As economies go, Japan always has been a bit of an odd duck. Since the market bubble burst some 15 years ago, it has suffered from chronic deflation, moribund real estate values, very high domestic savings rates and a malformed banking sector saddled by non-performing corporate loans. It also faces a growing demographic crisis in its aging workforce. Its saving grace has been exports of consumer goods, in particular electronics and automobiles, and it has relied on the comfort of strangers–foreign investors control much of the Japanese stock market. The result is an economy and stock market that ebb and flow based on the global economy, especially consumer spending in the United States and, increasingly, China.
With signs of a slowdown in Asia and the Americas, it will probably be a rough six months or so for the Nikkei, extending its losing streak through April. The economy seems stalled, and has perhaps slipped back into recession (although economic data in Japan are notoriously susceptible to revision). Annual GDP growth will likely remain only about 1% beginning this year through the remainder of the decade. The good news is deflation may end as early as a year from now, according to the Bank of Japan's semi-annual outlook, released on April 28.
But as with many things in Japan, much more lies beneath the surface. After long and painful restructuring, corporations have achieved three consecutive years of profit growth and now boast healthy balance sheets, with improved free cash flow; in the 1990s, return on equity peaked at about 3%, but it's now as high as 10%. Value-based investment managers are finding stocks trading at a discount to cash on the balance sheet, and some companies are buying back stock, like conglomerate Sumitomo Corp. (TSE: 8053), or increasing dividends; payout ratios could double to 30%. This is partly a defensive manoeuvre: in a couple of years, new regulations will allow foreign acquisitions of Japanese firms by stock swap.
Along with the return of inflation, that could be enough to finally reignite Japanese interest in investing. Banks have been net sellers of equities, as they unwound complex cross-holding share structures. According to John Millar, an Edinburgh-based portfolio manager with Martin Currie Investment Management Ltd. who manages the BMO Japanese Fund, insurance companies' holdings include only 5% domestic equities–leaving lots of room to grow, if the incentives are right. “On a three- or four-year view, that is potentially very exciting,” says Millar.
Likewise, Pauline Lee, a Hong Kong- based manager of the Investors Japanese Equity fund, is keen on the financial sector's efforts to sell fee-based investment vehicles in the domestic market. Millar is also watching Orix Corp. (NYSE: IX), a leasing company that has become a leader in securitization and off-balance-sheet financing, as a good medium-term story.
Another area tied to the financial sector is real estate. Residential prices in central Tokyo rose last month for the first time in 15 years, and are approaching London and New York levels. But real estate could still be relatively cheap, according to Rehan Chaudhri, who manages two global CI funds with Altrinsic Global Advisors in Stamford, Conn. “We think there are interesting structural issues where assets have gotten undervalued,” he says. Chaudhri expects homebuilder Daiwa House (TSE:1925), with a market cap of about US$6 billion and US$1.7 billion in cash, to reward shareholders with a buyback or dividend.
And what about Japanese exports? Lee points to office equipment maker Canon (NYSE: CAJ), while Chaudhri is tracking automaker Honda (NYSE: HMC); if its share price gets pushed below US$20 this summer, the automaker is very attractive. Millar, however, says his firm is very cautious about technology exporters. “Whereas in North America or Asia technology can be regarded as a growth cyclical, in Japan we would call it a more regular cyclical,” he says. “Asian companies have been able to Hoover up a lot of the growth, so the Japanese companies find themselves in fairly commoditized areas.” In Japan, it seems, nothing is ever simple.