Berkshire's Strategic Move in Japanese Trading Houses

We examine Berkshire Hathaway's increased investment in five Japanese trading houses, detailing the strategic rationale behind the move and the growth potential of these firms. We also delve into the challenges and criticisms faced by the trading houses, the impact of the "Buffett effect" on their share prices, and the future prospects for collaboration and deal-making between Berkshire Hathaway and these companies.

Introduction

In April 2023, Berkshire Hathaway made a bold move by increasing its stake in each of the Japanese trading houses to 7.4%. This investment builds upon an initial allocation of roughly $6 billion in August 2020. The five firms in question are Mitsubishi Corp., Mitsui & Co., Itochu Corp., Marubeni, and Sumitomo. This article will delve into the strategy behind this decision, addressing the historical context, earnings yield, potential for growing dividends, and future prospects for these companies, all while considering the various challenges and criticisms they face.

A Brief History of Japanese Trading Houses

The origins of Japanese trading houses, known as sogo shosha, can be traced back to the 19th century. These trading houses started as textile merchants during the Meiji Restoration period (1868-1912), a time when Japan was undergoing rapid modernization and industrialization. As the nation's economy grew, so did the trading houses, expanding their operations to include a wide range of commodities and products.

Throughout their history, these conglomerates have played a crucial role in Japan's economic development, acting as intermediaries between Japanese manufacturers and international markets. Their expansive networks and diversified portfolios have allowed them to weather economic downturns and adapt to changing market conditions. In the post-World War II era, they contributed to the "Japanese economic miracle" by facilitating the export of Japanese goods and the import of essential raw materials.

Over the years, these trading houses have evolved into modern-day conglomerates, engaging in a broad spectrum of activities such as trading, investment, and financing across various industries. Today, Mitsubishi Corp., Mitsui & Co., Itochu Corp., Marubeni, and Sumitomo stand as some of the most prominent sogo shosha in Japan, each with their own unique history and specializations.

Despite their long-standing significance in Japan's economy, these trading houses have faced a number of challenges in recent years, including slow growth, complexity, and international transactions. Nevertheless, their resilience and adaptability have drawn the attention of Berkshire Hathaway and its CEO, Warren Buffett. In the following sections, we will explore the rationale behind Berkshire Hathaway's increased investment and the potential outcomes of this strategic decision.

Understanding Berkshire Hathaway's Strategy

Berkshire Hathaway's initial investment in the Japanese trading houses, amounting to roughly $6 billion in August 2020, signaled a strong vote of confidence in these companies. The decision to further increase stakes to 7.4% in April 2023 demonstrates the company's long-term commitment and belief in their potential.

Warren Buffett, is renowned for his value investing approach. He is drawn to companies with strong fundamentals, trading at a discount to their intrinsic value, and boasting a stable track record. With an earnings yield of around 14% and the potential for growing dividends, the Japanese trading houses fit this criterion.

This investment also aligns with Berkshire Hathaway's long-term investment plan, which involves holding investments for 10-20 years. By maintaining a long-term perspective, the company can capitalize on the potential growth of these trading houses and benefit from compounding returns over time.

Let us see how Warren Buffett himself has outlined his rationale on the investment on CNBC:

Another crucial aspect of Berkshire Hathaway's investment strategy in the Japanese trading houses is its connection to the yen bond issuance. Berkshire Hathaway has issued yen bonds through 2022, with an SEC filing open for a new one. Yen bond rates are currently much lower than those for US bonds. The Bank of Japan (BoJ) has maintained its key short-term interest rate at -0.1% and the rate for 10-year bond yields around 0% during its March meeting. In contrast, the federal funds rate in the US stands at 4.75% to 5.00%. This difference in bond rates makes it attractive for Berkshire Hathaway to borrow in yen and invest in suitable Japanese companies.

In the next section, we will take a closer look at each of the five trading houses, examining their unique backgrounds and areas of expertise. This analysis will help provide a better understanding of why Berkshire Hathaway is keen on increasing its stakes in these companies.

An Overview of the Five Trading Houses

The five Japanese trading houses in which Berkshire Hathaway has increased its investment - Mitsubishi Corp., Mitsui & Co., Itochu Corp., Marubeni, and Sumitomo - each have their own unique history and areas of specialization. Here, we provide a brief description and background of each firm:

1. Mitsubishi Corporation

Founded in 1870, Mitsubishi Corporation is the largest and oldest of the five trading houses. It is part of the Mitsubishi Group, a conglomerate of Japanese companies spanning a wide range of industries. Mitsubishi Corporation is engaged in various businesses, including energy, metals, machinery, chemicals, and living essentials. It is also involved in infrastructure projects and has a global presence, with operations in over 90 countries.

2. Mitsui & Co.

Established in 1947, Mitsui & Co. traces its roots back to the early 17th century. It is a diversified conglomerate with a focus on energy, metals, machinery, chemicals, and food. The company operates in over 66 countries and has more than 40,000 employees. Mitsui & Co. has a history of strategic partnerships, acquisitions, and joint ventures, which have contributed to its growth and expansion over the years.

3. Itochu Corporation

Itochu Corporation was founded in 1858 as a linen trading company. Today, it is a highly diversified conglomerate with operations in textiles, machinery, metals, energy, chemicals, food, and general products. Itochu has a strong global presence, with offices in more than 80 countries and a workforce of over 120,000 employees. The company is known for its focus on innovation and sustainability, integrating these principles into its business strategy.

4. Marubeni Corporation

Marubeni Corporation, founded in 1858, is a global trading house with a diverse business portfolio that includes energy, metals, machinery, chemicals, food, textiles, and general products. With operations in more than 60 countries, Marubeni has a strong global network and a reputation for its expertise in project development and financing. The company is also involved in various infrastructure projects worldwide.

5. Sumitomo Corporation

Sumitomo Corporation, established in 1919, is part of the Sumitomo Group, another prominent Japanese conglomerate. The company has a diverse range of businesses, including metals, transportation, construction, energy, chemicals, and media. Sumitomo operates in over 65 countries and has a workforce of around 70,000 employees. It is known for its long-term strategic approach to investments and its focus on creating value through sustainable growth.

These five trading houses have deep historical roots and extensive networks, making them attractive investments for Berkshire Hathaway. In the following sections, we will explore the earnings yield and dividend growth potential of these firms, along with the challenges and criticisms they face.

Earnings Yield and Dividend Growth Potential

One of the primary factors that attracted Berkshire Hathaway to invest in the Japanese trading houses is their earnings yield. With an average yield of around 14%, these companies offer an attractive return on investment compared to other opportunities in the market.

In addition to the earnings yield, the potential for growing dividends is another factor that has piqued the interest of Berkshire Hathaway. High dividends are generally considered a sign of a company's financial health and its ability to generate consistent cash flow. Here, we take a closer look at the dividend potential for each of the five trading houses:

1. Mitsubishi Corporation has a history of paying stable dividends to its shareholders. In recent years, the company has increased its dividend payout, signaling confidence in its future earnings growth.

2. Mitsui & Co. has maintained a consistent dividend payout policy, with modest increases over the years. This indicates the company's commitment to sharing its profits with shareholders while ensuring adequate capital for future growth.

3. Itochu Corporation has seen a steady rise in dividend payouts over the past few years, reflecting its solid financial performance and strong cash flow generation. This trend is expected to continue as the company pursues new growth opportunities.

4. Marubeni Corporation offers a relatively high dividend yield, reflecting its commitment to returning value to shareholders. The company has managed to maintain stable dividends despite market fluctuations, showcasing its resilience.

5. Sumitomo Corporation is known for its high dividend yield, which currently stands at over 5%. The company's strong cash flow generation and long-term growth strategy make it an attractive investment option for those seeking dividend income.

These factors, combined with the fact that all five companies trade below 10 times forward earnings, make them particularly attractive to Berkshire Hathaway and other value-oriented investors. In the next section, we will address some of the challenges and criticisms that these trading houses face.

Challenges and Criticisms

While the Japanese trading houses offer attractive investment opportunities, they are not without their challenges and criticisms. Some of the primary concerns include:

1. Growth Concerns

Critics have raised questions about the growth prospects of these trading houses, given the mature nature of their businesses and the evolving global economic landscape. In particular, the transition to a low-carbon economy and a shift in global trade patterns could potentially impact their traditional business models.

2. Complexity

The vast array of businesses and investments within each trading house can make it difficult for investors to understand and assess their overall performance. This complexity can lead to a lack of transparency, making it challenging for shareholders to determine the true value of these companies.

3. International Transactions

Given their global operations and exposure to various markets, the trading houses are susceptible to fluctuations in international trade and geopolitical developments. The ongoing Ukraine war has caused disruptions in several sectors, affecting all five trading houses to varying degrees.

4. Struggles as Investment Managers

Attempts by the trading houses to expand into investment management have not been as successful as initially hoped. Several firms have struggled to generate consistent returns, raising doubts about their ability to effectively manage investments and create value for shareholders.

5. Expected Net Profit Drop

The combined net profit of the five trading houses is expected to drop for the year ending March, primarily due to the adverse effects of the Ukraine war and other market challenges. This decline could raise concerns among investors about the overall financial health of these companies.

Despite these challenges, Berkshire Hathaway's increased investment in the Japanese trading houses indicates a belief in their ability to overcome these obstacles and generate value over the long term. In the next section, we will explore the influence of Warren Buffett's investment on the share prices of these companies and the implications of this "Buffett effect."

The "Buffett Effect" on Share Prices

Warren Buffett's investment decisions often have a significant impact on the share prices of the companies he chooses to invest in, a phenomenon known as the "Buffett effect". This effect is driven by the confidence investors place in Buffett's investment acumen, and many seek to mirror his purchases in their own portfolios.

In the case of the Japanese trading houses, their share prices have soared since Berkshire Hathaway's initial investment in August 2020. This increase can be partly attributed to the Buffett effect, as investors follow in his footsteps and buy into these companies, driving up demand and, consequently, their share prices.

However, it is essential to note that the increase in share prices is not solely due to the Buffett effect. The trading houses' strong fundamentals, attractive earnings yield, and dividend growth potential also contribute to their rising valuations. In this context, the Buffett effect serves as a reinforcement of the inherent value of these companies, attracting even more investors to them.

It remains to be seen whether the Buffett effect will continue to drive the share prices of these trading houses upward, as market conditions and other factors can influence their performance. Nonetheless, Berkshire Hathaway's increased investment serves as a strong endorsement of the long-term value and potential of these companies.

Future Prospects and Deal-Making Opportunities

As Berkshire Hathaway raises its stakes in the Japanese trading houses, there is the potential for even closer collaboration and deal-making between the conglomerate and these firms. With board approval, Berkshire Hathaway could further increase its stakes up to 9.9%, signaling an even stronger commitment to these companies.

This closer relationship could open up new opportunities for both Berkshire Hathaway and the Japanese trading houses to engage in joint ventures, strategic partnerships, and mergers and acquisitions. By leveraging their respective strengths and expertise, they could capitalize on emerging trends and growth opportunities in various industries and markets, generating even greater value for their shareholders.

In conclusion, Berkshire Hathaway's increased investment in the Japanese trading houses represents a strategic move driven by attractive earnings yields, dividend growth potential, and the prospect of long-term value creation. Despite the challenges and criticisms faced by these companies, their resilience and adaptability have made them appealing to one of the world's most renowned investors. As Berkshire Hathaway deepens its relationship with these firms, the potential for further collaboration and growth is immense, offering exciting opportunities for both the conglomerate and the Japanese trading houses.

References. The following references were used for our discussion:

• CNBC interview
• Financial Times analysis of the investment
• Wikipedia Sogo shosha
• Our own outline of Berkshire's Bond strategy
• Current Japanese Bond rates (retrieved 2023-04-13)

Update June 19 2023 Berkshire Hathaway has increased its stake in the five trading houses to above 8.5% for each, cf. Warren Buffett doubles down on Japan, increasing stakes in five trading firms.

As discussed before, might even see a move towards 9.9% in the near future if market valuations allow it.