Japan is home to a unique corporate beast: the trading company. These companies have been beaten down, but are now enjoying a resurgence that investors would do well to track -- particularly with tax changes in 2017 that are to their benefit.
The simple name belies their complex nature. These are sprawling conglomerates, some of the most-storied names in Japanese business history: Marubeni (MARUY) , Mitsubishi (MSBHY) , Mitsui (MITSY) , Sumitomo (SSUMY) .
The operations of the sogo sosha, as they are called in Japanese, encompass the supply and distribution that gives them their name. But like the chaebol in South Korea, their subsidiaries are so extensive, with major operations in mining and energy production in particular, that Masami Iijima, now president of Mitsui, has likened them to private-equity funds.
Mitsui generates around half its profit from energy investments, making it the most resource-oriented of its peers. So the slide in oil, coal and other commodities has hit it hard.
Itochu (ITOCY) and Toyota Tsusho T:8015, as well as Sumitomo, have relatively low exposure to commodities. Itochu may be the best bet in the sector, with commodities once again drifting modestly weaker and a textiles business that's consistently double the industry average in terms of profitability.
Overhauling Japan's tax system is among one of the many shards of the "third arrow" of Abenomics, structural reform. It is also the most-difficult one to target. One of the changes that the government has already pushed through is to make corporate spin-offs tax-free.
That new status was granted as of the start of the Japanese fiscal year in April. Previously, parent companies had to pay capital gains on the shares they were distributing and treat any excess between shares in the new company and capital reserves as dividends.
The government says the new rules are in part to "overcome the conglomerate discount." Since the millennium, trading companies have traded, equity-wise, at a discount of around 20% to the overall Topix index, the broadest measure of stocks in Japan. But the spread widened to a 35% discount after the financial crisis, largely because of the hammering that the metals and energy sectors have taken.
Tax-free spin-offs would allow them to "unlock value" by spinning out non-core assets or by listing subsidiaries, in the eyes of Jefferies equity analyst Thanh Ha Pham. It doesn't hurt that the parents pay out a relatively attractive dividend yield of 3%.
There are several requirements to qualify for the tax-free status. The distribution can only involve shares in the spin-off. The parent can't be controlled by another company, and the subsidiary should not be either, after the spin-off. At least 80% of the employees should continue on with the same company, which must pursue the same business. And at least one of the directors of the subsidiary must stay on.
That rules out spinning off joint ventures, but leaves a lot of room to dispatch peripheral or undervalued operations. The trading companies typically generate higher returns on assets than their competitors in mining, machinery and the like.
Mitsubishi has already labeled its assets and is preparing to sell off mature businesses. Mitsui is due to announce its mid-term plan in May, which will also likely result in the streamlining of non-resource assets. Sumitomo will complete a review of the same possibilities in 2018.
Mitsubishi has recently lagged the Topix, with shareholders apparently unsure about management's explanation of its growth plans. The company reports full-year results for the last fiscal year on May 9; it will be interesting to see how the sharp rise in the price of coking coal last year plays into profits.
Coal surged after the Chinese government restricted domestic supply. Cyclone disruption in Australia in April also led to higher prices, although they have settled now the weather damage and rail supply Down Under have returned to normal.
Mitsubishi gets 70% of coking-coal sales on the spot market, the highest rate of its peers, which normally price the commodity quarterly. So it would get a higher short-term boost from the spike in prices. But it has not explained how much disruption it experienced transporting the coal to sea for distribution.
Mitsui will report full-year results the same day. It may well announce higher dividend or other measures to enhance shareholder returns along with its medium-term plans, a familiar pattern in Japan. With seven main industry groups, it may whittle down the targets for investment, Nomura notes.
Itochu is strong not only in textiles but also food and consumer-driven businesses. It is buying back shares and has a plan to boost its dividend from ¥55 per share to ¥60. Nomura rates the company its top pick in the sector. Only Toyota Tsusho has seen stronger share performance this decade, and the occasional dips it experiences look like buying opportunities as it gained around 30% in that time.
Sumitomo, Marubeni, Mitsui and Mitsubishi are all 15% lower or more since the start of this decade, again battered by commodities. Sumitomo shares have however performed well recently. The company is losing money in its nickels business, which is a risk of further underperformance. But its tubular-trade business, one of its strengths, lost money due to softening in the U.S. shale gas and oil industry last year.
The turnaround in steel-tube prices and the improvement in the shale business both bode well. What's more, the U.S. Commerce Department announced on April 11 that it will investigate possible dumping of tubular steel from South Korea, which could lead to additional duties on some of Sumitomo's competitors.
Trading company stocks have generally performed better than the Topix average since mid-2016. The recent recovery in commodity prices has already drawn active funds to the shares of the trading companies, Nomura believes. They weren't previously invested in the sector.
If the trading companies succeed in their spinoff strategies, expect that outperformance to gain pace.