Sky-High Prices, Overrated Japan

I had an interesting meeting recently with a portfolio manager for international equities.  When I asked him to describe a couple of recent portfolio additions, he said that he has been struggling to find anything new to buy at acceptable valuations.  He pointed to the run-up in value, the run-up in small caps, the run-up in emerging markets.  He noted that international markets were up 30% in the last 18 months in dollar terms, up 20% in local currency, and that "obviously" stocks aren’t worth that much more now than they were then.

I then asked him how he justified his substantial overweight in energy stocks.  He has something like 22% of his portfolios in energy, vs. 7% for EAFE, and he acknowledged he would overweight even more except that the funds have a policy limiting sector overweights.  Hasn’t energy had the same kind of run-up, I asked, as small-caps and emerging markets?

"Can you think of any other industry," he replied, "where prices have tripled?"  He said he assumes $50 oil, which he thinks is conservative, and even with that many energy stocks still appear to be much better values than anything else around.

I also asked him about his substantial underweight in Japan.  The explanation: He looks for high return on capital combined with low valuation — shades of Joel Greenblatt — and return on capital is pathetically low in Japan.

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Personally, I continue to have a hard time making sense of Japan as an investment opportunity.  Bulls emphasize that Japan is much cheaper than other developed markets on price/book and price/sales; bears emphasize that Japan is more expensive in P/E terms and that return on capital is awful.  In effect, bulls say, "You can buy assets cheap," while bears ask, "Why throw good capital after bad?"