The Japanese government is calling last Friday’s severe earthquake and resulting tsunami the worst disaster to befall the country since the Second World War. Early estimates suggest that at least 10,000 are dead, and perhaps many more. Hundreds of thousands are homeless. Severe damage to nuclear power plants in the worst-affected prefectures, north of Tokyo, has necessitated rolling electricity blackouts in Japan for the first time in a half-century.
This is a terrible human tragedy. But today I’m taking off my hat as a human being and putting on my hat as a portfolio manager to write about what I see as the major investment implications of last week’s event. They are:
1. The yen will have a short-term tendency to rise, as insurance companies liquidate foreign investments and bring money home to pay earthquake-related claims. Both individuals and companies will do the same thing. In the months after the Kobe earthquake of 1995, for example, the Japanese currency rose by about 20% against the dollar. If so, export-oriented firms will struggle some more.
2. Technology-related parts shortages are possible, but I think they’ll be less serious and shorter in duration than commonly expected. Several reasons why:
–In the thirty+ years I’ve analyzed companies it has invariably been the case that the damage to industrial plants due to explosions, wars and natural disasters is initially overestimated–usually by a lot.
–Ingeniously jerry-rigged solutions to production bottlenecks are almost always found.
–Ex autos, Japan isn’t the cutting-edge technology giant it was twenty-five years ago. It’s major IT products are commodity semiconductors, glass for flat panel TVs and monitors, and consumer electronics thingamajigs, like capacitors and connectors.
–The earthquake missed the industrial heartland south of Tokyo, where most of the country’s factories are located.
–Korea, Taiwan and China make adequate substitutes for almost everything (ex autos) that Japan produces. These areas can take up at least part of any slack from Japan. For example, TXN, one of the few international firms announcing significant damage, says it has already found replacement manufacturing capacity for 60% of the output from its Japanese fab in Miho.
3. Electric power may be an issue for some time. The obvious reason is that it will take a while to fabricate and install new nuclear power plants. NIMBY is another issue, especially if damaged reactors begin to release radiation. In addition, I think there are two non-obvious factors at work here as well:
–The main political platform of the post-WWII Socialist Party in Japan was anti-nuclear weapons, based on the damage done at Hiroshima and Nagasaki. After the Cold War ended, the Socialist became the Social Democrats. Their anti-nuclear stance transmuted itself into one against nuclear power plants. The 21st century successor to the Social Democratic Party is the Democratic Party of Japan, which is in power now for the first time since a brief stint (before self-destructing) over twenty years ago. Will the DPJ be as aggressively pro-nuclear as the Liberal Democrats, the other main party, were? I don’t know…but probably not.
–The predominant feeling today is that the half-dozen or so nuclear reactors that aren’t completely stable or that have already failed, have done so because no one planned for a 9.0 magnitude earthquake or a tsunami. I hope that’s right.
But in my experience, Japanese managers are under intense social pressure–in a way I as an American can’t really understand–to produce products that are up to specifications, and delivered on time and on budget. It’s virtually impossible for a manager to endure the shame of letting down his company, his coworkers, his neighbors, the people he went to school with…by telling his boss he can’t do so. That’s true, even if the requirements are completely unreasonable.
A manager may resolve this conflict by building a sub-standard product and asserting that it does indeed meet required specifications. I’ve seen this phenomenon in many Japanese companies, including (unfortunately) one or two that I’ve owned, where apparently no one has checked the manager’s work. Any hint of this practice in the nuclear reactor post-mortems could delay the approval of new nuclear plants.
Update: the LA Times suggests that two separate worker errors at one of the nuclear power plants owned by Tokyo Electric Power have increased the chances of a significant release of radiation into the atmosphere in Japan–escalating the political and stock market crisis there. It now seems to me that the odds of an anti-nuclear backlash have risen significantly.
4. Infrastructure being rebuilt will be state-of-the-art, and very energy-efficient, particularly so if there are delays in adding to electricity-generating capacity.
5. What the private sector rebuilds, and where, is open to question. Individuals will likely rebuild their houses, though perhaps on a more modest scale than they had. But corporations with a freshly signed check in hand may opt to move production overseas, something they might feel constrained from doing under normal circumstances.
early stock market reaction
The Japanese stock market opened on Monday down almost 10% on news of the earthquake/tsunami damage but rallied to close down about 6%. As I’m writing this on Monday night, another reactor explosion has been announced and the TOPIX is down another 4%.
Some people are arguing that this decline represents a buying opportunity. They reason that money policy will be accommodative enough, and that reconstruction spending will give the economy a big enough fiscal boost, to break Japan out of the malaise it has been in for two decades.
I don’t agree. I think that the core Japanese economic problem is its decision to defend the status quo of the 1980s rather than let creative destruction reshape the country to meet current and future needs. The country has chosen to retain a traditional way of life, even if that means no economic growth. While this remains so, I continue to think that Japan is reduced to being a special situations market, not one you need to have general exposure to. Of course, the current downturn is giving you a chance to buy special situation names relatively cheaply.
In New York, COH and TIF both sold off by more than 5% on Monday, on worries about their Japanese businesses. I guess I can’t quarrel with that, given that both stocks are up 50% or so in the past six months. Declines in LVMH or Hermès, which were down on the day by 2.5% and 3.5% respectively, despite the fact that both have arguably more to lose in Japan that either TIF or COH. On the other hand, the Europeans haven’t been the recent market stars that the American firms have.
The main point with any foreign luxury goods firm in Japan, however, is that the market there went ex-growth during the recent recession. Western companies have since switched strategies from expansion to extracting their invested capital as quickly as possible.
If you haven’t done so already, please complete this brief survey: