Steve Weiler manages from Corvallis, Oregon in the United States the Falcon Pacific Japan funds, which are comprised of two Japan equity long/short funds. Steve has over 17 years of experience living and working in Japan including, most recently head of equity research from March 1998 to May 2002 at Penta Investment Advisers. Steve is assisted in Tokyo by Nicholas Smith (a former Penta senior analyst) and three other personnel based in Oregon including Jack Bird (the former CFO of Penta) and Dana Lawton (a former sales trader from JP Morgan).
Steve invests the Falcon Pacific Japan funds in all market cap sectors in the Japanese market although many investments are made in small- to medium-cap companies in Japan since they are often under-researched and thus the best place to generate "alpha". The research process includes an intensive use of company visits as well as rigorous analysis of the industry fundamentals. Steve uses pair trades to the extent possible in order to reduce overall market risk in the portfolio.
The funds were launched in October 2004 and currently have US$4 million in assets.
- The investment team has hedge fund experience dating back to the late 1990s with Penta Investment Advisers. Besides the proliferation of new Japan hedge funds, how has the investment landscape changed (for better and worse) since you were at Penta?
- Do you think being based in Oregon will inhibit your ability to analyse Japanese companies and from raising assets for the fund quickly? As far as analysing Japanese companies is concerned, I lived in Japan for almost 20 years working most of that time as a stock analyst and I travel back to Japan six to eight times a year, so I do not feel that I am at much of a disadvantage in analysing Japanese companies. We work Japanese market hours on the West Coast so we are not at a disadvantage on the trading front. Also, our style is fundamental analysis which means that we are not rapidly trading in and out of positions where being physically close to the market may be an advantage. Finally, we have a research operation in Japan as well which allows for quick research visits where necessary.
- Can you explain the fund's "pair trading" strategy?
- Have you been able to source stock borrow at a reasonable price for mid/small-cap stocks (ie market caps under US$1 billion)? Where do you focus your shorts?
- After having worked at a Japan hedge fund during the difficult trading environment of 2000, what is your view of "risk" in running the portfolio and how will "risk" (as you define it) be controlled?
- How are you playing the theme of the shift to impairment accounting in Japan?
- The market consensus is that there has been a slowdown in sales for both exporters and domestic companies in Japan since July. If this slowdown continues, where will you find interesting long opportunities?
- Do you believe that Japan has currently regressed back into a recession?
- What interesting investment themes do you believe will emerge from the reorganisation and privatisation of Japan Post?
- Finally, what are you future travel plans to meet with prospective investors?
In many ways, Japan has become a much more rational market to invest in. During my time at Penta, the market or individual stocks would often trade on speculation regarding government or bank policy related to an overburdened corporate debtor or whether Japan was going to have a total "meltdown". Now much of Japan's bad debt legacy from the "bubble" era has been worked out. While at Penta, Japan was in a "one step forward, two steps back" phase. Now, Japan seems to be in a "two steps forward, one step back" phase and the markets and individual stocks trade more on fundamentals.
In some ways, being on the West Coast can be an advantage. Companies often make announcements in the late afternoon or evening Japan time. When I was based in Japan, this meant that sometimes I would be working frantically before the market opened the next day in order to digest the implications of a company announcement and catching up on the overnight news from the US and Europe. When working on the West Coast, I am able to consider the impact of a company announcement on stocks in our portfolio for several hours before the markets open without having to rush as much.
As far as raising capital is concerned, it is true that if clients want to see our offices in Oregon they have to make a trek to Corvallis, which is not as easy if we were based in Manhattan or Tokyo. Thus, it probably has slowed down the capital raising process to some extent. Nevertheless, we are in this business for the long term and over time we do not think it will matter. Clients ultimately are looking for returns and we believe we have the team to provide good risk-adjusted returns in the Japanese equity markets.
In my mind, there are two kinds of pair trades. A "pure" pair trade is based upon our view of the relative prospects of two companies in the same business. Thus, for example, perhaps we believe that the prospects for both Toyota and Nissan are deteriorating because the US auto market is expected to weaken and both are significantly exposed to that market. However, perhaps we also believe that Toyota has better exposure to parts of the world that are still growing, has better management, etc, and thus over time Toyota will do relatively better than Nissan. In such a case, we might choose to buy Toyota and short Nissan in the same amounts. If our analysis is correct, over time Toyota should outperform Nissan even if both weaken because of US market problems.
A "quasi" pair is one where two companies are in different businesses but there is a common dynamic affecting both. For example, shipping companies are having a banner year and are expanding their fleets with massive orders for new ships from shipbuilders. If one takes the view that this will ultimately create a glut of ships which causes the profits of shipping companies to decline, we would short the shipping companies and buy the shipbuilders.
The availability of borrow for stocks in Japan has greatly improved over the last few years and even for small- to medium-sized stocks, it is often possible to short them as Japanese domestic institutions are increasingly lending their portfolios into the market. As far as where we focus our shorts, the stupid (but true) answer is simply those stocks that we think are going to decline. It is somewhat more risky to short small company stocks because they tend to be more thinly traded but if one is careful, it is still profitable to short some small company stocks.
I think the lessons to be learned from 2000 are liquidity, liquidity and liquidity. The way to control the liquidity risk is to (a) limit the size of positions and (b) limit the size of the assets under management. On the former, we have a policy to top slice positions to the extent they exceed more than 5% of capital. On the latter, assuming our fund raising activities are successful we intend to "soft close" our assets under management in this strategy at US$250 million and "hard close" at US$500 million. We believe these policies will allow us to be nimble in the market and avoid some of the liquidity issues that caused problems for a lot of funds in 2000.
We believe that this is part of a very important trend towards "truth in accounting" in Japan. For many years, we knew that certain companies were in trouble because the values on their balance sheets for many items (primarily real estate related) were significantly overstated. However, because the accounting methodology did not force these losses to be realised, management and, to a large part, the markets chose to ignore the losses. The anticipation of impaired accounting is now forcing managements to deal with these issues. How we are "playing" this theme is very company specific. For some companies, the actual impairment losses may be less than what the market anticipates and thus the stocks may actually rally after the announcement. For others, the losses are greater than anticipated which may cause the stock to fall. As analysts, we have to use our analytical skills to ferret out the true nature of any losses as well as what the market expects and take a view as to the effect of the impairment on the perceived value of the security.
Fortunately for me, I happened to have a great deal of experience in the real estate field in Japan having worked as a sell-side real estate and construction analyst and with Jardine Fleming and Fidelity. Impairment issues in Japan often relate to real estate in one form or another which gives us an advantage in evaluating the extent of any likely impairment adjustments.
That of course is the structural superiority of hedge funds we can choose to be net short and profit on the market downside as well. Nevertheless, we can choose longs using a pair strategy like discussed previously even if we believe that the market will go down overall and still make money. Also, even if the economy goes into recession, there are always companies (many of them small- to medium-cap names) which will buck the trend because they have a new or superior product.
Because of problems in the US, I believe there is a significant likelihood that Japan will experience a short recession in 2005. However, because Japan has largely worked through much of the financial problems arising during the bubble era and because Japan is tying itself economically more and more with the dynamic growth areas of Asia, I believe that the Japanese market will de-couple itself even further from the US market and rally even if the US market languishes. According to some recent studies, Japan is already the least correlated of the major international stock market classes with the US and I would expect this trend to continue.
That is a tough one. In many ways, it depends upon how it is done. Japan Post is the largest financial institution in the world and how it is reorganised/privatised will have a significant impact upon many financial and other players in Japan. On the positive side, a deal with a convenience chain store like Lawson can provide a lot more foot traffic and increase sales for Lawson. On the negative side, the banks and insurance companies may have an even more overbearing competitor if Japan Post is privatised intact. In my view, it would be best for Japan if the bank and insurance parts of Japan Post were broken up on regional lines into competing entities but politically of course that is very controversial. We will just have to wait and see.
I travel to Japan every four to six weeks so I am always available to meet prospective investors there. As far as investors in the US and Europe, while plans have not yet been finalised, I and/or other members of the Falcon Pacific team plan to make some investor trips in early 2005. We of course welcome investors to our offices in Oregon or Tokyo and are also available for conference calls at any time.
Jack E. Bird
Chief Financial Officer
Falcon Pacific Capital Management LLC
1 541 257 2395