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 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 ut 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 c laim 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, Kouji 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,