Japanese Stocks: The Ultimate Undervalued Investment Opportunity (w/ Andrew McDermott & David Salem)
DAVID SALEM: Hello again, David Salem here. Happy to be back on Real Vision to explore with my good friend Andrew McDermott a question that I find endlessly interesting. Given the freedom that Andrew has enjoyed since setting up his own money management firm 10 years ago, why has he kept his own capital and his clients invested, more or less exclusively in Japanese stocks. Without further ado, let us get right into it with Andrew. Andrew, thank you very much for doing this. ANDREW MCDERMOTT: Great to be here, David. I am excited to have this conversation again. We have been having it off and on for 10 years, and it never gets old. DAVID SALEM: Well, as I noted in my intro, since you left Southeastern and set up your own shop a decade ago, you have kept your own capital and your clients invested more or less exclusively in Japan. To call that a non-consensus contrarian stance would be understatement to say the least.
Here is the question I want to start with. In your considered opinion, what do global investors as a group get most wrong about Japan? ANDREW MCDERMOTT: I would say that as a group, they focus more or perhaps too much on what Japan has done wrong, and not enough on what Japan has done right. To prevent extended monologuing, I will break that up into three little segments or doors, and you can pick which one we are going to go through but the first is really my least favorite, but the one that everyone spends the most time on, which is the macro. I will define that as politics and Central Bank and such. The second, which is slightly more interesting, although I am not a Japanophile by any means. I have left Japan twice in frustration. I have been as frustrated as anybody in some management
meetings. Nevertheless, I think the social element of Japan defined us as the habits that inform business practices. That is another area where we focus too much, or our industry focuses too much on the bad and not enough on the good. Finally, we spend our most time,
the micro, the actual process of selecting Japanese securities relative to other Japanese securities and other options we have around the world. I will let you decide which way we are going to go, but those are I would say the-- our punch line is that Japan is not perfect, but it rewards security analysis at the individual level, primarily, because so few people do it because they get distracted by the negatives on the other side. DAVID SALEM: Well, thank you. Reminds me of the game show where they gave you three doors,
and you got to pick one to go through. Taking note of the fact that I know well from conversations with you that it is a least interest or, frankly, relevance to your portfolio construction to talk about macro. I know with certainty that that is a really keen interest to the Real Vision audience. It is important, too, in the longer term. Let us spend at least a few minutes up front going through that door and talking about the macro backdrop for investing in Japanese stocks. By that, I mean the past, the present and the future,
as you envision it. You can start wherever you want in-- RAOUL PAL: Hi, I’m Raoul Pal. Sorry to interrupt your video - I know it’s a pain in the ass, but look, I want to tell you something important because I can tell that you really want to learn about what’s going in financial markets and understand the global economy in these complicated times. That’s what we do at Real Vision. So this YouTube channel is a small fraction of what we actually do. You should really come over to realvision.com and see the 20 or so videos a week that we produce of this kind of quality of content, the deep analysis and understanding of the world around us.
So, if you click on the link below or go to realvision.com, it costs you $1. I don’t think you can afford to be without it. DAVD SALEM: investing in Japanese stocks. By that, I mean the past, the present and the future, as you envision it. You can start wherever you want in the timeline.
I might encourage you, Andrew, to focus since he has just left the office, and he was a pretty big elephant in the room for many years, to talk about Abe-san and his legacy and how that relates to the big macro picture in Japan. ANDREW MCDERMOTT: Sure. I do not want to understate the importance of the macro. It is critically important to us, but like you, we employ a negative screen whether we are looking at companies or countries or employees, and we are looking for things that disqualify first. For us as US dollar investors looking primarily at preserving the purchasing power of our own capital, not meeting whatever the flavor of the day is out there in the money management universe, our expectations are simply stated, but difficult to achieve. That is a government that more or less provides us with enough room to get ourselves in trouble in terms of security selection, and a currency that more or less provides a stable unit of exchange. We can get in the currency wars, but
our view is that in terms of these macro issues, both in the political and monetary front, Japan is for better or worse, and it has been mostly better, a junior partner of the US. Its choices are constrained in the political realm and the monetary realm, and they have broadly been consistent with what the US is doing. That has gotten a lot harder to support for all the reasons that have been talked about in Real Vision and others as this macro policy in the US has become more and more determined of individual security outcomes. Our experience, both in the past and [?] Abe, has been that the macro leaves room for companies to operate. As an investor, my security selection is not determined by my knowledge of the politics or inside monetary policy. That is why we do not worry about Japan day to day
on the macro level, but when we talk to other people, it is interesting because the negative macro case in Japan is the most dissonant. They are either doing too much or too little in the political or the monetary realm all the time. Their demographics, their depth, their policies towards women, towards minorities, towards foreign competition are endlessly debated. The only thing that is consistent over the last really 20 years is they are always wrong.
That, of course, is the equal and opposite reaction to how things went from roughly the late 1970s through 1989 when they were always right, even though, again, at this individual security level, there was a lot not to like in that period. Our view is that people endlessly debate, the people in our industry endlessly debate the macro, because it gives them an excuse to not do the work of individual security analysis. It also gives you a free pass, because you can never really go back and track the performance of your macro discussions because there is so much evidence on each side. Now, I will say
that there have been some distinct positives over this period, including the Abe period. I have a Tolstoyan view that these political leaders do not dictate what is happening. They surf the wave, and Abe is a great example, because a lot of the so-called Abenomics things were not his policies his first time in power. He quite wisely read the tea leaves of what was already happening in Japan that was broadly good for shareholders, and he made some of those policies his own but this endless debate over how Abe's three arrows and whether they were good enough with it hitting the target, that was a distraction from some much more important points, and I will be brief on these. The first one is about Bank of Japan. I am not a Central Bank specialist, I do not spend a lot of time on it. The math is too hard for me, but I will know that 1989 December 26th, the Bank of Japan raised rates to 4.5%. It is interesting
they looked at inflation of 2.5% and they were frightened by. The US in almost exactly the same situation last year blinked. That decision to raise rates obviously pricked the bubble but in retrospect, it was incredibly important. Imagine the opposite, imagine if they had said, well, we have got to support asset markets, and we got to lower rates and keep the stock market, which at that time represented 44% of global equities, it was trading at stratospheric PEs. You cannot really compare today's PEs to those because you are going to have to consolidate financial statements. There was very little cash flow but stated PE was 60, the real PE was a lot higher. Yet they made the decision that obviously led to a big decline in equity prices that
in some ways, continues today. They let the market fail, but by doing so, they allowed the market to heal over time, and that is a really important part of the narrative that we sometimes miss. On the policy side, we have experienced over the last 20 years, increasing transparency, lower tax rates, a move toward liberalized free trade. I would
say that Abe's most important contributions on that have been his leadership and the TPP, and other multinational areas where Japan had always been viewed as an outlier and a barrier builder, when today, they are one of the foremost leaders in forging a free trade area. They were early in identifying China as both an enormous market opportunity but also a potential security threat. I think Abe has been a real leader there. Then finally, very quietly, and most importantly, they have managed a change in social fabric that has been very difficult to-- and we will talk about this more in point in the second area, but from a government policy, they have had to deal with these demographics, they have to deal with all this decline in economic growth. They have managed through immigration policies, through tourism policies, through infrastructure developments to really shift the economy to accommodate those changes in a way that has not been nearly as disruptive as people thought. All of that has created this
opportunity for companies to fix themselves. DAVID SALEM: Andrew, as a segue to that, you just complimented Abe for his leadership on certain issues, and I happen to agree. I also believe and I think you agree, too, but I want you to speak to the issue that their ginormous pension fund, GPIF, the Government Pension Investment Fund, has been a real leader, and I do not mean just recently with its emphasis on stewardship, but really going back 20 years or so to when [?] ran the fund and more recently, we have had Mizuno but I know you have some views about the intersection and the interrelationship between GPIF, the Japanese stock market, BOJ and its investments in stocks, and the larger topic is your active versus passive management. Take us down that road a little bit, because I think your views on that are quite unconventional and really interesting. ANDREW MCDERMOTT: Well, I am glad you reminded me of that. That is something
that I wanted to talk about, because Japan gives us a preview in 1989 of what a totally passive market looks like. Because at that time, about 40% of shares were cross-held, meaning that either Japanese financial institutions or corporates held shares in their own customers and people view this as a distinctive characteristic of Japanese capitalism. It is really not. It was a recent development in the middle of the Japanese economic boom. If you want to see a vivid depiction of how ruthless capitalism was in Japan, I recommend the immediate period after the war ended, I recommend Kurosawa's film Heaven and Earth, it is all about a hostile takeover, and so on and happened the 1950s. It could not be more real. You had the cross-holdings. Then you had within the pension and institutional investment industry in Japan, you have complete regulatory capture by the top three broker, something that persists to today, and I think it has been really a debilitating feature of the Japanese market. It is ironic because the people running those companies claim to be the most enlightened in a Western business school sense.
Yet, there is no equivalent of Scottish widows or even Allianz or any of the professional investment managers there are in Japan. If you run the pension plan at a company, you are typically on a rotation through the finance department. You are going to spend three years there. You are going to be judged versus the index. The broker is going to take you out a lot for dinner and you do not have a long term track record to worry about. Then finally, foreign investors, both in the late 1980s when, much like today, you any pretense of real financial analysis have been thrown out the window, and the only people still can-- or they spent a lot of time justifying why Japanese banks were six times books, but nobody believed it. It was the ultimate flow over fundamental
market, and as that even as we go today, foreign investors continue to be the most active members in the Japanese market traders, but that generally is part of a macro trade in which equities are viewed as an instrument that you trade against currencies, or GDP, or whatever the macro theme is. You have this situation where-- it does not mean the capital was not allocated and the prices were not found, it was just the managements had no oversight. That I think, had a big reason, it was a main major reason that capital allocation became so out of hand for so long at these larger companies. The person who really changed that was not an activist shareholder coming in from the outside, it was not private equity, it was not a bureaucrat, or at least a politician, it was [?]-san with the GPIF, which is a government pension fund. They confronted the reality that they were going to have to actually
sooner or later pay these pensions in real money and without Japanese companies earning better returns, they were not going to be able to meet their liabilities. They did a couple things. First of all, they adjusted the liability side by basically cutting benefits for everyone. Second, they professionalize the management of these pension plans, first, the part that the government held directly, and second, the part that companies had managed on behalf of the government for many years so taking that gigantic pool of capital in.
They then said about putting some very broad active management goals in place, and those consisted of first, setting a minimum bar for return on equity and profitability. Second, improving proxy voting, which had really not happened for most institutional investors in Japan. Third, insisting on some basic governance reforms, outside directors, a little more conflict of interest, disclosure. That really set the framework for what had already been going on at the smaller companies, which was just basically a little more oversight of managements. What we experienced early on was the Japanese companies that were not protected by this web of cross holdings and that were run by owner-operators who maintained big shareholdings in the company, they had never fallen off the wagon. They acted pretty intelligently all the way through and what [?] decisions and policies did is
they really broaden the basket of securities that were acting that way. The most important trend in Japan governance has not been the three arrows but rather the gradual unwinding of these shareholdings so that today, we are now in a position where most Japanese managements are accountable to shareholders, who are exclusively interested in the performance of the share, not in some other non-economic variable. That, to me, is a very important counterweight to a lot of other macro stuff people focus on. DAVID SALEM: That is a great segue over to that. Let us go through that second door then. We will call it the micro or company specific, because whatever the macro backdrop has been, you and your colleagues at Mission Value have shown that you can find individual companies that are capable of generating really pleasing risk adjusted returns. I would be interested, I think the audience would be too,
if you could just talk about some of the specific names, the stocks you are holding right now, and what you see in them that causes you to want to be an investor long term in them. Maybe, Andrew, start with some of the smaller cap names that the audience are probably not familiar with, and then we can segue over and talk about some of the ones that they might have already heard about. ANDREW MCDERMOTT: Sure. I guess when we talk about the securities we pick, maybe I will spend one minute on what we are driven by and then we are driven exclusively by compounding our personal capital. While we are, right now, a hundred percent invested in Japanese
equities, I have two very important partners in our business, Yohei Yamada who is in Japan and John Buford who is in Memphis and Mission Value Partners is really properly considered it is the intersection of the securities that we want to own individually. John worked with me at Southeastern, he was there for 17 years. He was my mentor there. When we started in 2010, he had a portfolio of 20 or so names, and none of them were in Japan. He and I worked collaboratively on a number of ideas in and out of Japan, but when I would share a name with him, if it were McDonald's or Nestle, that was pretty easy for us to do. If it were a company like Sazaby, which I will talk about now, I give them a ticker. He look it up, could not pronounce it, and he would throw up his hand and say, well, look, we just start a fund, and then I will invest in that and I will not have to go do all this stuff. That really was what we are doing, but whether it was McDonald's or Nestle or
any of the 20 or so names that John had or Sazaby or Hitachi or Daiichikosho, we are looking for exactly the same thing. We do not compromise just because it is in Japan. For us, that means that we want a high single digit real return. We want no loss, no chance that we can lose capital, which does not mean that we will not, but we will not go into a situation and say, well, 50% of these things are going to go to zero, but the other 50% are going to be 10 baggers, and so we are going to be fine over time. We will
give up that extra increment of return for the certainty that we are not going to lose money. When we say lose money, and we define that in real terms, so it is not enough for it just to be $100 of cash at 50 cents, that 50 cents has to be growing at least at that high single digit real rate so that we can afford the weight. The things that we like are things that meet that, and we personally can afford to live however we are going to live as long as we do not lose permanent capital. We are not constrained or concerned about the relative performance. We are absolutely concerned about the US dollar performance, and that is what
drives our security selection. It was reflected in our fee relationship with TIFF when we started, and it is what we do. These companies are not selected because of a view of Japan, but rather because they meet that criteria. Perhaps that was too long, a preamble, but without further ado, I will go into a couple if that is what you like. DAVID SALEM: Please do. Great. ANDREW MCDERMOTT: At the time that we started Mission Value, Japan was really on the outs. It was,
you talk to people and they would say, well, it does not matter whether it is cheap, these managements do not get it, and that would be a polite way, you hear a lot of other things too. We would look at a company like Sazaby, which was trading-- Sazaby was a little retailer, a couple 100 million dollar market cap, but management owned a big chunk of it. Because of their accumulated cash holdings or profitability over the decade, before they had a lot of cash, they also own 40% of Starbucks, Japan, which was publicly listed. When we bought the company on our own behalf, and then later on years, it was trading at less than the value of its cash and securities. They were raising their dividend, they are buying back shares, but there was no interest. There was one Wall Street analysts who followed the company,
we would talk to him and say, look, you have got all these assets that are much more valuable than your stock price, what are you going to do about it? They said, we are doing everything we can, but nobody cares between the time that we started our firm and the time when they announced an MBO, where we are headed, we bought 75% of the volume. There just no interest. This was happening at a time when Japan was supposedly the dead money for investors, a group called Steel Partners, which had been an activist and acted on behalf of a lot of endowments. They were blowing up. They were liquidating every Wall Street Journal editorial you read was about how Japanese managements do not care about shareholders, and yet we saw these this contrary example. Here was a group that
had terrific assets. They did what they could and then ultimately, they bought us out at a decent premium. Now, we fought that deal, because three or four years later, SoftBank or Starbucks did exactly what we thought which is buying the rest of that business at a gigantic premium that was a multiple on the market capital of the company when it went public or private, rather. That was an example at a time when we were told that Japanese managements do not care
about shareholders, that the actual managers acted rationally, and it did not matter what the stock market was going to do or doing, these managers acted as you would expect them to do. That is our central insight, which is there is no central insight. Japanese stocks, making allowances for some cultural differences that are true in any market. Pretty much follow the rules that we use everywhere else and that was an asset example. We had another that was more of a, if you use the Graham-Buffett continuum, that is Graham, then we had Daiichikosho, which sells crowcon machines, a terrible business, in a declining demographic, where no one is spending or so it appears. In fact, as that industry have consolidated from
13 players to two, and they had created a duopoly in which they had over 60% share. It was a royalty stream on the music libraries that constitute a karaoke library. More importantly, it was run by an owner-operator who knew he had a great business. Over the period, I have got my little chart, this is a time when Japan was really in the doldrums and yet they grew their earnings, I think a factor of five, they took their net cash and used it to pay dividends and to buy back shares. They invested for 10 years in a growth markets. It turns out old people like to sing so they started growing and selling karaoke machines to nursing homes. This all was happening at a time when Japan was becoming the smallest percentage of global markets on a market cap basis that it did not really ever reach. We had those small examples,
and the portfolio was filled with those, not all of them worked, but enough so that we knew that this generic narrative that Japan is a bad place for shareholders was just not accurate. DAVID SALEM: Do you want to talk about Buffett's recent move into Japan? What that tells you, because you wrote to me when you learned about it that you called it "vintage Buffett". I might ask you, Andrew, to explain what exactly did you mean by that? What is his recent move into Japan tell you about the environment in which he has decided finally to pull the trigger in Japan. I happen to know, and you can tell the audience that you had a dialogue with him way back almost 10 years ago in 2011 about Japan. Tell us that story, and then talk if you would about the particular stocks that he has now acquired on behalf of Berkshire.
ANDREW MCDERMOTT: We started MVP with the assumption that things cannot get any worse in Japan. That is 2010. Then, of course, things got a lot worse very quickly. We had the socalled Olympus scandal, which is the one stock that people know about, and which I was personally deeply involved in both my prior form and at MVP, and then you have the earthquake and the tsunami and the terrible tragedy at Fukushima, so earnings really did get worse. Not permanently, as you know, the day after the-- I was there for the earthquake, but I got back that next weekend. We called you and we put more money in the day the markets open. Well, the other person who
came to Japan at that time in 2000 was Buffett. Berkshire made its first small acquisition and he made very clear that he was interested in doing more in Japan. We wrote him. We wrote them about the two stocks that I just mentioned, Daiichikosho and Sazaby. We said, here, look, here is what we are seeing in Japan. Everyone says it is bad. We noticed you took a trip there. We would like to talk to you about it. Every value investor writes Buffett's tried to bail when they are in trouble, and we have done that in the past and what his genius is, he has his culture of saying, no, again, a negative screen. We did not expect to get a get a reply, and we did not
until one of my colleague came and he said, you are not expecting an email from Warren Buffett are you? I said one I am not expecting one but tell me more. He said, well, I have had one in my junk mail folder for a while and it is probably a joke, and we read it. Mr. Buffett said, well, look, I am interested in Japan, come see me. We did. I have on my wall a message
from him that says that when I go to heaven, St. Peter is going to ask me whether we found a Japanese company for Berkshire, and that is going to be the key whether we get in or not. We went to meet him and got there early, he opened the door, offered us coke. We talked about Japanese equities
for an hour or so. To put that in context, this is when Japan is hitting rock bottom. He said, I have not been there for 45 years, but I am interested now. Let us talk. The reason that what he did was vintage Buffett, and at least in buying this basket of trading companies was that when he met us, he was not interested in public securities in Japan. He was very clear about that. Then he turns around and buys a basket of public securities in Japan, because I would think, and having spoken to him about it, he would say, well, things changed in the same way that we are now, in our portfolio, migrating from the smaller cap companies like Sazaby and Daiichikosho to the larger cap ones like Hitachi, or Mitsubishi Estate, or Mitsui. The list goes on, all of which we can talk about and all of which they were really poster children for bad management in 1989 and have gone through this wrenching transformation and are today, really acting like owners, even though they do not have what we would consider traditional owners that Buffett is a pretty smart guy. He is saying, I think the balance of power-- I think, I think he is saying a couple things. First of all, the balance has shifted, so that I can look
at a broad swath of Japanese securities and be reasonably confident that from top to bottom, these managers are going to, on average, make decent decisions. The second thing he did was buy a basket and say, but I am not going to commit to any one of these because there is nothing different. There is not a lot of value to be added in picking this particular management, what I am trying to do is get broad exposure to Japan, broad exposure to commodities, to get out of the US dollar, and I think to, again, looking at that negative screen to say, I feel okay about the macro situation in Japan, all things considered.
There is so many things we learned from that. First, not to be constrained by what you have said in the past if the facts change on the ground. Second, to go against the tide, obviously. Then third, from our perspective, what is very interesting is that when we look at the companies he bought, and compare them to what we own, our market weighted cap is about $5 billion, it is clear that size is such a constraint for him and for so many. What we are buying is cheaper, and probably, I think profitable. I think he would probably be the first to say that, but it is just not easy to access in a way that when you have got hundreds of billions of dollars of investable assets out to put together. We see it as important not only in what he is doing but what he is not doing.
He is getting money out of the US financials. He is not investing in some of these other markets, most notably China, at least not in a big way. That, to us, speaks to almost an insurance mindset of risk management with a coupon, which is probably the best way to think about what he is doing, and in some ways, what we are doing, too. DAVID SALEM: You mentioned a large cap name that I want to talk a bit about. You and I have talked about it quite a bit over the years. Let me set it up with a little history. The name, of course, is Hitachi. As you and I
have discussed, when I was in business school in the 1980s, Japanese companies, you have already flagged this, do no wrong. Roll the clock forward to when you started your career in the late 1990s, and Jack Welch is named manager the century by Fortune Magazine, and it was I believe in 1999. I actually went back and tried to compute the total return on Hitachi and GE over two time periods, Andrew. One, the entirety of your career, and that is a pretty big gap. That is about 100% gap which is 500 bps, 500 basis points annualized. Then over the shorter time period, about half as long, since you launched Mission Value, Hitachi has outperformed GE total return now in US dollar terms by 140%. That is twice as big a gap and annualized gap of more than 1000 basis points. I cite those stats knowing that you have spent a lot of time on Hitachi,
but you have also thought pretty long and hard about GE, the so-called GE model, and what a comparison of the two. What Hitachi has done over the course of your career and GE, what lessons that teaches us as global investors about Japan, the US and stock selection. With that as a long wind up, why do not you pitch any thoughts you have about those two companies? ANDREW MCDERMOTT: Sure. We looked at GE as hard as we did at Hitachi, there was no-- again, we have no constraints and geographic constraints in terms of what we buy. Because of that, I am not speaking as a Japanophile, we could
have easily bought GE and not bought Hitachi and we did not. It is only when you look seriously at a company and think about putting capital on, do you really pay attention to it? I have obviously been aware of GE forever, but we spent some serious time on GE in the basic case was well, it is a global heavyweight, it is going to earn $2 a share, stock is 22, some of the businesses are underearning, but what is not light. That thesis has been broadly and was broadly embraced by a lot of value investors even at the tail end. By going in and doing the analysis, which really did not take that long, we realized what a house of cards that company was and what a terrible job management, current management, prior management had done, not just for shareholders, but really frankly, for our country. We looked at GE and Hitachi as standalone investments. We could have easily bought GE rather than Hitachi, but obviously we ended up as owners of Hitachi. Doing the work, it opened a window on this very interesting contrast
of how these two companies have dealt with things in the last 10, 15 years. They both came out of the financial crisis with a lot of challenges. I think the way that GE handled those challenges and the way that Hitachi handled those challenges really, unfortunately, tells you a lot about how so much of corporate America has lost its way and on the positive side. I really want to try to stay positive, we have come to the end of the year. I really think Japan has in some ways, a vaccine for what ails us in the US in terms of how capital markets can actually function if left to do their job. Hitachi started with capital, many years of huge losses, they finally raised equity in 2009. They raised-- maybe it is 2010, they raised a third of their capital and new equity and management, Shoyama was replaced by Nakanishi, and he came in and said we have got to get our returns up and these returns have to be real cash returns, and went through an excruciatingly painful process that took margins from 1% to 8%, that internationalized their board of directors, that got rid of their finance business, that exited their power business in ways that were incredibly innovative, not because of engineering so much as looking at doing a series of joint ventures and using their international board to extract themselves from some national projects that the Japanese government really wanted them to do on the shareholder's nickel, including a nuclear plant in England, and a gigantic project in South Africa. You contrast their policies and their decisions at
Hitachi to those of their Japanese pier Toshiba, which literally almost lost the company because of their poor management of these deals. You had this very interesting contrast within Japan of a big company doing the right thing, making hard choices, but doing so with very little fanfare. If you look up Hitachi's management, there are no books written by these guys, there are no CNBC profiles. You contrast that with your, I think, business copartner, Jeffrey Immelt who I will unhesitatingly throw under the bus for just doing the opposite. You can read his book, which he
wrote about how great he is when he started the company, and when he took over I think in 2000. That whole process of managing earnings for the benefit of executives taking credit for everything that goes right and taking no blame for anything that goes wrong, it is really the opposite of what is happening in Japan, where you will have CEOs who, including Hitachi, to take credit, really, for very little that goes right but they take the blame for what goes wrong. The compounding effect of the Hitachi approach within the Japanese ecosystem has been broadly positive up to and including today. They just announced the sale of their Turkish business to an overseas competitor or their international business to an international clients business to a Turkish competitor who has much broader scale than they do. It is very consistent with
their buying and selling over the last 15 years in a sensible cash flow driven way. It is the opposite of financialization, Hitachi got out of its finance business. GE cannot seem-- GE refuses to raise equity in a real way and that has had a major impact on their ability to invest in innovation, to invest in product. In Japan, you have had this opposite, and Hitachi is a great example of it. They got in financial
trouble during the bubble, but they never lost their core manufacturing or technical expertise. It is because the people who were sent to fix the businesses were not financial types, they were engineers. That is true up and down the company, or if it was not a technology company, it was a company like [?], a food company that brought people in who were business managers, not financial types. That is something that I think we can learn a lot from as we try to extricate ourselves from the mess that we are in right now. DAVID SALEM: You just referenced engineers, and I think we can also learn a lot. I know you and I have over the years of studying some of the great engineers we have had on the US corporate team. Let us just do
a little sidebar, because I know you are friends with a remarkable gentleman, who is now 84, Les Vadasz, who was of course, one of the early hires at Intel. Just tell a little tale, if you would not mind, Andrew, about your interactions with Les over the years, how Intel thought about balance sheet management in general and cash in particular, and how that has informed what you and John do with your own portfolio construction. ANDREW MCDERMOTT: Sure, and that is a great segue because as you know, the current CEO of Intel started his career in the finance department at GE and then he ran WebVend, and he went as a finance guy to PayPal and now, he is overseeing what I consider just disastrous decline in US competitiveness. One that Andy Grove, the founder and chairman of Intel, never would have happened, what happened. Les was a fourth employee of Intel, like Andy Grove, he was a refugee from Hungary, he spent his youth as a tank commander in the Hungarian army, and then he ended up in the US, or rather, in Canada. In the darkest days of February and March, I did some analysis on our companies. Our companies as a group had net cash and securities equivalent to two and a half years of SG&A, which was a metric that we looked at very hard because prior to March 23rd, there was real question about whether companies were going to be able to just survive if they did not have the cash on their balance sheet. Our companies had been criticized for having too much. When I did
the analysis, I looked back at Intel because Intel was a company we were considering in purchasing. Their balance sheet had had deteriorated markedly, and I look back at the years that Les and Andy ran Intel, and their balance sheet in Intel always had interestingly, two and a half years of SG&A. They had carried net cash forever. I wrote Les, and I said, look, tell me about how we got at Intel from a position where you always were in a position able to control your destiny to one where you are at serious risk of losing access to capital, because you are doubting the acquisitions you have made. It was so interesting, because what
it showed was that this orthodoxy of optimizing the balance sheet was not the orthodoxy of US companies even during their high growth period in the 1990s. Les was, among other things, he was the head of Intel Capital, so he was very involved in a lot of these startup companies, who is not just a number cruncher and just an engineer. What he said was, we never looked at Intel when we manage our balance sheet at what the market said, we always wanted to have enough to get us through a rainy day and we are focused on growth, not financialization. Andy Grove wrote the book, Only the Paranoid Survive, and that is how they ran it. I submit that the Japanese companies of today, Hitachi being a notable example, have a lot more in common with how US companies were run when they were run well than, frankly, a lot of the US companies today do. I think the cultural, the mindset that Andy Grove and that Les Vadasz brought to running those companies, it was this balance between real craftsmanship and engineering talent, and financial acumen. That balance has tilted a little bit maybe too far in the US, but it is just right in Japan, as we see these companies where they said, hey, we got to earn a decent return, but we cannot lose sight of the fact that what pays the bills here is our expertise and our customers and our employees. It is not how well we run a spreadsheet,
or how we can optimize our return on invested capital for the next six months. DAVID SALEM: Andrew, your comments about Intel and the way the company was run, I think constitute a logical segue, as you put it so well at the beginning of the conversation, three doors we can go through. We have talked a bit about macroeconomic, we have talked about the micro economic or company specific. Then the third door that you constructed was the social backdrop, if you will, and they
are of course all interrelated and interwoven and self-reinforcing in both a positive and a negative sense. I thought what we would do for the remainder of the conversation is focused on that third door, we will call it maybe the social backdrop. I thought as an intro to that, I just want to read back to you a quote that you sent me some time ago, which I think is really happed. We can then apply it to what is going on in Japan right now. It ran as follows.
"The Supreme irony would be if the very traditional features of Japanese capitalism, which the classic argument has always seen as backward, will actually be cherished by those who abide them and adopted by those who do not." What I want to ask you to do is talk about, and again, in a separate missive, you talked about- - and I thought in a really compellingly interesting way, you talked about Nissan when Ghosn was running it, SoftBank, where Masa-san is still running it, as exceptions that prove the rule. Talk about those two companies against the backdrop of the quote that I have just read back to the audience. ANDREW MCDERMOTT: Sure. That is a terrific quote by a
terrific guy Jonathan Allum who just retired after 30 years, and anyone who have really terrific commentary on the Japanese market. He is the only guy I have consistent have read. I had miss him, I admire him greatly. Anyone who is not familiar with his work, I encourage you to check out his valedictory address in the Financial Times from a few weeks ago from which that quote was taken.
Jonathan, like me, has always been interested in the fact that people treat Japan differently and our financial market, and focus a lot on the negatives and not so much on the positives as we have been talking about. There is another quote I would give from a Wall Street Journal editorial earlier this year, and it says, "The free market relies on virtues that the market itself cannot provide". I think that in the Japanese context, that has been proven. These social characteristics which are not uniformly positive, but the ideas of
diligence, the idea of constant improvement, there is the Monozukuri, even US companies have taken that from a manufacturing perspective and tried to apply it into what mixed results outside of Japan, because it is so embedded in the Japanese educational and social systems. That is also something that reflects itself in the way executives work. Japanese companies have been criticized for being so slow to change. That is, in many ways a valid criticism, but one of the strengths that comes from that is that the leaders feel deeply committed to the companies and to the societies in a way that we who have been told the primary focus is to manage our career, our outcome, that we maybe lose sight of, and compensation is an obvious example.
I would say that Hitachi is one of the greatest workout deals in history, and yet the CEO is paid $3 million to $4 million a year. Now, he gets other non-monetary compensation for sure but the fact that this CEO pay ratio has not really changed in 40 years in Japan, and it has in the US reflects an understanding all the sudden on the point of the elites that they are going to either hang together or hang separately, and there is no feeling of entitlement at the executive level that I think has been so corrosive in the US. That is a result of this Japanese society view that finance is a dirty business, it is a necessary evil as opposed to the objective to which we all should aspire. It is something I talked about a lot with my daughter who goes to the University of Chicago where everybody wants to be and the endgame is Goldman Sachs, internships there except for little language department. In Japan, you do not have that. There is no desire to be a money manager. There is no desire to be a chief financial officer. People want to make things to serve others, and that generally, it causes a lot of problems and people not-- and having too much of a hierarchy and having to wait your turn. In the very specific
circumstances that we are in today with this big difference between the 1%, the decline of a lot of manufacturing excellence and in so many areas because we do not have the right workforce, Japan has these social characteristics that are extremely valuable. We see that in the way that they have sailed through this pandemic, without any real challenges to either their social fabric or to their business fabric really, and they have managed this very well. I contrast that generic or general approach in Japan, which has broadly improved at earnings and cash flow, and all these other return on equity measurements without-- it is going to move slow and do not break things is the motto for most companies. I contrast that with the counter examples, you mentioned Nissan and SoftBank and I was Carlos Ghosn's neighbor for six years both in my first apartment and my second one, he was in the penthouse, we were down below. I have incredible admiration for what he did in his first few years at Nissan and yet, I was directly involved because at the time, we had shareholders in my old firm at both General Motors and at Renault and I know that there was an offer for him to go and be a CEO somewhere else. I know he could have made more money elsewhere. What was distinctive and I think ultimately, destructive, was his sense of entitlement and his desire to maximize his own personal outcome at really the expense of anyone else. I have been lied
to by CEOs all over the country. I have [?] all the world, not all the time but in other words, I do not say that Japanese managers always tell the truth, but never do they do something where they benefit at the expense of the company or their subordinates. They might lie to hide some accounting problem, but never ever, ever would you see a Japanese CEO flee the country and put the people who get them out of trouble in jail. Yet that
mentality is unfortunately something that we-- and that also shows up at SoftBank. We are in this real decision point in the Japanese market, which way are we going to go, you are told that the CEOs need to be much more mercenary-like, you look at the behavior at SoftBank that has been widely documented. You have taken the derivative team from Deutsche Bank, put them in charge, they have they manipulated markets, they funded WeWork, they funded Wirecard, they have really been at the center of everything that is, I think, wrong about financialization, and yet they are the best performing stock in Japan. The big question for me is, what lessons
are we going to take from this for our existing Japanese managements as they continue to evolve? Obviously, you look at Nissan in the first five years that Carlos Ghosn was there, they rapped while they outperform the Japanese competitors and global competitors. Today, they are barely profitable, and their credit rating is in trouble, and then you contrast that with Honda and Toyota, where they do not have celebrity CEOs, they do not pay their executives that much money, and yet those companies are prospering today, even in the pandemic. There is a lot for me personally, to reflect on, because I was a foot soldier in globalization. I spent the first 10 years of my life trying to get Japanese magnets to be more American, presented to an insurance company that we had a big investment in, and the title of the presentation was, Why You Should Be More Like AIG. Look at their capital allocation, you can learn a lot from them. DAVID SALEM: When precisely
was that? Is that before Southeastern, or after you joined the firm? ANDREW MCDERMOTT: No, this would have been in 2006. We had 20%? Is it-- we own about 20% of a Japanese insurance company, and we were mad at them for not optimizing the capital structure. I went in and said, look, here is a big presentation to the whole board and the headline was, Why You Should Be More Like AIG. I learned a lot from that. I spent the last 10 years of my career wishing US managements were a little more like Japanese and just put some numbers around that in the 10 years prior to 2020.
Somebody can check these, but I have done the math with Ed Yardeni's numbers in some Wall Street Journal reports. I think the US has basically bought back $4 trillion in stock buybacks against $2 trillion in net earnings or net operating earnings. We spent more than twice our income on buybacks. In Japan, buybacks are up seven times in that same period, yet cash flow is up even more in gross terms. The Japanese companies are-- yes, they are buying back
shares. Their dividends have increased every year. Our central thesis is that these companies that have net cash, that cash is going to be used for us for sure but in a prudent way. These Japanese companies today, our portfolio PE today is exactly the same as it was when we went to work for you at TIFF 10 years ago. What that means is that all of the performance has been the coupons minority has not been multiple expansion and the quality of those earnings in Japan is even higher than apparent earnings. Whereas I would argue that the quality of earnings in
the US, because so much of compensation is now run through the equity line, this is something Michael [?] has done, and the quality of earnings in the US is lower than it has ever been. In Japan, it is actually higher than it has ever been. Then we see that in our portfolio, we see it in other companies as well, although there is a lot more valuation dispersion as well now. DAVID SALEM: Andrew, we have referenced a couple times a really major inflection point in your career in 2010, when you decided to leave Southeastern with John and set up your own shop. Let us just go back. Normally, this is done at the front of these interviews, but by careful design, we did not start with it. Let us go back and just backfill briefly your career before you got to Southeastern, what it was like to be there. Then I want you to segue without any further
interruption from me, to some reflections that you have shared with me previously on the current status and future of active management in general and value investing in particular. Take us back in time and walk through the arc of that personal history, personal and professional history and bring us up to those topics that I just flagged. ANDREW MCDERMOTT: Oh, sure. Thanks, David. I did not know what money management was. My interest in Japan was drift with really a result in fact
that I was when I was young, I was a history buff and my favorite topic was World War II and specifically, the Pacific Theater. Guadalcanal Diary and 30 Seconds Over Tokyo were my about all the introduction to Japan that I had. In finance, I took an econ class in high school because I was the first guy in the history of the school to be thrown out of the mix choir, so there was no design, and that was the only option. There was no design to be involved in Japanese equities. This is a broad point on the successful investors are the people that have been interesting in the field. That is a positive, not a negative. It is self-serving, I know, but this
ability to be detached both from the industry in front of the specific market you are in and to have a take it or leave it attitude is vitally important, and certainly that characterizes both John and Yohei, my partners. Yohei being by far the smartest of the group with near PhD in artificial intelligence. He is just interested in a lot of things among which are security selection. Likewise, John. I went to Japan out of college because I wanted to leave the US. Because I had gone in college to travel around Europe and had a great time exploring, I viewed myself as a latter day Richard Halliburton, who is an [?] and who also went to Princeton, and then he wrote all these travel books, The Royal Road to Romance being the one that I had in my back pocket on the way to Japan. I fell into finance at
JPMorgan in Hong Kong, which was just fascinating because the people that I worked with there, included, among others, Weijan Shan, who just did an interview for Real Vision. Tim Weisner, the guy at the center of 1MDB in passing. Jeff Langlois, a guy who headed Morgan Stanley's efforts into China and had been a professor of poetry, Chinese poetry and then a business leader. Deng Xiaoping's granddaughter, who happened to be one of the early JP Morgan national talent program that they ultimately were invited for. It was a great way to fall into finance,
but I got the job because I was a computer guy. My specialty was helping non-technical people get comfortable with computers. I worked in a computer lab to pay for my tuition. I got into finance because I could use Excel at a time of transition from Lotus to Excel. Then I ended up wanting to work in venture capital in San Francisco, and by just total luck, and leaving the week before the Thai baht collapsed in 1998, and going to early 1997, I guess, going to San Francisco and from there, I got a call from a friend who had been offered a job at Southeastern to go look at for Japanese equities. He decided not to take the job but recommended that they talk to me and I decided to take the job but the main reason I took the job was because we bid for a houseboat in San Francisco and lost it and had no place to live. We had some personal reasons. My wife is Japanese, and her dad was not doing very well at the time.
We were willing to commute between Memphis and Japan at a time when no one else was. Going where they are not is really the theme of everything that has driven my career and just luck. When I got to Southeastern, it was two months before Jason [?] wrote a report or paper in [?] Magazine calling Southeastern the best mutual fund management company in the world. It was a terrific piece. I think it was accurate in many ways because what my bosses were doing, they are truly are investing their own money, and they are also willing to take an opportunity based on where they want to put their own money, even though no one else was doing it. This was a
time when the S&P was outperforming global markets in a way that is very consistent, Dave, with your framework. Creating this today is saying, hey, the US is great, but it is overpriced relative to the rest of the world. Ether had underperformed the S&P for 15 years or some crazy number. Southeastern to their credit, said, let us start an international fund right now. Let us center it on Japan, which is the most underperforming market in an underperforming world. The analysis is not that hard, we just need somebody to go do that legwork because we have a fiduciary duty to our existing investors to keep doing what we are managing. I think that, in retrospect, looking back on the lessons I have learned from that, and which later informed our creation of Mission Value Partners and looking at other partnerships, like Nomad and others that have been successful, those ingredients were really important. First of
all, there was a clear opportunity to invest your own money in a market that if you spent your own time doing it, you could make it work, but you had some other responsibilities. Then you hired someone. That meant that there are all sorts of good things that happen from that, because you are hiring someone in an environment where there is a lot to do, that person can very quickly demonstrate whether they can do work or not. There is a training opportunity that you can supervise. DAVID SALEM: In my favorite sport, we call that at-bats. I know your favorite sport is not my favorite sport. Back to you. ANDREW MCDERMOTT: Well, that is right. That is exactly right. There are a lot of at-bats, and there was a-- you can put your training wheels on because
John Buford did not want to hire me, and he is my partner now. I was the exhaust in choice. He had offered the job to six or seven people before I got, and this is-- to go to this value investing topic, there is just a sea change. At that time, I did not know what a mutual fund was, I did not know what value investing was. It just was not a thing, and today, it is still a thing. It is a huge thing, even though the performance is bad, their value investing programs, and all these schools are just a lot of people who are very well trained in the discipline. No one was interested in 1998, and that is a good thing. They offered me the job,
and said, look, I do not know if we will even do-- six months from now, we may have to shut this thing down, but it looks like it will work. That was a great, in retrospect, that was a great environment to learn from and to be part of. Now, of course, just like Japan getting a lot worse from 2010 to 2011, the environment for international investing got a lot worse from 1998 to 2000. I left tech venture investing in San Francisco in 1998. Just really, it looked like the dumbest career move in history for value investing also in 1998, and got to watch this incredible melt up, which felt a lot then the way it feels today, where you are just looking at this flows over fundamentals, and you could not believe it, but I learned an enormous amount from that experience, too, of how bad it can get before it gets good. It got really, really bad, and clients firing this talent and going to the grocery store having to wear a baseball cap because you were the dumb guy. It was a very much-- everybody knew you in those days, especially in a town like Memphis. How did that play out? Well, it played out beautifully. Because
when everything fell apart, we did not look like the rest of the market. We outperformed by 52% or some crazy number. Do not hold me to it, but looking back, it was not that we were as an analyst, that much better. It was that the environment was that much better. I think moving forward to today, you got a lot of really well-intentioned people who are working very hard, as Charlie Ellis and Charlie Munger and Jeremy Grantham have all pointed out much more eloquently than I can, we are squeezing blood from the stone, and there fewer equities out there. Those that are
out there, they do not get as cheap as they used to unless you are willing to take a lot more risk. It is a very crowded trade. Now, that has been the experience for last 10 years. Within Japan, we have been able to still exercise our discipline. It is much, much harder for those of us who were actually practitioners throughout this entire period to say that you can still do what we did in today's conditions with any real conviction. Now, I think there is a relative value trade that has developed very recently, just because we have gone so off the rails, but that gets into a bigger picture of whether these financial markets can perform their basic function of capital allocation and price discovery, as well as this public function that Ben Hunt has talked about. At the time we are trying to create social outcomes through this financial market, we can also expect it to reward value investors for doing what we do. That I think, is a central issue. Japan has a lot of good
lessons that we can learn that if we let this thing play out, it can over time, work, but it is very much an open question. DAVID SALEM: Andrew, I want to close with two more questions. One more professional, but it leads to the closing question, which is more personal. The first of the two questions relates to China. We have not really talked about it much if at all. If I am not mistaken, you have never invested a penny in the stocks of China domiciled companies.
Just share with us and with the audience, if you will, your evolving take on what is going on in China, look at through the lens of an active stock picker. ANDREW MCDERMOTT: Well, I mourned what has happened in Hong Kong, having lived there, it was an important part of my early life, obviously, it is where I fell into finance. At the time in 1994, it was just brimming with optimism. My job was to really be the executive assistant for a group of JPMorgan senior bankers, I would go into that Monday meeting, and I hate Monday meetings, as you know, because I think they sometimes create perverse incentives to do stuff you would not otherwise. It was a great learning experience. There is so much happening. When I started at Southeastern, our first investments actually were in China. They were
Swire Pacific and then later [?], but they were in Hong Kong, and they were very much with the view towards what I think was a commonly held view that financial markets were going to evolve towards a US model, and you could invest in Hong Kong and have really the best of both worlds, governance that you could understand and comfortable with and access to this very real and obvious growing cash flow stream coming out of China. Also, I worked on deals, and one of the luckiest things for me as a really very bad investment banker because most of the divisions I was in, where we did not close that many deals, but we worked on a lot of them, whether it was the tech banking at JPMorgan or the infrastructure banking in Hong Kong, where I cut my teeth. What I learned is that even if you are JP Morgan, the biggest bank in the world, and you have got your private equity group and everyone else behind you, and you are going to talk to people like Bechtel, and you are coming to invest in our case, it was a bridge and tunnel project, with a government guarantee a foreign exchange, and we put all the money, we did years of due diligence on it, the deal closed after I left. Well,