Will the time ever be right to invest in Japan?

Australian Financial Review, January 2008

Japan has started the new year as it ended the old: disappointingly. The Japanese stock market was down 6 per cent in the first 10 days of the year alone, after losing 11.3 per cent in 2007.

This was not the plan. Japan, we have heard repeatedly in recent years, is back: after more than a decade of miserable economic and stock market performance, Japanese banks and companies are in better shape, earnings are improving, and when consumer confidence returns everything will be rosy again.

This theory worked for a while, from late 2005 to mid 2006, but since then a familiar malaise has returned. It has, though, brought valuations down to low levels, which begs the question: is Japan a bargain, worth investing in as a contrarian approach? Or are investors just asking for trouble in a market that never seems to get going?

You can sense the frustration among Australian fund managers covering Japan. “Profit recovery in the last five years has been on a par with the other Western markets yet the derating has been so much worse,” notes Platinum Asset Management in its latest note to investors in its Japan Fund. An especial cruelty seems to be the fact that Japanese banks have taken the biggest hit in terms of share price performance from the sub-prime crisis, despite the fact that they have next to no exposure to sub-prime debt. There are lots of headaches Japan faces – a shrinking and ageing population, a vacuum in coherent and progressive policy since prime minister Junichiro Koizumi stepped down, companies that still don’t really believe in shareholder value – but what it really comes down to is confidence.

Kerr Nielsen, who runs Platinum, argues that many of Japan’s headwinds exist elsewhere in the world too: its demographic issues are mirrored in western countries, most developed world economies are dependent on world growth just like Japan is, and political troubles are nothing new. “When did capitalism really falter under good or bad leadership?” he asks. “Japan has clearly started to make more seriously the need to use the capital markets in a progressive way.” He thinks Japan has perhaps been more guilty than most nations in failing to realise that the balance of power in the world has shifted towards China, but otherwise thinks Japan’s challenges are global challenges.

So, with price/earnings ratios down to around 16 times and some big companies trading at below book value, does this make it a good time to invest in Japan? “No. But it comes down to trying to find those stocks that are either not going to be influenced by this cycle, or fabulous companies which will continue to grow even with some cyclicality, and which are priced as average companies. It’s all about stocks, rather than believing that you’re going to make money out of secular bull markets that go on forever.” Among the companies that Platinum and its Japan portfolio manager Jim Simpson think fit the bill are Sumitomo Chemical, an apparently dull company but with a joint venture giving it privileged access to cheap Saudi Arabian gas; West Japan Railway, which Simpson says has a “locked in growth rate of 10% plus”; Yamato, an express delivery company; and technology players with leading positions in speciality fields including Nitto Denko, Tokyo Electron, Ulvac and Ushio.

“We like what we own and see these companies growing whether the Japanese population shrinks or not and whether the government governs well or not,” Simpson tells investors. “The companies that we own fall into such a category where they have few fires to fight and clear strategies that are being executed with energy and efficiency. As an equity investor one can’t ask for more unless the shares are expensive. This is not the case in Japan today.”

Managers running global equities are looking closely at Japan, balancing the apparent good value with the country’s long track record of burning investors. “We think it’s cheap,” says James Falkiner, CEO and CIO of Falkiner Global Investors. “But then again it’s periodically presented that way on and off for the last five years.”

Falkiner notes, as many have done, that over the last 15 years one of the biggest issues Japan has faced is the state of its banking sector; the apparent return to health of this sector two years or so ago was one of the biggest reasons people have expected so much more from Japanese markets. “Broadly speaking it’s positioned reasonably well, but one thing is missing: a nice positively sloping yield curve.” That is, a clear and established pattern in which short term borrowings pay a certain low interest rate, and longer term borrowings a higher rate. That way banks can borrow cheaply at the short end, put it into risk free government bonds with a longer maturity, and pocket the difference, which in turn allows them to lend more freely. Lacking that, “the entrepreneurial function [in Japanese business generally] slows down because they can’t get finance. Banks are like the heart in the body and money is the blood: the heart is not beating much at the moment so the blood isn’t getting circulated around the body.”

Japan has one of the lowest interest rates in the world, at just 0.5%, but Falkiner argues that even this modest hike, after years of zero interest rates, may have been too much too soon. “They moved to a tightened policy before the economy really had its teeth into the growth phase.”

Japan has done nicely out of China’s emergence, partly because of the rising consumer power of China, which creates a market for Japanese exports, but particularly because there is a nice link between Japanese manufacturing of components, and Chinese assembly of them. But what Japan really lacks is demand or confidence at home.

It’s a shame, because Japanese companies are in pretty good shape and could be doing more. “A lot of corporates in Japan have significant levels of net cash on the balance sheet,” says Falkiner. “Increased gearing would be a good idea, it would boost returns to shareholders and get things back on the front foot. But if you are a risk-averse Japanese corporate manager looking at the domestic environment, you’re saying: I like the idea of cash on my balance sheet because I never know when I might need it.” Still, if prices keep falling, M&A is going to become more and more likely, at which point that surplus cash could be handy and markets will likely be driven back up again.”

Falkiner’s conclusion: “I think it’s a good time to buy on a three year view. The thing about Japan is you need to be patient, and it’s no good buying in then losing patience and selling out.”

Peter Walsh, director at Putnam Investments, thinks there are plenty of positive trends underway in Japan. “One is that Japanese companies for some time now have been cutting costs and clearing out balance sheets,” he says. “That’s been happening for 10 years. Coupled with that, you’ve also seen the yen decline significantly against most other trading countries, which has made it much more competitive globally as an exporter than it has been in the past.” (In turn, the threat of a rising yen is one of the many things that has made investors nervous, since it would dent those export numbers.)

Putnam has tended to opt for stocks like the shipping company Mutsui OSK, or the conglomerate Sumitomo, that benefit from trade and economic growth in emerging markets. “We still have a quite significant weighting at the moment at a country level,” says Walsh. “It’s the biggest overweight.”

Clearly, it’s a market that divides opinion, not just in Australia but in Asia too. “Circumstances do not favour Japanese equities,” says Tsutomu Fujita at Citigroup in Tokyo, who notes that already this year “as usual, Japanese equities are underperforming their global peers.” Yet at the same time Simon Liew, an investment strategist at Frontier Wealth Management in Singapore, is telling investors that one of his top mutual fund picks for 2008 is the DBS Japan Growth Fund, “a contrarian call against the negativity surrounding the Japanese market. Dividend yield on the Japanese market is now higher than the 10-year bond yield and historically, the stock market rises significantly when this happens as domestic investors pile in.”

Anyone considering buying a Japanese equities product in Australia needs to consider the impact of the currency. If the Australian dollar keeps getting stronger against the yen, then any returns from the fund will be diluted, unless the fund has a hedging strategy to neutralise the effect of the currency. Funds differ in their approaches to this point: look in the product disclosure statement for more details.

And if you go in, be patient. “Overall we think Japan is cheap,” says Falkiner. “But that doesn’t mean we expect explosive share price growth in the next three to six months.”