October 10, 2017

Dear Investor:

Famed investor Peter Lynch used to cite the “quiet facts”: the items you would read buried in the back pages, relinquished to a supporting role by the frenzy of breaking news.

Today the world focuses on Trump, North Korea and hurricanes, all of which inhabit the front pages. There is no avoiding that loud reality. But the quiet facts still coexist, lonely and neglected, just waiting for value investors to pay attention.

Recently, Bloomberg wrote about an unobtrusive sea-change that’s occurring in Japan, as banks sell off their cross-shareholdings to raise cash and meet earnings targets. At first blush, this seems worrying: selling off stocks to generate cash looks a lot like selling the fine china to pay the mortgage. But in Japan the banks have often owned shares in the companies that borrow from them, creating a conflict that led to poor lending practices as the banks rolled over bad debts instead of recognizing them as such. This unhelpful cycle led to buckets of non-performing loans and an insidious reluctance to advocate for shareholder rights. As a result, the new selloff in cross-shareholdings has a very welcome byproduct: improved corporate governance.

This turnabout has its roots in the low interest rates that have dogged Japan for years, as chronic deflation and low demand for loans have produced net interest margins as low as 80 basis points. Unable to make much money at their traditional business, banks have sold shares to remain profitable. In the process, cross-shareholdings are diminishing, leading to more diverse ownership, which is a good thing for owners’ rights.

Meanwhile, Japanese stocks (as measured by the DXJ exchange-traded fund), still trade at the incredibly low valuation of 1.3 times book value, even after returning 33% over the past twelve months. By way of contrast, the Dow trades at a frothy 3.3 times book value but has returned 27%.

As corporate governance improves and a more diverse ownership base leads to greater shareholder activism, Japan Inc. will look more and more like a bargain. And that’s a quiet fact.

With best wishes for the coming quarter.