As promised, the “Top 5 Japanese stocks through the Top 5 Value Investing Formulas” saga continues!
Last week you could read about “The 5 Best Japanese Stocks Through The Graham Strategy”. It’s an incredible strategy that has created millions of dollars in value over the years, and I am perhaps for the first person to write an article on it being used on Japanese stocks.
This week, we will focus the second legendary formula for value investors:
The Magic Formula
As written in my Value Investing Formulas article (HERE), the Magic Formula is based on Joel Grenblatt’s legendary value investor book “The little Book that Beats the Market”.
The formula attempts to find undervalued companies with high returns using two key ratios:
Return on Capital (RoC) = Earnings Before Interests and Taxes (EBIT) / Invested Capital
Return on Capital = Determines how efficiently a company puts the capital under its control toward profitable investments or projects. The ROIC ratio gives a sense of how well a company is using the money it has raised externally to generate returns.
Invested Capital = The total amount of money raised by a company by issuing securities to equity shareholders and debt to bondholders
Earnings Yield (EY) = EBIT / Enterprise Value (EV)
Earnings Yield, also called Inverted P/E, is a percentage value that shows how much earnings per share a company generates from every dollar invested in the company’s stock.
Enterprise Value = The total value of a company, defined in terms of its financing. It includes both the current share price (market capitalization) and the cost to pay off debt (net debt, or debt minus cash).
The formula first sorts all companies with a high return on capital (RoC) and then the lowest valuation using EBIT / EV-%.
By adding the points of the two ratios, you’ll find the best stocks at the lowest valuation at the top of the list!"
Adding My Secret Sauce
To remove any outliers from the Magic Formula ranking, I have vetted the stocks with my tried and true Value Vetting Strategy:
A P/E less higher than 6 but lower than 25
An average Earnings Growth higher than 7% over the past 7 years
Return on Equity at at least 10%
A dividend yield higher than 0.5%
Net debt / Earnings Before interest, Taxes and Depreciation lower than 2
Top 5 Japanese Stocks According to the Magic Formula
These are the 5 highest ranked Japanese stocks according to the Magic Formula:
You can download the full spec sheet of the companies here:
1. Melco Holdings Inc
Melco Holdings is a holding company mainly engaged in the development, manufacturing and sale of digital consumer electronics and computer peripherals, as well as the provision of Internet-related services. Through its subsidiaries, the Company offers memory modules, universal serial bus (USB) flash memory products, storage products, network hard disks, wireless local area network (LAN) products, digital home products and supply accessories, among others.
This is the number 1 company in the Magic Formula rankings, and for good reason! The company has a stunning 40.4% Return on Capital and a 34.8% Earnings Yield. Simply put, this can be interpreted as if you buy this company’s stocks for a ¥1000, it can technically repay that money in less than 3 years, and you will still own the same amount of the company. Its like buying a money printer!
Of course it is more complicated than that, but this example shows you how efficiently Melco Holdings invests the cash it receives from its shareholders.
Furthermore. for such a low margin industry, the company has a very impressive 6.8% profit margin (compared to peers like Mitsubishi Electric (5.8%) and Panasonic (3.8%)).
Risks
The biggest risk is its industry. Many segments Melco Holdings is involved in are priced like commodities and if competition gets fierce, their profit margins could easily be wiped out. Usually, electronic suppliers have to buy up other companies to keep expanding, which can be very lucrative with the economics of scale, but in a bull market like now, it can be hard to find valuable buy-up candidates.
Secondly, as you may have heard, COVID-19 has delivered an unprecedented shock to the world’s supply chains and companies like these most exposed. If the supply chain debacle does not recover soon, this stock could lose a lot of its valuation.
2. Pharma Foods International
Pharma Foods International Co., Ltd.’s business is hard to understand to say the least.
The company mainly engaged in mail order business and functional materials business. It operates through three business segments.
The Mail Order segment is engaged in the sale of supplements through advertising media such as televisions and radios.
The Functional Materials segment is engaged in the development and sale of functional materials such as GABA, Bonepep, Folic Acid eggs and Chicken Egg Antibody.
The Biomedical segment is engaged in the antibody contract manufacture business for drug discovery and diagnostics, and life science information (LSI) business for analysis and efficacy evaluation test of materials and products.
Its definitely an interesting company, but a quick look at the numbers gives me reason to jump straight to:
Risks
This company has an insane Return on Capital (ROC) rate of 1122.8% coupled with a impressive Earnings Yield of 14.1%. The ROC rate is likely a one-time profit hike from one of their R&D endeavors panning out successfully. This is quite common in pharmaceutical companies because of their unpredictable field, with their future being decided by secretive agencies like the FDA. If you look at a more famous pharmaceutical company like Moderna, who had the mRNA breakthrough last year; it is also hovering at an extremely high ROC rate of 300-500%; something that will definitely go down if the company does not find equally impressive and widely demanded product as the Moderna COVID-19 vaccine every year.
The Pharma Foods International stock has already dropped 25.5% since the last year which indicates that a lot of investors are already taking home their profits, or just expect less success from the stock in the foreseeable future.
Pharma Foods is definitely a company with good fundamentals, but only invest if you know this industry well.
3. WDB Holdings
WDB Holdings operates in three business segments:
The Human Resource Service segment is engaged in the work of client customers mainly through temporary staffing and contracting contracts.
The CRO (Contract Research Organization) business segment acts on and supports experimental work in basic research of pharmaceuticals, quasi-drugs, cosmetics and development work after clinical trial.
The other business is engaged in the contracted manufacture of organic chemicals, as well as the product development and sale, and the research of the aquaculture and breeding of clams, fishes and algae, among others.
As you can see, its a company with vastly different segments, which makes it hard to get a good strategical overview.
However, numbers do not lie: With a ROC of 102% (average past 7 years 98%), an Earnings Yield of 13% and a P/E 16.9 (relatively high for its industry, but its historical average is 18.5). On top of that, the company hands out around 30% of their profits to dividend, which indicates a clear shareholder focus.
With their main industry segments being an upwards trend, it is safe to say that this might be one investment for the books.
Risks
Its hard to get a good understanding on a company this diversified. They seem to aim for synergy between its business segments, but from a quick glance they could just be a conglomerate who bought too many companies for any real synergy. Conglomerates are usually valued at a discount because of their administrative overhang, and hence, if WDB Holdings continues to branch out into different industries, we’d likely se a drop in its P/E ratio and its stock price.
4. Nintendo
The company that needs no introduction. Nintendo was featured in my first value investor article “The 8 Most Undervalued Stocks in Japan, and The World(?!)”. Turns out, the Magic Formula also shows its a huge value stock!
As mentioned in that article, Nintendo has gone from record hype and valuation to record profits with no hype in less than 2 years!
Fundamentals wise, the company keeps churning out cash like a money printer, but investors’ forward guidance is bleak: Immense competition from mobile games (something Nintendo has dropped the ball on completely), supply chain disruptions that have lead to a shortage of Switch consoles, and what many sees as a lack of innovation with no new consoles in sight and a lack of third-party games, there are definitely reason to be gloomy.
At the end of the day, Nintendo has immense core value, not only in its brands and IP, but in its innovative tech and creative people!
With a P/E of a measly 14.1 (41 average over the past 7 years), a relatively sustainable ROC of 158%, this company should looks insanely attractive for any value investor!
Risks
As mentioned above, Nintendo has a lot of hurdles ahead. If the management continues in the course they are aiming at now, it might be a value trap, with decreasing demand from their present console and low support from game developers.
However, Nintendo has come back from a slump many times before, and with better fundamentals and a bigger stash of cash than ever, there is no reason why they cannot reinvent themselves again!
5. Itochu Corporation
Itochu Corporation is a long time favorite on this newsletter and was ranked as the 3rd most valuable stock in “The 8 Most Undervalued Stocks in Japan, and The World(?!)”article. Its a Japanese trading company, or conglomerate, that operate companies in everything from textile manufacturing to IT. It owns huge chunks of companies like Converse, Family Mart and LeSportsac.
The company is definitely on the lower end of the Magic Formula ranking with an ROC of 7.6% and an Earnings Yield of 8.9%, but it has consistently delivered increasing profits and shareholder value.
To summarize, Itochu’s portfolio of companies is so widespread you might as well buy a NIKKEI 225 index fund, but with this stock you get a dividend yield of 2.6% and a stake in your favorite convenience store Family Mart, so why not?
Risks
No matter how good the fundamentals look for Itochu, there is a reason why conglomerates are usually discounted:
Firstly, the administrative overhang of managing hundreds of companies can make them so inefficient at administrating their assets that they become worth less than if they were individually managed.
Secondly, as stated above, with exposure to as many industries as Itochu has, the company’s share price has often trailed the biggest Japanese Indexes, so instead of buying Itochu, it might be a better bet to just buy a Japanese index fund.