Although investors are expecting the japanese economy to be the source of investment opportunity there are still underlying problems
Many fund managers think that the Japanese stock market will give the best returns when the global recovery happens. Stock market valuations in Japan are considered to be cheaper than western countries and good companies easy to pick.
However, Japan is still not without its problems. There are concerns about the export industry if the US dollar weakens; some fund managers question whether or not valuations are cheap; and the country is also facing more and more competition from Asia.
The Japanese market has been one of the worst performing markets over the past few years. The Nikkei and the Topix have both continued to fall over the past three-years and the economy remains in the doldrums.
For example, the Japanese Nikkei 225 Index has gone down approximately 51%from three years ago, and the S&P Topix has gone down approximately 50% from three-years ago.
Research by S&P has shown over the past year because of grim market conditions and cautious managers tracking errors have narrowed, typically to a 4%-5% range, compared with 5%-7% previously.
Robert McKillop, head of Japanese equities at Standard Life, warns: 'The structural reforms by the government have been very disappointing. For example, in the financial sector the banks are still struggling and the new governor has not made any proactive monetary policy.'
In addition, the government reform processes on pensions has caused the stock market to decline.
According to S&P research the Japanese Government's decision to allow around 300 corporate pension funds to give back assets to the government has had a marked effect on the market in recent months. Stocks must either be liquidated for cash or an indexed portfolio constructed. This has caused a dent in the price of popular large-cap stocks driving the markets to lows.
Most fund managers are presently underweight in Japan because of lack of momentum in global equities.
According to Frederic de Merode, senior portfolio strategist at Fidelity, the Japanese market's biggest concern has been the direction of the US consumer. The US consumer buys a large amount of Japanese goods.
The Japanese economy and market is currently being driven by the global export cycle and is very dependent on the US consumer.
It is expected when the global economy starts to recover Japan will reap the benefits. It is possible the global economic recovery could start in the fourth quarter of this year.
De Merode thinks if stronger growth in the US occurs there could be better performance in Japan as recovery will be driven by the export cycle.
Although this is likely to be the case, there are concerns for exports if the US dollar weakens.
If the US dollar weakens it becomes a concern as it makes Japanese products more expensive. Although it is okay at the moment Steven Wheeler, head of Japanese equities at Insight, thinks there is still a need to be cautious. For the past two years, the Japanese government has defended the yen when it has dropped to a dangerous point.
Some Japanese companies have plants in high cost countries such as Europe that could put a strain on finances. Companies who can outsource production to cheaper areas may have a competitive advantage. Some Japanese companies are shifting manufacturing to China to take advantage of wage costs that are a fraction of those in Japan
Furthermore, Japan is not the only country that has strong export links with the US. Korea could be considered as a rival as well as Latin America.
Although McKillop thinks Japan still has a competitive advantage over other countries in such areas as the automobile and machinery industry, Asia is starting to catch up.
According to Basil Masters, chief investment officer at Credit Agricole, unlike the rest of Asia, Japan is geared towards the top end of things and profitability is high. Japan also exports a lot to Asia and exports from countries such as Korea are not as big in the US.
He expects when the global recovery takes places foreign investors will start investing back into Japan in areas such as electric machinery and transport.
On a bigger picture, De Merode also sees recovery in the area of pharmaceutical and healthcare. He says around one eighth of the population is above 65, if things continue as they are now a quarter of the population will be over 65 in 2015. If that is the case it will be good for the pharmaceutical and healthcare industry.
But there is serious doubt among fund managers as to whether or not there will also be a recovery in the Japanese domestic sector.
Masters thinks the pharmaceutical industry is not geared towards a recovery because of the price cuts the government has announced in pharmaceutical industry. This has depressed profits.
The recovery when it comes will be led only by the export market ' the domestic economy will not improve enough to generate demand.
Another area where recovery will come in Japan is through structural and economic reform.
According to McKillop although the selling of pension funds has caused the market to go through a trough, he expects in the longer term it will be good for the companies.
From a GDP perspective Japan can also be considered to look attractive.
Its GDP has been revised up following resilience in domestic consumption and investment. While this has only been marginal this has been partly due to accumulation of wealth in Japan and the willingness of Japanese consumers to spend more money.
Although overall the GDP forecast is still around 1% and the country still has a deflation problem, little changes make a difference.
There has also been a change in the profitability of companies. Corporate profits have increased by almost double from the previous year.
According to Wheeler, profits are still expected to increase this year. Companies are beginning to restructure and there is a lot of M&A activity. There are talks about cost reductions or combining separate operations and outsource services.
McKillop says: 'Japan is seeing companies take things in their own hands. Although it is not as aggressive by Western standards it has been raising profit recovery. Last year operating profits went up 40%.'
De Merode says: 'The good news is that unlike other markets the differentiation between good and bad companies is extreme on the Japanese Topix index. Also, in valuation terms the Japanese market is very cheap and price to cash flows are seven to eight times cheaper than the UK, Eurozone and the US.'
However, it is not all that clear cut. The distinction between quality companies is not necessarily as easy as it was. Wheeler's view is there are some companies that are losing competitiveness. For example, Sony has been revised down and the company needs to revaluate its strategy.
Knowing the true valuation of a company can be difficult in Japan ' at the end of the year companies may need to write off costs that may be up to 30% of the valuation of the company.
According to Masters while market valuations have been deflated over the past few years, some sectors are still expensive such as material stocks. There are many reasons why a company may outperform and the difference between good and bad companies is notnecessarily to determine.
Even though a company may be performing badly now, it is possible it may recover and start to outperform in the future.
According to research by S&P, many managers are doubtful that any upturn in the Japanese market is imminent, at least not without better global sentiment. But there are bright spots amid the gloom. In a continuation of the stock-picking theme that has dominated the past 12 months, managers point to quality blue-chips as being historically cheap. Other stocks are seen as having recovery potential regardless of whether or not companies have undertaken necessary restructuring simply because their prices have fallen so drastically.
But, within this depressing scenario, the S&P view is that most managers are adamant that there is a lot of potential for successful stock picking, reflecting the divergent features of Japanese companies. Some domestically orientated companies have been restructuring. Others are shifting manufacturing to China to take advantage of wage costs that are a fraction of those in Japan, although a consensus seems to be developing that this is not enough. Some companies are simply so cheap that they are seen to have recovery potential regardless.
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