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Buffett's Inflation Bet With The House(s)
Two summers ago Berkshire Hathaway bought century-old Japanese conglomerates. Warren Buffett got a good deal on inflation-protection. (PBL #3 2022)
“We can expect to see more use of disguised payout reductions as business struggles with the problem of real capital accumulation. But throttling back shareholders somewhat will not entirely solve the problem. A combination of 7 percent inflation and 12 percent returns will reduce the stream of corporate capital available to finance real growth.”
— Warren Buffett, “How Inflation Swindles the Equity Investor”, Fortune, May 1977
The above 1977 quote from U.S. value investor and businessman Warren Buffett is relevant again today, June 2022:
For 10+ USD billion market capitalization stocks the current global median trailing Return on Common Equity (ROE) is around 13%. According to TIKR.
Official consumer price inflation (CPI) is running hot. Above 9% for the OECD countries in the trailing data as of April 2022. (Or above 6%, if we exclude food and energy. For people who do not eat, transport, power/heat/cool or produce.)
Western central banks' decade of aggressive money printing created strong asset price inflation. Add handout checks and tax relief (fiscal stimulus) and supply issues in the recent pandemic. Inflation has now found its way into real economy prices and wages. With a recession long overdue, Western economies now face threats of stagflation.
When price inflation (expectations) rises at the same time as economic growth (real GDP) slows. Often accompanied by recession and increased unemployment. Especially if central banks raise interest rates to regain inflation control.
Selected stagflation effects
1 Consumption: With stagflation real (after-inflation) disposable (after-tax) household income can stagnate or shrink. Living expenses simply rise faster than income from working. Discretionary spending is postponed when job security and access to credit become more insecure.
2 Corporate investment: Demand is reduced and input costs rise. Companies respond by cutting costs and raising prices. Capacity investments are postponed. Shoring up liquidity and keeping access to credit is the priority.
3 Bond investments: Extended periods of stagflation means lost purchasing power for fixed-coupon bonds. Coupons and repayments over such bonds' holding periods will buy less future consumption. To add, higher interest rates cause immediate (mark-to-market) losses on long-maturity* bonds.
4 Stock investments: For most stocks, stagflation is also bad:
Reinvestment costs: Operating companies face reinvestment cost increases. For most of them, these increases can not be covered fully by raising prices (without losing sales volumes). Accounting profit margins may still look OK, especially if the companies postpone reinvestment. But wear-and-tear forces businesses to eventually replace assets at inflated prices.
Valuation headwind: Cost of capital soars with rising interest rates. This means lower earnings multiples. Like long-duration bonds, the highest valuation stocks face more mark-to-market loss risk on interest rate increases.
Distress risk: Low margin, reinvestment needs, poor pricing power, and a lot of short-term debt. Such businesses quickly face serious credit risks in a stagflation scenario. If not priced at a discount, the equity risk-reward is poor.
(* Technically long duration, a measure for how long into the future we expect the bulk of an investment’s future cash-flows to arrive.
How about (1) low-multiple stocks? In (2) trading and financing centers for (3) commodities, (4) goods, and (5) infrastructure? Not a bad combination for trying to keep up with stagflation.
In this week’s first PiggyBack Letter (PBL) we piggyback Warren Buffett’s insurance conglomerate, Berkshire Hathaway. From Berkshire’s Omaha, Nebraska across the Pacific. We study Japanese trading houses, a niche industry theme still in play.
At the end of this week, there will be another PBL.
During July Your Analyst provides summer reading-type posts.
In August we are back with PBL while preparing actionable research.
Summer greetings from Sweden to all Piggyback readers!
Johan Eklund, CFA
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Disclosure: At the time of publication the author or associated entities held long positions in common shares of Itochu, Marubeni, Mitsubishi, Mitsui, and Sumitomo.
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Berkshire's 2019– Bet On Japan Inc
It was August 31, 2020. U.S. value investor and businessman Warren Buffett’s insurance conglomerate Berkshire Hathaway [U.S. ticker NYSE: BRK BRKA BRK.A BRKB BRK.B] sent out a press release. The heading may have surprised U.S.-focused Berkshire-watchers:
“Berkshire Hathaway acquires 5% passive stakes in each of five leading Japanese trading companies”
The concise release went on:
Berkshire had acquired stakes in Itochu, Marubeni, Mitsubishi, Mitsui, and Sumitomo. Via regular share purchases on the Tokyo Stock Exchange over “approximately” 12 months.
The slightly over 5% outstanding shares stakes were “long-term”.
Berkshire may increase its holdings up to a maximum of 9.9% of shares in any of the five houses. Buffett pledged to seek board approval from the trading houses before purchases beyond 9.9%.
“I am delighted to have Berkshire Hathaway participate in the future of Japan and the five companies we have chosen for investment. The five major trading companies have many joint ventures throughout the world and are likely to have more of these partnerships. I hope that in the future there may be opportunities of mutual benefit.”
— Warren Buffett, chairman and CEO of Berkshire Hathaway, in a short comment to the August 31, 2020 press release on Berkshire’s share purchases in five Japanese trading houses Itochu, Marubeni, Mitsubishi, Mitsui, and Sumitomo
The trading houses' stock returns before Berkshire’s release were weak. In early 1992 the Japanese bubble economy was deflating after the 1980s. From then the shares produced mean and median total returns of 3% per year (CAGR) over the nearly three decades until August 2020. Even in a low inflation, Japanese yen world such low returns do not compensate for equity risk.
Now securities returns and fundamentals can be very different, even over decades.
Sogo Shosha = General Trading House
Japan’s export-led modern economy has historically relied heavily on trading houses. These traders set up and managed ever-growing portfolios of international export-import relationships for the Japanese business and government economy. In doing so they ended up becoming power centers in large, interconnected industrial groups.
(For background, see for example Robert W. Dziubla, International Trading Companies: Building on the Japanese Model, 4 Nw. J. Int'l L. & Bus. 422 (1982))
Sogo shosha are larger, more diversified trading houses. Gradually they are adding more trading, logistics, project financing, and investments far outside Japan.
Note: Japanese Cross-Ownership
Large Japanese keiretsu business groups share brands, such as Mitsubishi. There can be multiple parent, subsidiary, and affiliated companies that are interlocked but still have independent listings on stock exchanges.
Always consider how the group’s cross-shareholdings and ownership control structures can benefit or disadvantage the specific company being analyzed.
Be careful not to mix up companies when looking up stock tickers.
A brief intro to the “big five” that Berkshire invested in, in alphabetical order:
1 Itochu [Tokyo ticker TYO:8001, U.S. OTC ADR*: ITOCY]
Itochu dates back to 1858 (incorporated 1949) and currently operates in 60+ countries. Its concise business description of current trading and financing activities:
“ITOCHU is involved in domestic trading, import/export, and overseas trading of various products such as textile, machinery, metals, minerals, energy, chemicals, food, general products, realty, information and communications technology, and finance, as well as business investment in Japan and overseas.”
2 Marubeni Corporation [TYO:8002, U.S. OTC ADR*: MARUY]
Marubeni spun out of Itochu in the early 1900s, recombined with Itochu during WWII, and returned as a separate trading company again in 1949. Like Itochu, the group is active in 60+ countries with extremely diversified activities:
“Marubeni… conduct importing and exporting (including third country trading), as well as domestic business, … across wide-ranging fields including lifestyle, ICT business & logistics, food, agri business, forest products, chemicals, metals & mineral resources, energy, power, infrastructure project, aerospace & ship, finance, leasing & real estate business, construction, industrial machinery & mobility, next generation business development and next generation corporate development. Additionally, the Marubeni Group offers a variety of services, makes internal and external investments, and is involved in resource development.”
3 Mitsubishi Corporation [TYO:8058, U.S. OTC ADR*: MTSUY]
One of three large listed parent companies in the Mitsubishi industrial group, dating back to the 1860s. The others include Mitsubishi Heavy Industries, which controls the Mitsubishi Motors car brand. And Mitsubishi UFJ Financial Group, Japan’s largest banking group.
As a trading house Mitsubishi Corporation (“Mitsubishi”) is active in around 90 countries. It runs a wide range of activities:
“Natural Gas, Industrial Materials, Petroleum & Chemicals Solution, Mineral Resources, Industrial Infrastructure, Automotive & Mobility, Food Industry, Consumer Industry, Power Solution and Urban Development… MC’s current activities have expanded far beyond its traditional trading operations to include project development, production and manufacturing operations.”
4 Mitsui & Co [TYO:8031, U.S. OTC ADR*: MITSY]
The large Mitsui industrial group’s origins date back to the 1600s. After WWII Mitsui & Co (“Mitsui”) was incorporated in 1947 as the major trading house of the group. Mitsui is active in over 60 countries and, as readers expect by now, diversified:
“We are multilaterally pursuing business that ranges from product sales, worldwide logistics and financing, through to the development of major international infrastructure and other projects in the following fields: Mineral & Metal Resources, Energy, Infrastructure Projects, Mobility, Chemicals, Iron & Steel Products, Food, Food & Retail Management, Wellness, IT & Communication Business, Corporate Development Business.”
5 Sumitomo Corporation [TYO:8053, U.S. OTC ADR*: SSUMY]
The Sumitomo industrial group’s origins date back to the 1600s as well. Sumitomo Corporation (“Sumitomo”) was incorporated in 1919 and is active in 60+ countries.
Sumitomo currently has six “Business Fields”:
Transportation & Construction Systems
Media & Digital
Living Related & Real Estate
Mineral Resources, Energy, Chemical & Electronics
Plus one “Next-Generation Business” in Energy Innovation.
(* Liquidity for ADRs varies, all readers should do their due diligence.)
Shareholder Value Creation
As businesses, trading houses are very exposed to the physical trading of commodities and goods. This makes them cyclical.
The next chart shows Return on Common Equity (ROE). Trading houses generated mid-teens % median ROE in the early 2000s commodities bull market. Despite structural issues in Japan’s economy. In the 2010s commodity bear market, profitability dropped. Most trading houses were pressured to a low single-digit % ROE trough in 2016. Berkshire bought after a 2017–2018 recovery, into the 2020 global pandemic.
Under the hood of the ROE, a promising trend is that the trading houses have deleveraged. In the 15 or so years before Berkshire bought shares, the Equity-to-Assets (E/A) more than doubled. From 16% median E/A in 2005 to 34% median 2020.
What is happening is a shift of focus. From the asset-intensive, high competition, lower margin physical trading the trading houses are reinvesting more in higher-return, higher-risk investing. To balance the investment risks the trading houses are decreasing their debt loads. Instead, investments can use more external project financing and partner capital**. This increases the capital efficiency of the trading houses. If investment returns and risk management work out.
(** Infrastructure can be financed with long-term, secured project debt. The lenders tend not to get recourse beyond the investment asset. This helps investors diversify over high-risk projects with controlled downside risk.)
The after-tax Return on Total Assets (ROA) remains low and shows cyclicality with commodities. If the investment strategies succeed, the ROA should increase over time.
Berkshire’s Opportunistic Value Timing
So the underlying value creation seems OK and is possibly changing for the better. What about the stock market valuation?
The next chart shows Price-to-Tangible Book Value (P/TBV) multiples. Trading houses traded at median premiums of more than double tangible book value (P/TBV > 2) in the early 2000s. The last big commodity bull market.
The mid-2010s commodities bear market pushed median P/TBV down to P/TBV 0.6–0.7x. A one-third discount on tangible book value. While Berkshire started buying at smaller 2019 discounts, the 2020 pandemic cheapened the price for part of its stake.
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Performance to Date
So how has Buffett & Co's signal done so far, one year and ten months after Berkshire's positions were disclosed?
Stock Returns: Not bad, with above 25% median and mean total returns per year (CAGR). See chart below.
Fundamentals: More important, the trading houses have benefited as expected from pandemic supply constraints and initial waves of commodities inflation. The deleveraging has continued. See Charts 3 and 4.
Valuation: A quick revaluation to tangible book premiums followed Buffett's investment in 2021. As of June 2022, the median trading house is now back to trading around tangible book value. So the investor gets any “hidden” longer-term values in these power centers “for free”. See Chart 5.
(And for a Background on value metrics, see PiggyBack’s Shades of Value).
Our piggybacking of Warren Buffett’s Berkshire Hathaway into Japanese trading houses can teach us many things.
From a general value investor perspective:
1 Commodity Inflation Tollbooths
Trading businesses take a percentage toll on economic activity. This is less inflation-sensitive than production. A trading operation enjoying enough competitive advantage should be able to protect its gross margin. It also has less maintenance reinvestment to cover at inflated costs.
In this case, much of the trading is in physical commodities and other necessary input goods. Here we move beyond inflation insensitive, to inflation protection. Or even to inflation-winner positions. Inflation gains for any commodity segment are unpredictably lumpy, like call options. Trading houses own portfolios of options.
2 Infrastructure Private Equity
Japanese sogo shoshas are not only powerful traders. They also mobilize large amounts of risk capital into long-term physical project investments. From a Western perspective, this makes their equities a private equity investment hybrid.
3 Global Diversification
Some of us might be even more U.S.-focused than the global stock market indices. With the trading houses, Buffett got domestic Japanese and global diversification to “home” market macro risks, in Berkshire’s case the U.S.
Major regional stock markets, like Tokyo, may also widen our opportunity set. The U.S. stock market of 2019–2020 may not have offered large-scale, low-valuation opportunities in similar businesses.
In addition, Berkshire has their own, investor-specific benefits from this position:
1 Macro Bet/Hedge
Berkshire has raised bonds in Japanese yen. A lot of them. As of Q1 2022, the conglomerate had 7.5 USD billion equivalent of JPY bonds outstanding. With maturities 2023–2060 and weighted average interest rates of only 0.6%.
Recall that long-duration bonds are likely inflation losers for an investor (the creditor). As a borrower (the debtor) Berkshire profits if inflation reduces the real value of future bond payments. Use bonds to finance potential inflation-winner stocks. Result? Inflation profit potential, on both the balance sheet’s asset and liability sides.
Currency-wise, the stock position also hedges JPY exposure. Borrowing JPY, by issuing bonds, to reinvest in JPY stocks limits the net exposure to JPY.
2 Future Collaborations(?)
Buffett hints at potential future collaborations in the trading house press release. His U.S. insurance conglomerate and the Japanese trading house conglomerates. Shared aspects include (1) permanent capital, (2) international investing, and (3) industry expertise. Examples of the latter would include energy and infrastructure. While not yet concrete, Berkshire’s shareholdings could give a seat at the table for future deals.
To Be Continued
PiggyBack's future, premium research may offer opportunistic stock coverage on selected Japanese trading houses.
The business of moving, trading, and financing physical stuff is not going away soon.
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Johan Eklund, CFA
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