Japanese Stocks: The Ultimate Undervalued Investment Opportunity (w/ Andrew McDermott & David Salem)

Japanese Stocks: The Ultimate Undervalued Investment Opportunity (w/ Andrew McDermott & David Salem)

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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,  

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2021-02-04 11:48

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