How America Is Becoming Japan-Like


No, American stocks haven't seen a bear market spanning decades. Nor have we seen persistent deflation.

But the U.S. equity markets are getting scary, not because valuations are frothy, but because companies are holding too much cash. Way, way too much cash.

What's Japan got to do with it?
Value investors know that when it comes to poor equity returns, Japan is No. 1. Yes, Japanese stocks are up big this year. The WisdomTree Japan Hedged Equity Fund , which removes the effect of currency fluctuation, is up some 36%. But when you look past the recent rise and to the fundamentals, you'll notice that Japanese stocks were cheap for a reason. That reason is their ridiculously low returns on assets and equity.

This chart of World Bank data on Japanese ROEs really does tell a story of a thousand words:

Graph of Japan: Return on equity (%)
Graph of Japan: Return on equity (%)

With the exception of 2006, returns on equity in Japan have not touched double digits in the past 12 years.

You see, Japanese companies suffer from a cultural problem: Shareholders come last.

In an event that is well known in value investing circles, Jim Grant of Grant's Interest Rate Observer took a big position in a Japanese manufacturer. It sold for well under book value -- a price lower than net current assets. In short, the company was worth more dead than alive.

But when Grant went to speak with the management team about the company's cash pile, shareholders were the last concern. The company defended its policy of holding too much cash, citing the company's responsibilities to suppliers and customers. Management never paid out a dime. The company was later sold for -- get this -- a price that implied a negative enterprise value. The buyers bought the company with its own cash and still had money to spare. What a deal!

He later told Barron's about his complete resentment for investing in Japanese stocks:

We invested in Japanese value stocks. We closed it in December of 2010, because we weren't making money, and it was immensely frustrating. Japanese corporate managers, by and large, don't own equity. They have a platonic interest in the stock price. In the absence of a lively market for corporate control, there is no check on management doing nothing.

Why American companies need to do something with their money
People buy stocks for the returns. Over time, ownership of a business tends to be a really good investment. The S&P 500 has historically returned about 10% per year to investors.

But when cash piles up, stock market returns go down.

Japan and its local companies are a perfect example. Look at Nintendo , which holds $8.2 billion in cash on its balance sheet. If it were to pay off all of its short- and long-term obligations tomorrow, it would still have about $5.7 billion in cash to distribute to shareholders. Despite all that cash, Nintendo had a valuation of about $10 billion just one year ago. Today, its shares imply a $16.5 billion valuation.

Even after a big run in its share price, cash makes up one-third of its value.

And that's a problem. Cash doesn't create returns for investors, especially when investors want equity-like returns. Nintendo is basically a Japanese money market account that just so happens to make game consoles and manage the Seattle Mariners on the side.

I'm not singling out Nintendo; it's just a well-known example. In fact, Japanese companies have such a cash problem that a new index was launched in an attempt to make Japanese corporate executives better capital allocators.

Why American stocks aren't all bad
The good news is that American stocks simply suffer from a tax problem. By and large, American companies are holding cash because it's stored overseas. Bringing it back would trigger corporate taxes as high as 35%. A chart from FactSet's latest Cash & Investment Report shows how quickly cash is piling up:

Source: FactSet.

More American companies should do what Apple has done. Apple floated long-dated bonds at paltry interest rates to finance dividends and share repurchases. Its longest bond, which will mature in 2043, yields just 5.03% to maturity. That's practically nothing once you adjust for tax deductible interest and the time bondholders will have to wait to get their capital back. Large public companies can easily finance similar maneuvers, pay very little in interest, and return capital to shareholders.

And that's exactly what they should be doing. But they aren't. There are hundreds of excuses, but the plain and simple reality is that the cash on a company's balance sheet is the shareholders'. The sooner it gets put back into the business, or paid out to shareholders, the faster investors realize a return.

If there's anything we as investors need to do, it's convince public companies to work in shareholders' interests and give cash to its rightful owners. The longer we wait while cash sits idle, the lower our returns become. And while these growing cash piles are diluting our returns, they're also making it easier for companies to justify another billion bucks in the bank.

In 2014, take a stand. Make sure your voice is heard. Call investor relations, dial in to conference calls, and make sure you pick a side in every single proxy vote. Companies can ignore one investor, but they can't ignore all investors. It's time for investors to start getting paid, through dividends, buybacks, or both.

To quote a late-night commercial, "It's my money, and I need it now."

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