Japan Value Report

Value-oriented Equity Investment Ideas for Sophisticated Investors
A Monthly Publication of BeyondProxy LLC  Subscribe at manualofideas.com

“If our efforts can further the goals of our members by giving them a discernible edge
over other market participants, we have succeeded.”

Investing In The Tradition of
Graham, Buffett, Klarman
Year IV, Volume IV
May 2, 2011
THE JAPAN ISSUE
When asked how he became so
successful, Buffett answered:
“We read hundreds and hundreds
► Context: Japan, the country and the economy
of annual reports every year.”
► 20 Japanese companies profiled and analyzed
Top Ideas In This Report
► Proprietary selection of top investment candidates
Konami
(Tokyo: 9766, NYSE: KNM) ……. 50 ► Plus: Exclusive interview with Scott Callon
Ricoh
(Tokyo: 7752, OTC: RICOY) …… 90 ► Plus: Exclusive interview with Mark O’Friel
Toyota Motor
(Tokyo: 7203, NYSE: TM) …….. 106
► Plus: Superinvestor holdings update

Also Inside ► Plus: Favorite screens for value investors

Editorial Commentary ………………. 4
Superinvestor Update ………………. 7 Companies mentioned in this issue include
Interview with Scott Callon ………… 8 Advantest, Aeon, Aisin Seiki, Asahi Breweries, Asahi Glass, Asahi Kasei,
Interview with Mark O’Friel ………. 12 Astellas Pharma, Bridgestone, Canon, Central Jap. Railway, Chubu Electric,
Chugai Pharma, Chuo Mitsui, Dai Nippon Printing, Dai-ichi Life,
Japan, the Country and Economy … 17
Daiichi Sankyo, Daikin Industries, Daiwa Securities, Denso,
Screening for Japanese Ideas …….. 24
East Japan Railway, Eisai, Fanuc, Fast Retailing, FUJIFILM, Fujitsu,
Profiles of 20 Japanese Companies 30 Hitachi, Honda Motor, Hoya, ITOCHU, Japan Tobacco, JFE Holdings,
Selected Statistics on Japan ………110 JS Group, JX Holdings, Kansai Electric, Kao, KDDI, Keyence, Kirin,
Screens for Value Investors ……… 115 Kobe Steel, Komatsu, Konami, Kubota, Kyocera, Kyushu Electric,
Marubeni, Mitsubishi, Mitsubishi Chemical, Mitsubishi Electric,
This Month’s Top Web Links …….. 124
Mitsubishi Estate, Mitsubishi Heavy, Mitsubishi UFJ Financial,
Mitsui + Co., Mitsui Fudosan, Mizuho Financial, MS + AD Insurance,
About The Manual of Ideas
Nikon, Nippon Steel, Nissan Motor, Nitto Denko, NKSJ, Nomura, NTT,
Our goal is to bring you investment NTT Data, NTT DoCoMo, ORIX, Osaka Gas, Otsuka, Panasonic, Resona,
ideas that are compelling on the
Ricoh, SANYO Electric, Secom, Seven + i Holdings, Sharp,
basis of value versus price. In our
quest for value, we analyze the top Shin-Etsu Chemical, SMC, Softbank, Sony, Sony Financial, Sumitomo,
holdings of top fund managers. We Sumitomo Chemical, Sumitomo Electric, Sumitomo Metal,
also use a proprietary methodology
to identify stocks that are not widely
Sumitomo Mining, Sumitomo Mitsui, Sumitomo Realty, Suzuki Motor,
followed by institutional investors. T+D Holdings, Takeda Pharma, TDK, Terumo, Tohoku Electric,
Our research team has extensive Tokio Marine, Tokyo Electric, Tokyo Electron, Tokyo Gas,
experience in industry and security Toray Industries, Toshiba, Toyota Industries, Toyota Motor,
analysis, equity valuation, and
investment management. We bring a West Japan Railway, Yahoo Japan, and more.
“buy side” mindset to the idea
generation process, cutting across
industries and market capitalization (analyzed companies are underlined)
ranges in our search for compelling
equity investment opportunities.

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Table of Contents

EDITORIAL COMMENTARY ......................................................................... 4
SUPERINVESTOR HOLDINGS UPDATE ..................................................... 7
EXCLUSIVE INTERVIEW WITH SCOTT CALLON ....................................... 8
EXCLUSIVE INTERVIEW WITH MARK O’FRIEL ....................................... 12
SOME CONTEXT: JAPAN, THE COUNTRY AND THE ECONOMY .......... 17
SCREENING FOR JAPANESE INVESTMENT OPPORTUNITIES............. 24
TOP 100 TOKYO STOCK EXCHANGE COMPANIES, BY MARKET VALUE ......................................... 24
PROFITABLE COMPANIES WITH 5-YEAR ROE > 5%, TRADING AT < 1X BOOK ............................... 26
PROFITABLE COMPANIES WITH 5-YEAR ROA > 5% .................................................................... 28
CHEAPEST BASED ON TANGIBLE BOOK TO MARKET VALUE ......................................................... 29

PROFILES OF 20 JAPANESE INVESTMENT CANDIDATES ................... 30
ADVANTEST (TOKYO: 6857, NYSE: ATE) .................................................................................. 30
CANON (TOKYO: 7751, NYSE: CAJ) ......................................................................................... 34
FUJIFILM (TOKYO: 4901, OTC: FUJIY) ...................................................................................... 38
FUJITSU (TOKYO: 6702, OTC: FJTSY) ...................................................................................... 42
HITACHI (TOKYO: 6501, NYSE: HIT) ......................................................................................... 46
KONAMI (TOKYO: 9766, NYSE: KNM) ....................................................................................... 50
KUBOTA (TOKYO: 6326, NYSE: KUB) ....................................................................................... 54
KYOCERA (TOKYO: 6971, NYSE: KYO) ..................................................................................... 58
MITSUBISHI UFJ FINANCIAL (TOKYO: 8306, NYSE: MTU) .......................................................... 62
MITSUI (TOKYO: 8031, OTC: MITSY) ........................................................................................ 66
NOMURA HOLDINGS (TOKYO: 8604, NYSE: NMR) ..................................................................... 70
NIPPON TELEPHONE AND TELEGRAPH (TOKYO: 9432, NYSE: NTT)............................................ 74
NTT DOCOMO (TOKYO: 9437, NYSE: DCM) ............................................................................ 78
ORIX (TOKYO: 8591, NYSE: IX) ............................................................................................... 82
PANASONIC (TOKYO: 6752, NYSE: PC) .................................................................................... 86
RICOH (TOKYO: 7752, OTC: RICOY) ........................................................................................ 90
SHARP (TOKYO: 6753, OTC: SHCAY) ...................................................................................... 94
SONY (TOKYO: 6758, NYSE: SNE) ........................................................................................... 98
TDK (TOKYO: 6762, OTC: TTDKY) ........................................................................................ 102
TOYOTA MOTOR (TOKYO: 7203, NYSE: TM) ........................................................................... 106

APPENDIX: SELECTED STATISTICS ON JAPAN .................................. 110
FAVORITE STOCK SCREENS FOR VALUE INVESTORS ...................... 115
“MAGIC FORMULA,” BASED ON TRAILING OPERATING INCOME ................................................... 115
“MAGIC FORMULA,” BASED ON THIS YEAR’S EPS ESTIMATES ................................................... 116
“MAGIC FORMULA,” BASED ON NEXT YEAR’S EPS ESTIMATES .................................................. 117
CONTRARIAN: BIGGEST YTD LOSERS (DELEVERAGED & PROFITABLE)....................................... 118
VALUE WITH CATALYST: CHEAP REPURCHASERS OF STOCK ..................................................... 119
PROFITABLE DIVIDEND PAYORS WITH DECENT BALANCE SHEETS ............................................. 120
DEEP VALUE: LOTS OF REVENUE, LOW ENTERPRISE VALUE ..................................................... 121
DEEP VALUE: NEGLECTED GROSS PROFITEERS ....................................................................... 122
ACTIVIST TARGETS: POTENTIAL SALES, LIQUIDATIONS OR RECAPS ........................................... 123

THIS MONTH’S TOP 10 WEB LINKS ....................................................... 124

© 2008-2011 by BeyondProxy LLC. All rights reserved. SUBSCRIBE TODAY! www.manualofideas.com May 2, 2011 – Page 3 of 126


Editorial Commentary
Japan has been on our radar screen for quite some time. The aftermath of this
year’s Great East Japan Earthquake has given us the impetus to look at this market in
more detail — and to try to identify some bargains among Japanese mid- and large-
cap stocks. These companies are quite accessible to non Japan-based investors, as
they trade on one or more stock exchanges in addition to the Tokyo Stock Exchange.
When an already cheap market becomes even cheaper due to an exogenous
shock, value investors are bound to take notice. While the human toll of the Great
East Japan Earthquake has been devastating, we have confidence in the ability of the
Japanese people to rebound from disaster. Japan has gone through many trying
periods in history, repeatedly emerging with a newfound zeal to grow and prosper.
Most of the issues that have kept investors away from Japan over the years
remain today. Japanese companies still have not embraced a goal of achieving strong
returns on equity. Corporate boards remain entrenched, and value-unlocking strategic
actions remain an exception. On the positive side, many Japanese companies are
highly competitive on a global scale and have built truly global brands — Canon
(CAJ), Sony (SNE) and Toyota Motor (TM) are just a few. Executive compensation
at Japanese companies remains reasonable, contrasting sharply with the experience
of major U.S. corporations. Finally, Japanese companies’ balance sheets tend to be
among the strongest in the world, with many large companies owning substantial
excess assets. The latter can be seen as a positive or a negative, but the fact is that
much improvement is possible at Japan Inc. Excess assets could be rationalized over
time, while returns on equity have ample room for improvement. Contrast this with
Corporate America, where profit margins have almost nowhere to go but down.

Here are a few lessons from our research into Japanese companies:
Lesson #1: There is not a “Japanese” company. However, there is Canon that
derives ~80% of revenue from outside Japan; there is Advantest that is set to become
the largest global producer of semiconductor test equipment pending the acquisition
of Verigy; and there is Toyota that created the world’s first mass-produced hybrid
car. These firms are leaders in their industries and defy being labeled “Japanese.”
Lesson #2: Company-specific factors remain paramount for valuation.
Companies like Kubota and Mitsui are benefiting from the same trends that
Caterpillar and Glencore are taking advantage of. They also face similar risks, which
likely outweigh the risk associated with a Japan-based headquarters.
Lesson #3: Governance is not all bad. In our research, we’ve mostly come
across committed and experienced managers who are not overpaid or incentivized to
bet the house every day they walk through the doors. Another often overlooked fact
about Japan’s corporate governance is that it is a shareholder-meeting system, not a
board-level governance regime. Shareholders have strong legal rights and can call a
shareholder meeting at will. If shareholders want to dismiss the board or double the
dividend, with enough votes it can be done, even against the board’s wishes.
Lesson #4: The “Mitsubishi UFJ” factor. The Japanese mega bank, with
customer deposits representing two thirds of total assets, has avoided the fate of
some of its Western peers during the 2008/09 financial crisis. Indeed, it has taken



advantage of weaker rivals to buy up assets, including community banks in the U.S.
as well as a stake in Morgan Stanley. Supported by strong balance sheets, many
Japan-based companies are similarly expanding their business. On the other hand,
quite a few Western firms have taken on debt to buy back shares at the top of the
market, ruining investors in the process. So much for “efficient” capital structures.
Lesson #5: Key issue is long-term competitiveness, not how “Western” the
management culture is. It is underappreciated how well-invested Japan-based
companies are and how much they spend on R&D to advance their competitive
moat. This, however, is one of the key determinants of long-term shareholder value.
On this account, it is interesting to observe how former household consumer
electronics companies such as Fujifilm and TDK have stumbled and are attempting
to reinvent themselves. Similarly, Sony investors would probably prefer if Howard
Stringer could win some product battles against the likes of Apple than if he were to
split the role of CEO and chairman or sell the financial services business.


We are pleased to bring you two exclusive interviews this month, each of which
sheds light on the peculiarities of the Japanese equity market as well as the way to
identifying compelling investments in Japan. Scott Callon and Mark O’Friel have
decades-long experience and impressive track records in Japan. We think you’ll
enjoy the conversations a great deal.

We highlight three intriguing Japanese investment opportunities:

Konami (Tokyo: 9766, NYSE: KNM, $19.50 per share; MV $2.6 billion)
$45

$40

$35

$30

$25

$20

$15

$10

$5

$0
Apr 03 Apr 04 Apr 05 Apr 06 Apr 07 Apr 08 Apr 09 Apr 10 Apr 11

Under the direction of CEO and founder Kagemasa Kozuki, Konami has
expanded from an arcade games producer in the 1970s to one of the world’s major
gaming companies, with a strong franchise in video game software publishing.
Despite conglomerate tendencies, including a loss-making foray into fitness clubs,
Kozuki remains incentivized to create long-term value as the largest shareholder with
28%. Recent valuation is attractive relative to the earning power inherent in
Konami’s businesses.



Ricoh (Tokyo: 7752, OTC: RICOY, $58 per share; MV $8.4 billion)
$140

$120

$100

$80

$60

$40

$20

$0
Mar 02 Apr 03 Apr 04 Apr 05 Apr 06 Apr 07 Apr 08 Apr 09 Apr 10 Apr 11

Office printer and copier manufacturer Ricoh derives high-margin, annuity-like
income from equipment maintenance, rentals and consumables, which represent
nearly half of revenue. This offsets the more volatile product sales and leads to
relatively stable free cash flow generation. Ricoh’s modest valuation fails to reflect
this, as shares trade at 1.1x tangible book and a 10+% FCF yield based on average
free cash flow during FY06-10. The balance sheet is stronger than it may appear as
cash and finance receivables offset the gross debt balance. Despite product
commoditization risks, the risk-reward is attractive.

Toyota Motor (Tokyo: 7203, NYSE: TM, $80 per share; MV $125 billion)
$160

$140

$120

$100

$80

$60

$40

$20

$0
Apr 02 Apr 03 Apr 04 Apr 05 Apr 06 Apr 07 Apr 08 Apr 09 Apr 10 Apr 11

Car industry pioneer Toyota is struggling following multiple “shocks” including
the financial crisis of 2008/09, the massive U.S. vehicle recall in 2010, and most
recently, due to production issues related to the Japanese earthquake. While it may
take time, an eventual reversion to average profitability should reward long-term
shareholders. Trading at tangible book, the shares offer an attractive risk-reward as
Toyota is likely to deliver normalized ROEs of 10+%, in-line with historical
experience.

Sincerely,

John Mihaljevic, CFA
and The Manual of Ideas research team



Superinvestor Holdings Update
We recently profiled the holdings of 50+ top investment managers, based on their Schedule 13F-HR filings with the
Securities and Exchange Commission. On this page, we provide an update on the latest disclosed purchase and sale activity
by the same group of investors. This information is based primarily on Schedule 13G or 13D filings and Form 3 or 4 filings.

Increases in Superinvestor Holdings

Latest Market Stock Price ($) Shares Owned Holdings
Trade/ Filing Value Latest Filing ∆ since Latest ∆ since as % of
Filing Type Investor Company / Ticker ($mn) Date Date Filing (mn) 12/31/10 Company
4/8/11 4 Second Curve Primus Guaranty / PRS 186 4.89 5.01 -2% 6.5 0% 17%
3/21/11 13D Pershing Sq. Alexander & Baldwin / ALEX 2,190 52.65 41.57 27% 3.6 new 9%
3/18/11 13G Glenview Meritor / MTOR 1,600 17.00 17.85 -5% 5.4 33% 6%
3/15/11 4 Icahn Hain Celestial / HAIN 1,310 30.43 28.67 6% 7.1 n/a 17%
2/23/11 13G Scout Domino’s Pizza / DPZ 1,080 17.97 16.49 9% 3.0 21% 5%
2/16/11 4 Ancient Art ZipRealty / ZIPR 56 2.75 2.71 1% 2.2 0% 11%
2/14/11 13G Lone Pine Ctrip.com / CTRP 5,290 36.86 40.65 -9% 7.9 83% 5%
Source: SEC filings, The Manual of Ideas compilation and analysis.

Decreases in Superinvestor Holdings

Latest Market Stock Price ($) Shares Owned Holdings
Trade/ Filing Value Latest Filing ∆ since Latest ∆ since as % of
Filing Type Investor Company / Ticker ($mn) Date Date Filing (mn) 12/31/10 Company
4/19/11 4 Second Curve Mercantile Bank / MBWM 78 9.06 9.50 -5% 0.9 n/a 10%
4/8/11 4 Breeden Zale / ZLC 116 3.61 3.99 -10% 7.5 -17% 23%
4/5/11 4 Second Curve CompuCredit / CCRT 151 4.22 6.83 -38% 3.5 -19% 10%
4/4/11 13D Third Point Nabi Pharma / NABI 242 5.76 5.78 0% 3.5 -8% 8%
4/1/11 13D Southeastern Pioneer Natural / PXD 11,660 100.10 103.81 -4% 5.0 -61% 4%
3/29/11 13D Southeastern Telephone & Data / TDS 3,510 33.72 32.81 3% 9.6 -17% 9%
3/28/11 13G Bares Hallmark Financial / HALL 170 8.46 8.08 5% 1.9 -20% 10%
3/1/11 13D Breeden Hillenbrand / HI 1,330 21.50 21.47 0% 3.1 -25% 5%
Source: SEC filings, The Manual of Ideas compilation and analysis.

The Manual of Ideas follows portfolio moves by Bill Ackman, Pershing Square; Lee Ainsle, Maverick; Chuck Akre, Akre Capital; Zeke Ashton, Centaur Capital;
Brian Bares, Bares Capital; Bruce Berkowitz, Fairholme; Richard Breeden, Breeden Capital; Tom Brown, Second Curve; Warren Buffett, Berkshire Hathaway;
Francis Chou, Chou Associates; Chase Coleman, Tiger Global; James Crichton, Scout; Ian Cumming and Joe Steinberg, Leucadia; Boykin Curry, Eagle; David
Einhorn, Greenlight; Phil Falcone, Harbinger; Alan Fournier, Pennant; Glenn Fuhrman and John Phelan, MSD Capital; Jeffrey Gates, Gates Capital; Tom Gayner,
Markel Gayner; Kian Ghazi, Hawkshaw; Ed Gilhuly and Scott Stuart, Sageview; Glenn Greenberg, Brave Warrior; John Griffin, Blue Ridge; Howard Guberman,
Gruss; Andreas Halvorsen, Viking Global; Mason Hawkins, Southeastern; Lance Helfert and Paul Orfalea, West Coast; Chris Hohn, Children’s Investment Fund;
Carl Icahn, Icahn; Rehan Jaffer, H Partners; Seth Klarman, Baupost; John Kleinheinz, Kleinheinz Capital; Eddie Lampert, ESL Investments; Quincy Lee, Teton;
Dan Loeb, Third Point; Steve Mandel, Lone Pine; Sandy Nairn, Edinburgh Partners; Mohnish Pabrai, Pabrai Funds; John Paulson, Paulson & Co.; Boone Pickens,
BP Capital; Mark Rachesky, MHR; Lisa Rapuano, Lane Five; Larry Robbins, Glenview; Bob Rodriguez and Steven Romick, First Pacific; Wilbur Ross, WL Ross;
Ken Shubin Stein, Spencer; Chris Shumway, Shumway Capital; David Tepper, Appaloosa; Peter Thiel, Clarium; Prem Watsa, Fairfax; Wally Weitz, Weitz Funds;
and David Winters, Wintergreen.



Exclusive Interview with Scott Callon
We are pleased to bring you the following interview with Scott Callon, Partner
and CEO of Ichigo Asset Management, Ltd. A brief biography follows:
On behalf of Ichigo, currently serving as Chairman and Representative
Statutory Executive Officer of Ichigo Group Holdings Co., Ltd. (2337), a
Japanese real estate asset manager listed on JASDAQ (ichigo-holdings.co.jp).
Previously, Managing Director, Head of Equities, and member of the
Executive Committee of Morgan Stanley Japan; Chairman of the Foreign
Securities Council of the Japan Securities Dealers Association (JSDA); and
Chief Executive Officer of PCA Asset Management of the UK Prudential
Group. A.B., Woodrow Wilson School, Princeton University, 1986 (Phi Beta
Kappa and summa cum laude (highest honors)), and Ph.D. in Political Science
from Stanford University.
Author of Divided Sun: MITI and the Breakdown of Japanese High-Tech
Industrial Policy, 1975-1993, winner of the Arisawa Prize. (“Callon’s findings
are extraordinary... It is essential for anyone trying to get a little closer to the
core of what makes Japan tick.” Japan Times).
Has lived in Japan for twenty-two years; fluent in spoken and written
Japanese. Chartered Financial Analyst (CFA).

The Manual of Ideas: Tell us about the genesis of your firm. What goals did
you have at the outset, and what operating principles have guided you since
then?
Scott Callon: We started the firm in early 2006, so it has been five years now.
Our goal was and continues to be to serve our investors by investing wisely and
judiciously on behalf of their enduring missions (we invest primarily for
endowments and foundations), to partner with great companies and management
“Japanese valuations are
teams, and to support positive change in Japan. We are high-commitment value
truly unique: it is the only
investors. We believe that valuation ultimately is the single most important
market in the world where
determinant of investment merit and ultimately returns. We seek to be
you can buy consistently shareholders of outstanding companies that have demonstrated their excellence
profitable companies at a over many years and yet trade at substantial discounts to their fundamental
discount to their tangible value.
asset value.”
We are Japan specialists and invest only in Japan. Japanese valuations are
truly unique: it is the only market in the world where you can buy consistently
profitable companies at a discount to their tangible asset value. We strive to
invest with respect and humility – it is an enormous challenge to run a public
company and the management teams of our portfolio companies have our
deepest respect. We seek to focus our portfolio on the best return opportunities
available and have only about ten major positions. We are not in the
diversification business – we expect to be only a small part of our clients’ highly
diversified portfolios and thus we concentrate only on what [we] consider to be
our very best investment ideas.



MOI: You have received much publicity for successfully standing up for
shareholder democracy in Japan in the case of Osaka Steel’s proposed merger
with Tokyo Kohtetsu in 2006. How has this event shaped your investment
approach since then? What lessons have you learned?
Callon: We think Tokyo Kohtetsu is Japan’s best small steel company. We
thought that back in 2006 and still think that today. We have never sold a share.
With all due respect to the proposed buyer, which was a larger, also
extraordinarily successful steel maker, we and a large number of other
shareholders had a strong desire to remain as shareholders of Tokyo Kohtetsu.
Unfortunately, we could not reach agreement on what the Tokyo Kohtetsu
shareholders hoped for as an acquisition price, so we and nearly three-quarters
of the individual shareholders chose not to vote for the acquisition, which
proved to be the first successful shareholder-led proxy in Japanese history.
For us, the first key lesson was that Japanese shareholders are willing to
stand up for their rights. The second was that we as a firm needed to work
harder at building deeper relationships with our portfolio company management
teams to reach agreement on the way forward. In 2006, we had just started out
as a firm, had not yet built the depth of relationship with Tokyo Kohtetsu that
we typically aim to achieve, and quite frankly were taken by surprise at the
merger announcement. The outcome may have been in its own way history-
making, but it also strengthened Ichigo’s commitment to building and
maintaining close relationships and alignment with our portfolio companies.
MOI: Help us understand your investment approach more broadly. What are the
key criteria you employ when making an investment decision?
Callon: Again, we’re value guys. We do not try to guess what the market is
thinking or will be thinking, we do not track flows of funds, etc. That is not to
say that we think those particular approaches to investment are wrong – it is just
not what we do. There is lots of room in the capital markets for a variety of
approaches and the markets are stronger for having diversification in investment
approaches. However, in our case, we are valuation fundamentalists. We seek to
buy companies that are trading around or below tangible book value, who
typically have dominant market positions in specialized markets (smaller market
“We think Tokyo Kohtetsu is size and specialization invites less new entry), conservative balance sheets, and
Japan’s best small steel high returns on net operating assets – in short, companies with great operating
company. We thought that and financial performance over time and through multiple economic cycles. Our
back in 2006 and still think basic framework is to think of corporate value as made up of two fundamental
that today. We have never components: asset value and operating value. Asset value tends to be simpler to
sold a share.” understand (although usually requires a translation from book value to market
value), and we generate a view on operating value using conservative views of
the future and relatively high assumptions about cost of capital.
MOI: What role, if any, do macroeconomic factors play in your investment
strategy? Are you worried about how Japan’s high debt, aging population or
other macro variables may affect real equity returns in the long-run?
Callon: We are entirely company-focused. Operating cashflows, assets required
to generate those cashflows, etc. are what is fundamental to us. Having said that,
macro factors clearly feed into company operating performance. If the
population is shrinking, then retail sales are also likely to shrink. We own a
couple of great retailers, and we have forecast very little in the way of future



growth from them. However, if you have a market cap that is 60-70% made up
of cash holdings, a dominant market position which translates into significant
positive cash flow, and a price-to-book ratio well below one, you can build in a
large amount of macro deterioration and still be confident of generating a
reasonable return. In fact, what we tend to find is that the negative demographic
headwinds have been overly-priced in, that the negative scenarios baked into
certain companies’ stock prices are wildly more extreme than what is actually
happening.
MOI: For investors that may be new to Japanese equities, are there any Japan-
specific “checklists” that you would recommend going through before
investing?
Callon: Not really. We think the fundamental principles of sound investing
apply the same in Japan as they do anywhere else in the world.
MOI: Many investors, most notably Warren Buffett and Jim Rogers, have
expressed a view that the Japanese stock market may present buying
opportunities following the sell-off related to the March earthquake? Do you
share this view, and, if so, do you think the opportunity may extend beyond
retracing recent share price declines? In other words, could this catastrophe
accelerate changes at the corporate or government level that could lead to more
sustained value creation for shareholders of Japanese companies?
Callon: We do share the view that there have been some significant buying
opportunities post-quake. Alongside the deeply saddening human loss, the
disaster has impacted Japanese companies on three levels: 1) Direct physical
damage (destruction of corporate assets such as factories, loss of employees,
etc.); 2) Secondary sectoral spillover effects, either negative or positive (supply
chain disruptions, electricity shortages, substitution effects as production shifts
“Japan’s ROE challenge is away from suppliers in Tohoku to other regions, heightened demand for goods
really about the E, not the R. such as construction materials, alternative fuels, bottled drinks, etc.); and 3)
Japanese companies’ returns Macro effects, again both negative and positive, including a dampening in
are very similar to those of discretionary consumption as the Japanese people mourn, loosened monetary
peers in the US and Europe, policy to lessen the initial supply and demand shocks to the economy, massive
so the R part of the equation infrastructure spending to rebuild Tohoku, etc. What is striking is that for a
is fine. The driver of low number companies the sum of these three impacts has been quite moderate
ROEs is thus the relative to how much their shares have been sold off.
denominator, E: Japanese Although this is not something that we have attempted to price into our
firms frequently have very company-level valuations, we do think it possible that the aftermath could prove
large amounts of retained to be a catalyst for positive and accelerated change.
earnings, often in the form of
cash, so the returns are MOI: While Warren Buffett has recently sounded optimistic on Japan, it
remains telling that he has not made any significant investments in Japan. As far
diluted across a massive
back as in 1998, Buffett commented in a speech to University of Florida
equity base.”
students that one reason for his lack of interest in Japanese companies are their
low returns on equity. Despite low ROEs remaining a characteristic of the
Japanese equity market in general, can you point to any exceptions to this
“rule”? Are there any developments that may lead to improving ROEs in the
future?
Callon: Japan’s ROE challenge is really about the E, not the R. Japanese
companies’ returns are very similar to those of peers in the US and Europe, so
the R part of the equation is fine. The driver of low ROEs is thus the


denominator, E: Japanese firms frequently have very large amounts of retained
earnings, often in the form of cash, so the returns are diluted across a massive
equity base. On the one hand, this is enormously comforting: Japanese balance
sheets are about as bullet-proof as they come and cash has real value. However,
the large equity bases do dramatically reduce ROEs, so from a shareholder’s
perspective, this is a negative.
The good news is that more Japanese companies are working towards
higher capital efficiency and increasing shareholder distributions via both higher
dividends and share repurchase, but this is clearly going to happen over time.
We actually prefer to discuss this issue with management teams in terms of EPS,
rather than ROE. Growing EPS is clearly in everybody’s interest, and EPS can
“The sell-side is a business, be grown both via increasing total earnings and reducing share count, so we
and Japanese equities have think a balanced approach of both managing for earnings growth and buying
underperformed for so long back shares when they are inexpensive is appropriate.
that the sell-side has MOI: How do you generate investment ideas?
retreated (along with a good
Callon: We invest only in Japanese small caps, so we need to build our
chunk of the buy-side), so our
understanding of our portfolio companies directly. The sell-side is a business,
investment universe has no and Japanese equities have underperformed for so long that the sell-side has
research coverage to speak retreated (along with a good chunk of the buy-side), so our investment universe
of. If one is investing in has no research coverage to speak of. If one is investing in Toyota, there are
Toyota, there are plenty of plenty of folks out there expressing a view, but our universe is under-researched,
folks out there expressing a under-known, and under-owned.
view, but our universe is
under-researched, under- MOI: What is the single biggest mistake that keeps investors from reaching
their goals?
known, and under-owned.”
Callon: Hmm. Not sure. I do think it is important to be extraordinarily prudent
about downside risk, to test worst-case scenarios and make sure one is protected
under those scenarios. In our case, we don’t use leverage and prefer to have cash
on hand. Both of these decisions potentially constitute a drag on returns, but
they also radically diminish risk during extreme negative market environments.
MOI: Are there any books you would recommend to non-Japanese investors
looking to learn about Japan?
Callon: Gillian Tett, Saving the Sun: How Wall Street Mavericks Shook Up
Japan’s Financial World and Made Billions. John Dower, Embracing Defeat:
Japan in the Wake of World War II. Junichiro Tanizaki, The Makioka Sisters.



Exclusive Interview with Mark O’Friel
We are pleased to share with you our recent conversation with Mark O’Friel, the
managing partner of MOF Capital, an alternative investment fund focused on
investments in Japan and China. Prior to starting MOF Capital, Mark was with
Steel Partners Japan as managing director and head of the Tokyo office in 2008
and 2009. Previously, he jointly led Morgan Stanley’s U.S. proprietary trading
business in North America from 2002-05. Mark formerly directed Morgan
Stanley’s Equity Division in Japan, acting as senior equity risk manager and a
member of the firm’s Global Equity Operating Committee from 1996-2002.
Under his leadership, Morgan Stanley achieved leading market share in the
Japanese equity market and received Institutional Investor’s top ranking for
equity research in Japan. Mark served on the committees of the Tokyo Stock
Exchange that wrote the regulations and guidelines for program trading, options
trading and new technologies. He also represented Morgan Stanley on the board
of the Osaka Stock Exchange. He began his Morgan Stanley career as an equity
derivatives and program trader, introducing some of the first quantitative trading
strategies in the Japanese market. Mark began his career in Japan as a market
strategist for Sanyo Securities. He serves on the board of the Kennedy Child
Study Center in New York City. He is a member of the Leadership Council of
the Harvard School of Public Health. He is active with the Harvard School of
Public Health China Initiative, which partners with the Chinese Ministry of
Health to advance health and social development in China, Room to Read, Math
for America and Harvard College. He is a graduate of Harvard College.

The Manual of Ideas: Mark, thank you for taking the time to discuss Japan at
this pivotal moment in the country’s recent history.
Mark O’Friel: Thank you for the opportunity to speak with you about Japan.
The country has just experienced a tragedy that goes beyond words, with 25,000
“Despite high levels of people dead or missing. The pictures of the earthquake and ensuing tsunami
government debt, the damage are heart rendering. The resilience that the Japanese of Tohoku have
government actually has shown in the face of this event is a profound statement to the strength of the
quite a bit of leeway. Ten- national character. The best of Japan is on display throughout the country.
year JGBs have remained What is overlooked in the reports and pictures of the disaster is in fact how
quite strong.” well prepared Japan was and how the damage was minimized. The earthquake
itself, despite its unprecedented size, caused relatively little damage. Even near
the epicenter, collapsed buildings and deaths were few. This is after the main
earthquake of 9.0 and over 800 aftershocks greater than 4.5.
The before and after satellite pictures now available on the web are
testimony to the power of nature. The pictures now and the pictures one, five
and ten years from now will be testimony to the speed and efficiency of how
Japan can rebuild physical infrastructure. Japan has a long history of rebuilding,
from the aftermath of World War II to the Kobe earthquake. Despite high levels
of government debt, the government actually has quite a bit of leeway. Ten-year
JGBs have remained quite strong.



The earthquake and its aftermath will not be a catalyst for change in Japan.
The government, corporate Japan and its population will seek to draw on the
traditional strengths of discipline, perseverance, hard work and self sacrifice.
MOI: You have spent the major part of your career in Japan. Tell us a little
about your background and what motivated you to work in Japan.
O’Friel: Japan had already become an economic power when I began my
career, but it was just beginning on the path of deregulation of its financial
service sector. The early eighties was also the first phase of the globalization of
U.S. financial firms. Investment banks were just opening or expanding what had
been small outposts overseas. Given my interest in Japan, it seemed interesting
for me to take the opportunity to spend one or two years just out of college
overseas and then come back to the U.S. Two years ended up being twenty.
I first worked at a Japanese investment bank. At that time I lived in a
company dorm and experienced firsthand the Japanese style of management.
This was at the beginning of the equity and real estate stock bubble.
I moved to Morgan Stanley where I was “present at the creation” of
international derivatives markets. We were among the first traders of the Hang
Seng, the SIMEX and the Osaka 50 futures contracts. Morgan Stanley facilitated
the first program trades and the first electronic trades on the Tokyo stock
exchange. As markets grew and became more sophisticated we helped introduce
options, over the counter options and algorithmic trading to Japan.
Morgan Stanley also had one of the leading prime brokerage businesses in
Asia. We were able to deal with many of the leading hedge funds as they
increased their exposure to Japanese shares.
After running the Morgan Stanley Equity department in Tokyo, I moved to
the buy side. First running an internal hedge fund for Morgan, then with Steel
Partners Japan and now on my own.
MOI: How has your view of corporate Japan evolved over the years?
O’Friel: As I mentioned above, my first exposure to corporate Japan was
working at a Japanese company. Those were the heady years just after the
“Japanese managers are less publishing of Japan as Number One, a book by Ezra Vogel, my mentor at
likely to own a large amount Harvard. At that company, I learned the difference between management theory
of shares in their companies. and execution. They were an affiliate of Nomura Securities and tried to use the
same business plan. However they did not have the human resources, capital or
Thus, the interests of
scale to execute the plan.
managers are less likely to be
directly aligned with It was obvious to me, a naïve observer fresh out of school, that there really
shareholders, especially was no “corporate Japan,” just as there is no “corporate America.” There are
short-term shareholders.” good companies and there are bad companies. That being said, there are some
management philosophies that are more prominent in Japanese companies. In
general the Japanese have a broader view of who the stakeholders are in
corporations. There is a sense of responsibility to workers, vendors, clients and
regions that is stronger than at most U.S. firms. Japanese managers are also less
likely to own a large amount of shares in their companies. Thus, the interests of
managers are less likely to be directly aligned with shareholders, especially
short-term shareholders. This was true when I first came to Japan and is true
now. The result is, although management is much more focused on the interests



of shareholders, there is still little interest in financial engineering for the short
term benefit of stock prices.
MOI: Given the mixed track record of activist funds in Japan, is it justified
investing in Japan using an activist approach?
O’Friel: I would highlight the distinction that you made in your question. There
is a difference between the success of activism used as part of the investment
process and the success of particular activist funds, especially given the small
sample size of such funds.
Activist funds can act as a bridge between what the majority of shareholders
want. Often large shareholders remain silent and prefer to “vote with their feet”
by selling shares. However, there are fund managers who have complemented
their success in Japan by behaving in an activist fashion, that is, working with
management to implement change. These shareholders might not be noisy, but
they have frequent and meaningful meetings with managers and directors of
corporates. Japanese companies have always been innovative and willing to
learn from the outside. Corporate finance departments and CEOs are willing to
listen to shareholders. Gaiastu is a well recognized term in Japanese vocabulary
that describes using the threat of foreign pressure to implement change. The
improvements in balance sheets of corporate Japan over the last decade can be
attributed to some degree to shareholder pressure.
MOI: How would you assess the state of corporate governance in Japan? For
investors looking to invest in Japanese equities, are there any governance related
checklists that you would recommend?
O’Friel: Corporate governance can be defined as monitoring the behavior of
corporations so that efficient operations can be maintained, and assuring that the
benefits accrue fairly among shareholders, management and other stakeholders.
Legal shareholder rights in Japan are comparatively strong. Majority votes of
shareholders can enforce change. The issue is that there are often more than a
majority of shareholders that have no interest in the level of corporate
governance and little interest in monitoring management.
The first checklist point is the makeup of shareholders. Some items to
check are the level of the institutional ownership, the number and relationship of
“In [terms of executive cross shareholdings and the amount of insider or management ownership.
compensation], Japanese The second item to check is the board membership. There has been some
corporations are far superior movement to improve the governance of corporate boards. The TSE has
to companies in the West.” introduced some guidelines. Corporate boards in Japan are often large and have
few independent directors. An analysis of the number and relationship of board
members will give you an idea of the level of independence.
A third item is executive compensation. In this area, Japanese corporations
are far superior to companies in the West. There are few cases of management
enriching themselves to the disadvantage of shareholders or employees.
MOI: Many investors, most notably Warren Buffett and Jim Rogers, have
expressed the view that the Japanese stock market may present buying
opportunities following the selloff related to the March earthquake. Do you
share this view?



O’Friel: One of the reasons that the stock market rebounded so sharply after the
immediate selloff was the vote of confidence by Buffett and other foreign
investors. They realized that the damage of the earthquake and tsunami, while
devastating in its human toll, was not huge in its infrastructure and economic
ramifications. The three prefectures most directly affected by the quake (Miyagi,
Iwate and Fukushima) account for only 4% of the population and GDP of Japan.
However, damage to facilities did effect national supply chains and distribution.
Then came the news of the damage and leaks at the Fukushima nuclear
facilities. This has created more uncertainty in the medium term. 3% of the
electrical capacity of Japan is now offline. This has begun to affect production
outside of the areas directly impacted by the quake. In addition, both private
consumption and consumer confidence in Japan will be eroded as the impact of
blackouts continues.
The loss of consumption on the private side will have to be measured
against the rise in reconstruction demand. There will be gains in government
consumption and public investment.
While it is undeniable that the rebuilding process in Japan will be fast and
efficient, it is vital that the repairs to the nuclear facility proceed without
interruption and that the government is transparent about the damage and the
impact of any dispersion of radiation.
MOI: Will the recent catastrophe accelerate changes at the corporate or
government level that could lead to more sustained value creation for
shareholders in Japan?
O’Friel: The general public has increased its demand for transparency from the
government and from TEPCO. This might inspire the creation of an independent
nuclear regulatory agency. The crisis has also highlighted the cozy relationship
between regulators and the regulated in the power industry.
We must keep in mind that tragedy often inspires countries to search for
their core strengths. I think the Japanese nation, its people and its corporations
will look to their core to help the rebuilding. They will look to the values of
solidarity, patience and discipline. There is no indication that these noble traits,
however useful they are to surviving and overcoming this disaster, will lead to
fewer or better regulations or different views of corporate governance.

“The three prefectures most MOI: While Buffett has recently sounded optimistic about Japan, he has not
directly affected by the quake made any significant investments there. Are there any developments that may
(Miyagi, Iwate and lead to improving returns on equity in the future?
Fukushima) account for only O’Friel: The particular way of valuing Japanese companies has been the subject
4% of the population and of debate throughout the course of my career. Many of the valuation metrics
GDP of Japan. However, have come into line with global norms. Once, brokers and companies struggled
damage to facilities did effect to justify P/E ratios of 60x to 100x as something that was unique to Japan. P/E
national supply chains and ratios are now at levels in the low teens, which compare favorably to other
distribution.” international markets. Price to book, especially for mid-cap and small-cap
stocks, is low. There are many with price-to-book ratios below one.
MOI: What are some of your key investment criteria?
O’Friel: I have three simple criteria. First, the investment business is all about
trust and values. If the management of an investment target is trustworthy and



shares common values with the investor, then the opportunity is worth closer
inspection. Otherwise, it is best to stay away, short or, if given the capacity,
replace management. Second, valuation is the primary determinant of long-term
returns. Being right on the concept and right on the price are two very different
things. Finally, patience is important. If one is patient, it is easier to be a
contrarian and to wait for the fat pitch.
MOI: What is the single biggest mistake that keeps investors from reaching
their goals?
O’Friel: Research has shown that the single biggest error is overconfidence.
“…valuation is the primary
Investing is hard, with elements of skill, hard work and luck. An investor who
determinant of long-term
attributes every success to skill is susceptible to overreaching. Despite the
returns. Being right on the
outward veneer of successful managers, most are rather modest in reference to
concept and right on the their own skills. They know what they do not know. They respect the market.
price are two very different
things.” MOI: What books would you recommend to non-Japanese investors looking to
learn about Japan?
O’Friel: Any of the John Dower books, from War Without Mercy to Embracing
Defeat, tell the story of how Japan rebuilds from disaster and will give readers a
clue as to how Japan will respond to the recent earthquake. Ronald Dore’s Stock
Market Capitalism: Welfare Capitalism challenges the preconception that there
is one way of global capitalism. It highlights similarities between traits seen in
Germany and Japan. It is especially relevant given the 2008 shocks to the
“Anglo-American” system.



Some Context: Japan, The Country and The Economy
POPULATION SIZE – JAPAN IS DWARFED BY THE U.S. AND SEVERAL EMERGING COUNTRIES

th
Japan is ranked 9 in terms of
population size, but its rank may
slip in the coming decades.

Source: Japan Statistical Yearbook 2011, The Manual of Ideas.

POPULATION GROWTH HAS TURNED NEGATIVE

The decline in
youth is
worrisome for
Japan’s long-term
economic and
social outlook.

Source: Japan Statistical Yearbook 2011, Chapter 2: Population and Households, The Manual of Ideas.



JAPAN’S POPULATION PYRAMID HAS BECOME TOP-HEAVY…

Source: “Statistical Handbook of Japan 2010” by Statistics Bureau, Japan; The Manual of Ideas.

…AND WILL LIKELY BECOME EVEN MORE TOP-HEAVY OVER TIME

Increased
immigration or a
higher birth rate
are likely
necessary for
Japan’s long-term
viability as an
economic power.

Source: Japan Statistical Yearbook 2011, Chapter 2: Population and Households, The Manual of Ideas.



DISTRIBUTION OF ESTABLISHMENTS AND EMPLOYEES IN JAPAN

Corporations,
both large and
small, dominate
the employment
picture.


GDP BY COUNTRY – JAPAN REMAINS AN ECONOMIC POWERHOUSE *

Japan’s economic
significance dwarfs
what might be expected
when considering the
country’s population
size ranking.
That said, China
recently surpassed
Japan in terms of GDP.

*
Based on 2008 data. Source: Japan Statistical Yearbook 2011, The Manual of Ideas.

JAPANESE GDP HAS STAGNATED FOR MORE THAN A DECADE

The Japanese economy
has made little progress
against a backdrop of
multi-year deflationary
pressures.




NOT SURPRISINGLY, SALES AND PROFITS HAVE ALSO STAGNATED

The financial crisis has
affected the profits of
“Japan Inc.” in an
unprecedented way.


TRADE INCREASED THROUGH 2008, BUT EXPERIENCED A SHARP SETBACK AS A RESULT OF THE FINANCIAL CRISIS

Japan has consistently
maintained its status as
a leading exporter and
generator of trade
surpluses. The latter
have shrunk in recent
years, as imports have
become more important
to the country.




NEARLY ONE-HALF OF REVENUE FROM BOND ISSUANCE, WHILE NEARLY A QUARTER OF BUDGET GOES TO DEBT SERVICE

Japan relies heavily on
debt issuance to fund
the annual budget.

Social security and debt
service represent large
burdens on Japan’s
budget. Offsetting these
needs is a relatively low
allocation to defense.


“NON-PRODUCTIVE” SPENDING (RETIREES AND DEBT SERVICE) HAS BEEN INCREASING OVER TIME

Japan’s has radically
reduced land
preservation and
development
expenditures in order to
fund other priorities.




JAPAN’S GOVERNMENT DEBT-TO-GDP RATIO STANDS OUT AMONG DEVELOPED COUNTRIES

Japan’s debt-to-GDP
ratio may have passed
the “point of no return”.


UNEMPLOYMENT HAS INCREASED BUT REMAINS QUITE LOW

Japan’s unemployment
rate fell to remarkable
lows prior to the crisis.




RETAIL SALES HAVE BEEN ON THE DECLINE FOR NEARLY TWO DECADES

The fate of Japan’s
retail industry was
sealed with the bursting
of the late-80s bubble.


NUCLEAR PLAYS A SMALL BUT NON-NEGLIGIBLE ROLE IN JAPAN’S OVERALL ENERGY MIX

Natural gas may gain
share in the wake of the
recent Fukushima
nuclear plant disaster.


JAPANESE STOCK MARKET VALUES REMAIN SIGNIFICANTLY BELOW THE 1989 HIGH

Two “lost decades”:
The aftermath of the
1980s bubble has
been exacerbated by
persistent deflationary
pressures.



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