Trading Japan from the heights of Everest

Julian McManus, Miami-based fund manager for Everest Capital''s Japan Opportunities Fund, discusses the firm''s multi-strategy approach to Japan.

Everest Capital, a $1.2 billion hedge fund, headquartered in Miami, launched its Japan Opportunities Fund in January 2003. The fund currently stands at $60 million and has a capacity of $300 million. The fund was up over 25% in 2003 and has enjoyed a return of over 12% to date in 2004.

Everest launched its Japan long/short fund in 2002. What was the rationale for setting up your Japan Opportunities Fund a year later?

McManus: Everest's Japan equity long/short fund is market neutral and makes money on its ability to pick stocks (long and short) without taking any sector directional positions. The fund targets a low volatility and has very tightly controlled risk parameters. It performed very well in 2002 when it was up 11% at a time when the Japan market was down 18%.

However, at the end of 2002 the view of our team, based on our experiences on the ground in Japan and on the macro outlook of Marko Dimitrijevic (Everest's founder), was that when Japan finally turned the corner the big opportunity was going to be directional. Our market neutral long/short fund did not have the mandate to capitalize on this, so we decided to launch the Japan Opportunities Fund, which would express a positive view on Japan. The fund is multi-strategy, and invests in equity, debt, convertible bonds, currencies, high yield and distressed debt.

What factors convinced your team that Japan had reached the end of its downward spiral?

As it turns out, our timing was spot on. We launched the fund three months before Japan hit its bottom.

The catalyst was probably the resolution of the banking problem, but there were a number of factors underlying our view that Japan was turning the corner.

Generally, we felt that asset prices had overshot on the downside over the last decade. Even now, Japan is still extremely cheap compared to other equity markets and its own history. Over the last three years we've been witnessing a lot of progress in corporate reform behind the scenes. This is true, for example, in the steel, glass and cement industries where management have been consolidating and merging to attain pricing power, and have been cutting costs by various methods including offering early retirement to personnel.

Markets weren't appreciating this, as the micro economic efforts were being eroded by deflation. But the deflation problem has now improved as Bank of Japan, Ministry of Finance and private sector banks have shown a better coordination in macroeconomic policy.

Another important factor for Japan's recovery was the introduction of REITs in 2001-2002. These became popular instruments with investors as they offered a 6% yield at a time when interest rates were basically zero. Because they were financing so quickly, and raising so much capital, the REITs had to keep investing in properties to maintain their yields. This effectively put a floor on real estate prices in Tokyo for the first time, providing an efficient clearing mechanism for the real estate collateral that banks were trying to dispose of to clear their bad debt. In fact, Everest invested at the private equity level in the first three REITs in Japan before they went public.

What is the philosophy behind the investment process?

The investment process centres around being opportunistic. The secret is being comfortable switching between equity, debt, derivatives, currencies, high yield and whatever other asset classes are available. We look at all instruments and pick what represents the best value and risk reward. We are particularly well qualified to do this at Everest as we can leverage off the expertise of our team members with product specific knowledge including high yield, risk arbitrage and distressed debt.

Give us some examples of non-equity opportunistic trades that the Japan Opportunities Fund has made.

One example of an opportunistic trade is Isuzu, the Japanese truck maker whose debt we bought in the 60s and 70s in 2001 and sold at 98 at the end of last year. The company's debt became cheap when their credit was downgraded by S&P in 2001. We conducted detailed company visits and cash flow modeling and discovered that this debt was actually a good buy, as there was a predictable surge in demand down the line driven by the government's new diesel emission regulations. We also realized that the banks would now allow Isuzu to default on its debt obligations, as these were relatively insignificant compared the $3 billion in loans that banks had extended to the company. We took further comfort in the fact that General Motors, which held a strategic stake, took a write down on this and increased its investment.

On the interest rate side, we continue to be short Japan Government Bonds. We feel that there is a lot of room for Japanese rates to rise, and inflation has only just started to come though.

Another opportunistic tactic we used recently was to switch a position in one company from its equity to its convertible bonds, as these offered more protection on the downside while still allowing us to share in all the upside.

Partly as a hedge, although we can do this opportunistically if the need arises, we have been long yen calls and dollar puts. As we are quite long Japanese equities we want to hedge ourselves. In the situation where the yen strengthens through 100, this could have a material negative effect on the Japanese equity market.

Does the rise of China present an opportunity or threat to Japan?

The prevailing view until about a year ago was that China was a threat. Recently that has changed 180 degrees to seeing China as an opportunity due to the huge demand it is generating for Japanese capital goods. Chinese companies need these goods immediately to support their growth and have not had time to work out how to make products of this level of technology or quality. China's rise has also been a catalyst for some complacent Japanese companies to tighten up their act.

You come from a long only background at Lazard Asset Management based in Tokyo. How does it differ trading Japan in a hedge fund based out of Miami?

The process is not that different. What both Lazard and Everest are good at doing is looking at Japan in the global context. Initially I was a bit concerned that companies in Japan would be less receptive to me if I was part of a hedge fund, but I have not found this to be the case. I've only had one company refuse to speak to me because I was a hedge fund manager.

There are lots of benefits to being based in Miami. The distance allows us to be more objective, so that when the markets are experiencing periods of short-term volatility we can sit back and focus on medium and long term views. Obviously if you're not on the ground you don't go to every analyst meeting or participate in market chatter, but we don't feel that this is where our advantage lies so we don't think we're missing much. I visit Japan every other month, and when I'm not there Matthieu Vermersch, who oversees all our Asian portfolios, is usually visiting the region.

The main advantage of being based with the rest of the team in Miami is that we can leverage off each other's ideas. We all sit together in an open plan office and the flow of ideas and information is very quick.

What type of return and volatility does the fund target?

The Opportunities Fund targets a return in excess of 20%. We try not to manage volatility through a budget in this fund, although we do keep it below the volatility experienced by the Japanese market. We do have risk controls and position limits in place, and this keeps things relatively tight.

Have you seen interest in the fund from Asian investors?

Most of our investors are US institutions, particularly endowments rather than fund of funds. But we have seen quite a lot of interest in Singapore, mainly from family offices and high net-worth individuals, and from Japanese institutions.

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