Hedge fund bear vindicated with 10% gain shorting Japan stocks

HONG KONG: After cutting a sometimes lonely figure as a staunch bear amid Japan’s stock-market rally, Shannon McConaghy has been vindicated.

The US$48mil Japan-focused hedge fund he manages for London-based Horseman Capital Management Ltd returned 10% in the first 10 months of the year, a gain that would have ranked it second best among Japan long-short equity hedge funds tracked by Eurekahedge Pte. Such funds have lost 4.2% on average this year and only a third have made money.

In all but one of the six years from 2012 through 2017, investors piled into Japanese stocks, encouraged by Prime Minister Shinzo Abe’s moves to improve corporate governance and the Bank of Japan’s stimulus measures.

The benchmark Topix shot up 150% between the start of 2012 (Abe came to power in December of that year) and the end of last year. This year, it’s down about 10%.

McConaghy’s fund opened to external investors in December 2015, and he hasn’t been just a moderate bear. The fund’s value of bearish investments has outstripped bullish ones to the tune of about 80% of assets since inception. It’s made bearish calls on regional banks, mid-sized retail and property firms, and most recently threw machine-tool makers into the mix, McConaghy said, declining to identify any specific companies.

“It’s an interesting psychological exercise when everybody else is joining the crowd, going the other way,” McConaghy said in a phone interview from London. Now, “longs are very unappealing in Japan given we’re moving toward a banking crisis and a rollover in the real estate space.”

Japan’s stock market capitalisation to GDP ratio – a metric that’s sometimes called the Buffett indicator and that’s used to determine whether a market is under or overvalued compared to a historical average – is currently around 113%. Globally, surges past 100% have been followed by dramatic corrections, McConaghy said.

When he’s picking what stocks to short, McConaghy looks for those in industries that have been weak during the nation’s stock rally and that will continue to struggle even without a global market collapse.

Regional banks have been where the fund has seen some of the most appealing returns.

“Because they’ve been using accounting tricks and hiding nonperforming loans, it’s very clear to me that the vast majority of investors aren’t aware of actual earnings and balance sheet weakness,” he said. “Even on past overstated earnings, these banks still trade on price-earnings ratios above the global bank average.”

A decline in customers and suppressed interest rates mean more than half of Japan’s regional lenders have loss-making core businesses, McConaghy said, citing the country’s financial regulator. A high savings rate has led to fierce competition for loan clients, further pushing lending rates below their break-even point, he added.

To minimize losses, banks have been booking capital gains from securities investments as income. But with the weaker market and rising currency-hedging costs, their ability to keep doing that is diminished.

“We may find there is zero equity value in many regional financial institutions in Japan,” he said.

McConaghy’s newest short is Japan’s machine-tool manufacturers, which rely on the continued expansion of car combustion engine makers. Car engines that require far fewer components will hurt the sector, as will weakness in the US and China auto markets.

It hasn’t always been smooth sailing for McConaghy.

The net asset value of the external-investor share class for the fund has risen by only 6% since inception, taking into account this year’s gain. Founded by John Horseman 18 years ago, the firm’s assets have fallen to US$958mil, from US$2.5bil in August 2016. — Bloomberg