Having been the prime example of how not to run an economy for so many years, Japan's stock market seems to be on another upturn. But with this one be as fleeting as the last?
It was a seminal moment for global capitalism. In August 1986, Tokyo overtook Wall Street to become the world's biggest equity market. On this measure, Japan had become the most powerful economy, eclipsing the US and Europe, and for the next three years Japanese equities were the asset class of choice for international investors. Wall Street's 1987 crash barely registered in Tokyo and the Nikkei Index continued to rise until December 1989 when it hit 38,915.87. At this point, the Japanese market was worth 74% more than Wall Street.
Things are different today. After a bear market of such seriousness which the West has not seen since the 1930s, the Nikkei bottomed last April at 7,607.88, down 80% on its peak, having been battered not only by the bursting of Japan's domestic asset bubble, a crippled banking system and the collapse of its post-1945 corporate governance codes but also more recently by global terrorism, geopolitical chaos preceding the Iraq war and Sars.
Japan Inc seems, however, to be on the turn. From the low point last April to the end of March, Japanese equities rose 79% in dollars, outperforming the UK which rose 39%, and the US which rose 27%. Now investors ask whether such outperformance will continue at a time when Japan is gaining from the boom in Asia in general, and China in particular. Can Japanese shares, after years of misery, regain their sparkle?
One thing seems clear. Investors seeking merely to track market indices may face disappointment because they are dominated by the winners during the bear market. This trend is already visible. Some great Japanese exporters, who did well in the bear phase, have underperformed since last April. This should not be a surprise. Such companies are valued alongside US and European rivals because they trade in the same countries and are managed in similar ways, avoiding the cross shareholdings and cosy banking relationships that have damaged Japan Inc. The western-style returns on capital have enamoured them to foreign investors, leaving 'over-owned', to use fund manager parlance. Take Canon, the copiers and printers company, which gained 156% during the bear market but then lagged the recent revival. Then there is Honda, the motor manufacturer, which rose 102% in the bear market but then underperformed.
Asia is Japan's biggest export market representing 44.7% of exports in the first half of 2003 compared with just 25.8% to the US. This compares with 42.1% and 29.5% a year earlier. Exports to Asia are different in composition to those in Japan's major export markets in the West. Whereas exports to the West are heavily weighted towards consumer goods, especially discretionary consumer goods, exports to Asia are more exposed to machinery, basic materials and other industrials. Therefore, it is not surprising that a different set of stocks are benefiting from the current booming export cycle. It also happens that these stocks are trading at extremely low levels in both historic price and absolute valuation terms. The opposite can be said of many of the winners during Japan's bleak financial winter - and stocks that win when economic clouds are grey do not necessarily shine when the sun comes out.
PLace your bets
So, where might investors find the winners of the next few years? Some might buy banks, which have outperformed since last spring along with other domestic sectors that did badly during the long winter for equities, yet this may be a risky strategy because there is likely to be as much bad news as good from Japan's banks over the coming years. It is likely that current non-performing loans are underestimated and with bank lending still falling, down 4.3% year-on-year in March, their core operating businesses are showing no signs of recovering. This might turnaround as deflation continues to ease. The corporate goods price index posted its first positive number in March +0.2% year-on-year, having been negative for 41 months prior to February when it was flat. The risk is that this is merely a normal cyclical export-led recovery that would peter out if the global economy were to slow.
A less risky strategy might be to attempt to capitalise on the deep value lurking in the less 'over-owned' areas of Japan's stockmarket. Such areas are starting to attract activist investors, such as Steel Partners, the US firm, and M&A Consulting, a local company, which scent that managers can be pressured to become more shareholder-friendly. It is a good time for activism. Asia is booming and investors can find modestly-priced companies that are raising sales, cutting costs and contemplating higher dividends and share buybacks, key ingredients in improving shareholder returns. These areas of the market should provide good returns regardless of the economy. If the economy is strong that will merely add fuel to the fire.
Here are some examples. Shimachu is a furniture retailer that has increased overseas procurement, reduced costs and increased efficiency. The shares have done well recently although half of its market value is still represented by the cash in its balance sheet. Foreigners own 29% of the equity, a high figure for a secondary stock, and pressure is being applied for cash to be returned to shareholders. Then there is Descente, a sportswear group, which was losing money but then shifted production overseas and cut staff costs. At one point last year its market value was below its cash balances yet it is now back in profit and can resume dividends.
Taikisha is an air conditioning group whose market value is about 70% backed by cash. It trades on 17.5 times earnings, a low rating for a cyclical company coming out of a downturn and winning business from China. It has seen a sharp turnaround in orders in recent months and this is not reflected in the valuations at present. Wakita is a construction equipment distribution company. Clearly this has not been a great business in Japan over the past decade and the company was so battered by its problems that it was valued in 2002 at only a third of its cash. It was priced for bankruptcy yet its business has since bottomed and the company has taken an active approach to raising returns. In response, the shares have more than tripled but about 80% of its market value is still represented by cash.
Lastly, a larger stock trading near its all-time relative lows is Nippon Unipac, Japan's leading manufacturer of paper products. The stock has undertaken an aggressive restructuring plan and with further restructuring to be done, the company expects to double profits through cost cuts alone over the next three years while cutting debt by over 20%. Meanwhile, the company is raising export prices due to the exceptional demand in Asia, further evidence of Japan's neighbours assisting in ending their deflation.
In the late 1970s, Wall Street was full of similar stocks. Predators responded by attacking inefficient managements, forcing America to become more shareholder friendly and fuelling the 1980s bull market. Something analogous is now happening in Japan and the potential for capital gains could be substantial.
Investors thinking of using indexes to capture upside growth may be disappointed as the indexes are dominated by bear market winners who could be bull market losers
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