell companies, the subsequent writedowns, were all designed to funnel hundreds of millions of dollars out of operations.  The cash was used to cover massive losses run up in speculative portfolio trading.   A small coterie of company insiders had kept them from public view for as much as twenty years through fraudulent accounting.

My immediate reactions?

Two of them:

Wow!   …like a bad novel.

–and–

Wow!  …welcome to Japan.

on further consideration

As to Olympus itself, I think there’s lots more to come.  You don’t need a half-billion dollars to fix inflated balance sheet entries.  Writedowns do that.  This isn’t about paper losses that haven’t been recognized.  It’s about active investment accounts that can’t be closed until debts are paid off.   Who are the lenders?  Was the debt collateralized by, say, Olympus plant and equipment?  How was this all hidden for years?

In general, Olympus illustrates how traditional Japanese companies have one foot–and perhaps both–firmly planted in a samurai-like world that’s governed by a rigid system of rights and obligations among insiders.  In this world, shareholder value has no place.

Companies like this can trade at far below the value of their assets.  But that doesn’t mean they’re cheap.  Nor is it, in my opinion, because investors think the books of such companies are as cooked is Olympus’s seem to be.

I think they trade at prices that make a Western value investor salivate because experienced market participants understand that the company won’t use its assets for the benefit of shareholders.  Managements are happy to destroy the assets, if need be, so they can preserve the jobs and relative status of management and employees.  Outsiders, including holders of the company’s equity, don’t count.

investment implications

One is to avoid these apparently asset-rich companies.

More important, it seems to me there has been a wholesale rejection of this modus operandi by younger Japanese citizens.  The “counter-culture” companies the latter run operate along profit-maximization, shareholder-friendly principles.  They also find their samurai-generation rivals easy pickings.  That’s where I think any investor interested in Japan should look.  Many are worth considering even for those with no need to be in Japan, because they then to be really good companies.