Stephen Givens is a corporate lawyer based in Tokyo.
Hailed as a contrarian bet, Warren Buffett's across-the-board 5% investment in each of Japan's five largest trading companies is a jarring departure from the basic investment principles that have made him famous.
One wonders whether too much cash chasing too few attractive opportunities outside Japan has tested his legendary discipline and seduced him into entering a market he has openly disdained in the past.
Students of Buffett will be familiar with his derisory take on investing in Japanese companies. Noting that he could borrow yen long-term at 1% interest, in order to invest profitably in Japanese companies, he figured, "all I have to do is beat one percent. So far I haven't found anything. The Japanese businesses earn very low returns on equity. If you are in a lousy business, you will get a lousy result even if you buy it cheap."
No question, the five Japanese trading houses -- Mitsubishi Corp., Mitsui & Co., Itochu, Sumitomo Corp., and Marubeni -- like their bank and insurance company cousins, are cheap. With the exception of Itochu, whose market cap is 1.34 times net asset value, the trading companies' price-to-book values are all well south of 1.00. But as Buffett has repeatedly warned bargain-hunting investors, a low price-to-book value is never a sufficient reason to buy.
The real question is whether Japanese companies are good businesses that will sustainably deliver outsized returns on equity in the same way as the iconic names in Buffett's portfolio such as Apple with 69% ROE for the second quarter this year and Coca-Cola on 51%. The most recent annual ROE figures for the five trading companies range from a high of 16.90% for Itochu to a loss-making -11.3% for Marubeni -- overall modest but not spectacular.
Buffett has taken out a 30-year yen-denominated loan of $6 billion, the acquisition cost of his interests in the trading companies, at an effective interest rate of 0.6%. Perhaps, following his earlier logic, he figures that modest ROE is palatable if the underlying cost of capital is so cheap. But the fact remains he used to be disdainful of this investment approach. Nor is this the approach that earned the supercharged returns that made him a legend.
That the trading companies are essentially conglomerates operating in multiple lines of business is another striking departure from Buffett's original principles. In his 2014 letter to Berkshire Hathaway shareholders Buffett wrote, "Conglomerates have a terrible reputation with investors. And they richly deserve it." Following this principle, Buffett's portfolio is loaded with companies that do one thing exceedingly well -- not Jacks-of-all-trades.
Itochu's website proudly announces that it operates in a comprehensive array of business domains, from upstream areas, such as transactions involving raw materials, to downstream domains, such as retail. The domains it covers include textiles, metals and minerals, food, machinery, energy and chemicals, general products, real estate, information technology, and financial services. The other Japanese trading companies are all similarly "diversified."
Conglomerates have fallen out of favor and largely disappeared outside of Japan. Investors prefer to pick their investments a la carte, not an eight-course dinner preselected by the chef. In a highly competitive global environment, it is unlikely one company can maintain a competitive advantage across multiple business domains.
Buffett's aversion -- until now anyway -- to conglomerates is the flip side of his famous moat metaphor: "The most important thing [is] trying to find a business with a wide and long-lasting moat around it... protecting a terrific economic castle with an honest lord in charge of the castle." Apple and Coca-Cola exemplify companies in Buffett's portfolio that have wide and intimidating moats that keep competitors at bay.
The trading companies, by contrast, have no moats to speak of. For one, they all compete against each other on the same playing field using the same playbook. If they have any enduring competitive edge, it is a peculiarly Japanese one -- historical loyalty of their Japanese customers in the same zaibatsu or keiretsu group. And of course, they face constant competition from more focused, single-domain players.
Which raises another puzzling deviation from Buffett's core principles: Why did he allocate his chips across the table, in equal amounts, on all five major trading houses instead of betting on a single winner? Putting investment eggs in multiple baskets obviously hedges risk, but placing equal bets on GM, Ford, and Chrysler is a formula for an average, watered-down return, not the market-beating returns that made Buffett's reputation. By definition, not all five will emerge as winners.
In a world of zero interest rates and massive coordinated money printing by central banks to prop up post-COVID-19 capital markets, Buffett's play on Japan's trading houses may be the best available option short of returning his massive $130 billion cash pile to shareholders. But if so, it is a somber reminder of how much the world has changed since the mid-1960s, when Berkshire Hathaway began racking up average annual gains in excess of 20% for a half-century.
Those who read the investment as a vote of confidence in Japan are mistaken. If anything, it should be a warning of the consequences of socialized monetary policy that allows clever investors like Buffett to buy undervalued Japanese companies at zero interest rates.