Here's a long but interesting article. The UTEK recommendation is at the end.
JAPANESE "BIG BANG" TO GIVE U.S. TECHNOLOGY STOCKS A LIFT?
By: Joe Dancy, Lone Star Growth Investor
As the worldwide economy becomes more intertwined governments can exercise less regulatory control over the financial sector. Global capital markets quickly vote their approval or disapproval of governmental policies - with potentially devastating impacts on a specific economy. In this interconnected economy money flows to where it is treated best, and where it can earn the best return.
Recognizing this Japan, the world's second largest economy, is about to implement a sweeping plan to deregulate its financial industry that could irrevocably alter the way that nation does business with the world -and it could have implications for the U.S. stock market.
Dubbed the "Big Bang" after the 1986 deregulation of the London securities market, the goal is to move the Japanese financial industry from a highly regulated environment with tight governmental ties to business to one where global capital markets are allowed to freely exert their influence.
Japanese Are Prodigious Savers
This is significant for the following reason: the Japanese people are the world's most prodigious savers and have over $15 trillion in aggregate personal savings - one-third (1/3) of the world's total savings and a sum greater that the annual output of the American economy.
An average Japanese household has over $126,000 in savings according to governmental statistics - and the savings rate is 13% in Japan versus 5% in the U.S. If these funds are freed so that they can be invested where they can earn a higher return, some Japanese governmental officials have expressed concern that they "will see massive capital flight."
Japanese depositors have paid a large price for a regulatory structure that has kept interest rates depressed. The Bank of Japan has been forced for years to set the official interest rates close to zero percent, in part to offset depressed asset prices and to keep banks solvent. Due to restrictions more than 60% of Japanese household savings is in savings accounts that yield 0.25 to 0.33%.
Depositors provided the banks with cheap capital, which will disappear under the deregulatory efforts. On a $100,000 account, the annual pre-tax return on that investment would be $250-330. Compare this rate of returns with those achieved in the last decade in the U.S. or European bond or stock markets - U.S. Treasury bonds are offering more than ten times the yield of Japanese banks - and you can guess where some of that money will head.
While Japan has one of the highest savings rates in the world only 10.4% of household financial assets are invested in stocks. This compares to 25% of household assets in stocks for American households (who have a much lower level of savings on average).
Experts also expect investment trust products to absorb large quantities of Japanese funds. Only a small portion of individual financial assets in Japan are in financial trusts, and many experts expect this number to increase sharply. Various trust products will be offered to investors to meet their needs and risk levels.
Some experts think that investment trusts will send "money into higher-return foreign markets " which may result in assets "pouring out of the country."
Japan's Economic Problems
Governmental protection has left Japanese banks with billions of questionable loans, many in troubled Asian countries, and many now face what some have called a "tidal wave" of defaults. The domestic Japanese economy also faces a recession after nearly a decade in the economic doldrums. In theory, free financial markets in Japan would take the lead in allocating capital instead of the authorities - and the positive effects of financial deregulation would cascade through the economy.
The Japanese economy is now stalled - it grew at 3.5% in fiscal year 1996 and it is estimated that it had no growth in fiscal year 1997 which ended March 31. In 1998 some economists are predicting a decline of 0.2% or more in the economy unless stimulus packages are adopted - meaning that the country is on the verge of a recession.
Meanwhile the unemployment rate has surged to a postwar high of 3.6% - a shocking level to many in an economy where many employees work for one employer for life. Given the weak economy and uncertain outlook, many Japanese investors may seize the opportunity to invest elsewhere.
Further, by 2020, 60 of every 100 Japanese will be over 60 years old, and Japan's life insurers have performed very poorly - averaging an annual return of 2.5% for the last 15 years - and some have even reneged on their guaranteed returns. Deregulation is needed to boost investment returns to insure pensions are paid timely, although the cumbersome tax structure and poor accounting standards for business remain in place.
Proposed Regulatory Changes
The first changes came in April when controls on foreign exchange transactions were relaxed. On that date individual Japanese investors and Japanese companies can take their money out of Japan and invest through a brokerage in New York or elsewhere, and banks can sell mutual funds. Over the next three years the Japanese government plans to remove barriers and restrictions throughout the financial system abolishing the barriers separating banks, securities houses, and insurance companies.
To exploit these developments a stampede of European and American companies, including Merrill Lynch & Co. and Fidelity Investments, are preparing to push into this market. Fidelity plans to focus most of its efforts on teaching customers the concepts of risk management and financial planning - since investment options have been limited many investors are not as sophisticated as they are elsewhere.
Citibank has accumulated 850,000 individual accounts in Japan, a gain of 50% in the last year. Citibank ran a private banking ad that targets those with more than $800,000 in financial assets to manage - and each time the ad has run Citibank claims to get 300-600 responses, far more than expected. GE Capital is also preparing to expand in this market.
Global Stock Markets Could Move Much Higher
A major inflow of Japanese funds into U.S. markets - which could be a fraction of the total savings - would keep interest rates lower and could send equity prices much higher. In addition, capital outflow may weaken the yen making exports to the U.S. even cheaper, again reducing inflationary pressures in the U.S. Low inflation supports higher equity values - earnings discounted to the present are worth more - especially for companies that are growing rapidly.
On the other hand the Japanese are largely risk-adverse investors and flows of savings into new markets and products may take some time. Also, bureaucratic controls and social attitudes may slow or temporarily stop deregulatory efforts - but in an interconnected global economy such deregulatory efforts are essential to insure capital is allocated efficiently - which should benefit Japanese industry in the long run.
Competition will increase rates that will be paid to Japanese savers, which will cause banks to closer review the financial condition of the businesses applying for loans. Businesses may have to increase profitability to become more efficient to qualify for loans, a process that may create a short term credit crunch in a stagnant economy.
Failure to adopt these reforms - and they may stall - will just extend the problems of allocating capital through a bureaucracy - and will extend the economic problems in Japan and throughout Asia. The Asian crisis never will truly be resolved until the Japanese financial system is restructured - a restructuring that should aid foreign equity markets.
Impact on Semiconductor Equipment Stocks
An incredible two-thirds (2/3) of all world capital investment since 1990 has taken place in Asia - large sums of which originated from Japan. Not all of that has been invested in technology, but a large amount has been invested in this growing segment of the economy. For example, Semiconductor Equipment and Materials International estimates that Asia accounts for 31% of the global market for semiconductor equipment.
Due to the Asian crisis analysts have estimated that 19 fabs and major upgrades have been delayed or canceled - amounting to around $20 billion or more in expenditures that will be delayed or canceled. Jean-Phillippe Dauvin, chief economist for SGS-Thomson, predicts that the cutbacks will align supply and demand much quicker than would ordinarily occur - fabs are running at 92% capacity now versus 87% in 1996 - and he predicts strong demand for equipment will start later this year.
Two major trends are underway in the semiconductor industry that support Dauvin's proposition: (1) the trend to smaller feature sizes, and (2) the trend to larger size wafers. Both trends will make the manufacturing process more efficient, and give plants using the new technology an economic advantage. Should a firm decide to skip a generation of technology for economic reasons, they have found it very difficult and expensive to catch up with the industry.
Based on the cancellations, uncertainty as to the impact of Japan's Big Bang on Asian economies, a possible recession in Japan, we feel that a value oriented approach to stock selection is prudent at this point. Last week VLSI Research updated their forecast for 1998, and they expect a 3.4% increase in semiconductor equipment expenditures. If conditions should weaken, consolidation may well occur in the semiconductor equipment industry - and a value based selection process should provide protection on the downside.
Lone Star Long Term Selections
The estimated earnings growth of companies in this sector are impressive - much higher than estimates for the overall economy - and for long term investors current prices for some companies look attractive. Using a value based approach looking for future growth with limited downside, as long term investors we like Model Portfolio companies Ultratech Stepper (UTEK), FSI International (FSII), and Align-Rite (MASK) - especially if these stocks should dip from current levels.
Semiconductor equipment manufacturer UTEK has a consensus estimated long term earnings growth rate of 28.7% according to Zacks, a price to book ratio of 1.6, and carries no debt. FSII has an estimated long term earnings growth rate of 25.0%, a price to book ratio of 1.1, and carries a low debt/equity ratio (0.16). Both companies have good products, technology, and management.
Photomask manufacturer MASK is somewhat less cyclical than other semiconductor equipment stocks since circuit designs are always being modified and upgraded which requires new photomasks. Zack's has an estimated long term earnings growth rate of 20.0% for MASK, a trailing price to earnings of 13.4, a price to book ratio of 1.9, and it carries no debt. The company is a micro-cap, with a capitalization of around $70 million.
Carl Johnson of Infrastructure, in an interview on the Internet Financial Connection, noted that they like photomask makers Photronics (PLAB) and DuPont Photomask (DPMI) for the same reasons we like MASK.
PLAB has a consensus long term growth rate of 23.6%, a trailing price to earnings ratio of 25, a price to book ratio of 3.3, and a debt/equity ratio of 0.36. DPMI has a consensus long term growth rate of 20.6%, a trailing price to earnings ratio of 18, a price to book ratio of 2.6, and carries no debt. Both PLAB and DPMI are attractive long term investments in our opinion, but have not been included in our Model Portfolio.
Best wishes,
I2 |
