Japanese Internet firms offer something new: high returns

Posted at 04/17/2014 6:49 PM | Updated as of 04/21/2014 9:23 AM

TOKYO - Some Japanese Internet companies are getting a boost from foreign investors as Prime Minister Shinzo Abe pushes for an elusive strength his country's firms are not known for - high returns.

Overseas long-term investors were already hunting for stocks with growth potential, good governance and higher returns on equity before Abe took office in December 2012. But it's been a hard slog for many as the world's third-biggest economy stumbled through 15 years of deflation and sporadic growth.

It came as no surprise then when Abe's prescription to repair the economy with massive monetary and fiscal stimulus sent the Tokyo market on a tear.

And now, stocks such as MonotaRo , M3 Inc, Kakaku.com Inc, GMO Payment Gateway Inc, and Start Today Co.T are getting a new tailwind as "Abenomics" puts the spotlight on greater return on equity.

"These are entrepreneurial companies with founders in there, first-generation founders in many cases," said Roger D. Edgley, a portfolio manager at Wasatch Advisors, which is based in Salt Lake City. This can mean they are nimbler than more established, and bureaucratic, Japanese companies, he said.

This agility eliminates a major obstacle, especially when firms make big investments such as M&A or overseas expansion.

"Some of these companies are change-makers," said Edgley, who owns stock in all five of the companies and manages more than $2 billion in the firm's international growth strategy.

In January the Japan Exchange Group, the owner of the Tokyo Stock Exchange, launched the JPX-Nikkei 400 Index, which focuses on stocks with higher ROE. After a slow start, the index is attracting attention after Japan's Government Pension Investment Fund, the world's largest pension fund, adopted the JPX-400 as a benchmark for some of its passive stock investments.

Japanese companies traditionally have not focused on maximising shareholder value, instead prioritising stability and long-term business relationships cemented by interlocking webs of cross-shareholdings. A lack of outside corporate directors has meant little pressure for management to keep shareholders happy.

Overall, Japan's listed firms returned just $9.10 for every $100 of shareholder equity in the financial year ended in March, far below the 15.10 percent ROE at U.S. companies and 12.60 percent at Asian companies excluding Japan, Nomura Securities reckons.

In contrast, MonotaRo, which operates an online shopping site selling industrial tools to smaller Japanese manufacturers, boasts an ROE of 31.4 percent. Its foreign ownership has risen to 78.3 percent from 67.0 percent over the past two years. That compares to a Japanese average of just 28 percent.

While the Nikkei benchmark jumped 57 percent in 2013 thanks to Abenomics, these entrepreneurial companies soared as much as 225 percent. The internet stocks have pulled back with the broader market this year but they still may look expensive.

Nonetheless, some overseas investors predict even bigger returns over the coming decade.

"Long-term foreign investors would not buy shares of companies with low ROE even if their price/earnings ratios were cheap," said Shingo Ide, chief financial researcher at NLI Research Institute.

Some of the companies that have strongly outperformed the market were created by entrepreneurs around the burst of the dot.com bubble in 2000.

These smaller internet companies are not household names, but occupying a niche could be an advantage.

Foreign investors have complained that big-name Japanese companies tend to hold on to less profitable businesses and sit on mountains of cash rather than investing for growth or distributing money to investors.

Among bellwether exporters, for example, Sony Corp 6758.T runs such businesses as TV, finance and gaming, while Toyota Motor Corp 7203.T has a financing business and a house building business. Frustratingly for investors, Sony's ROE was just 4.9 percent, and Toyota's 8.5 percent for their fiscal years ending in March last year.

Japanese internet firms are also spared from the woes that hurt even the country's most profitable companies - shrinking demand due to rapid aging of population.

The country's e-commerce market is still small compared with other countries, leaving a lot of room for companies like MonotaRo to expand their business in Japan.

Last year, Japanese people spent $46.8 billion on e-commerce, according to Euromonitor. That compares with $207.6 billion Americans spent, while Chinese people spent $98.53 billion and British spent $53.0 billion. Per capita, that puts Japan at roughly half the spending of the U.S. and well behind the U.K.

Kabir Goyal, equity analyst at Wasatch Advisors who was in Japan last month with the fund's portfolio manager Edgley, said his fund has invested in Japan for more than 10 years.

"We've been meeting with more high quality small caps that are led by entrepreneurial founders," he said. "This is aided by the rapid acceleration of e-commerce in Japan, which is opening up opportunities for new business models."