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Is it safe to go back to Japan?
Japan's recovery is still evolving, as are its reforms in banking, labor and law. For investors who want to buy in, here are 5 companies reaping the rewards.
By Michael Brush
If you missed last year's spectacular rise in the Japanese stock market, its not too late.
Japan is recovering. The storys intact, says Mark Headley of Matthews Japan Fund (MJFOX). But he cautions that you probably shouldn't expect to match the 45% jump the Japanese stock market has made since last May.
It may be a bumpy ride, too. With such gains already in pocket, traders and investors are quick to pull the trigger at any sign of trouble. Just look at what happened to the Japanese market in January, when government officials raided the offices of Livedoor -- a high-profile Internet company founded by the brash Takafumi Horie -- on suspicion of securities law violations. The Nikkei 225 stock index fell 5.7% in the days following the raid.
But Japanese stocks soon recovered all of those losses, a lesson for investors eyeing Japanese stocks today. Use the sell-offs to build positions in a market that should continue to see good growth over the next several years.
After 15 years of going back and forth between recession and slow growth, Japan has finally broken out of its economic malaise, agrees Hugh Patrick, director of the Center on Japanese Economy and Business at Columbia Business School. Japan's Nikkei index is still 60% below where it was in 1989, before Japan's stock-market bubble popped.
Inflation, jobs are back
Here are three big reasons Japan is back:
No. 1: Inflation, normally bad for stocks, is a welcome sight in Japan after years of falling prices, says Mark Jason, an analyst with AIM International Growth Fund (AIIEX). It means companies can raise prices, which helps profits. It means consumers will spend, because they no longer think they can get things cheaper in a few months. Banks are also making more money since the value of deposits isnt eroding.
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No. 2: A growing economy also means more jobs. The really appealing thing about Japan is that they are now in a hiring mode, and wage growth is starting to turn positive, says Marc Tommasi, managing director for global strategies at Manning & Napier Advisors, which manages nearly $12 billion in assets. Large companies in particular stepped up hiring sharply in recent months. This is important because they typically pay 20% to 30% more than smaller companies, says Merrill Lynch economist Jesper Koll. And pay is increasing overall as the labor market tightens. That should push up consumer spending, says Koll.
No. 3: Japanese producers are getting a big boost from the weak yen, which has dropped steadily since 2000 and now trades at levels last seen in 1985. This makes Japanese goods look cheaper to foreigners, so they buy more. Trade with China is rising especially fast.
Reform finally takes hold
Behind these signs of life is a slew of reforms that make it easier to do business in Japan. Since these reforms are likely to stick, Japans rebound is probably more than just a flash in the pan. Analysts point to the following key changes:
Japan is cleaning up its banking sector. The banks have received a big boost from the government, which injected funds into them to help write off bad loans. A healthier banking sector means more loans and economic growth.
Layoffs are OK, thanks to labor-law changes. Before, it was very hard to let someone go simply because a company was doing poorly, says Patrick. Companies can also save money and keep a more flexible work force by hiring more contract workers and temps.
Legal reforms are creating more competitive companies. The government has forced banks and companies they do business with to end their practice of cross-shareholding. Japan's longstanding keiretsu system of interlocking shareholdings often meant weak companies were simply nursed along by companies who owned their shares, because the weak companies, in turn, held the stronger company's stock. Now companies have to fix what ails them or face being acquired wholesale by another firm more willing to do the housecleaning, says Patrick.
The postal system is being privatized. The Japanese put an enormous amount of wealth into savings accounts run by the postal system. These government-controlled accounts are often invested in pork-barrel projects that do little to stimulate economic growth, says Tommasi. Gradual privatization of the postal system -- pushed through by Japanese Prime Minister Junichiro Koizumi -- will mean that more of this money gets invested in sensible projects, at least in the long run.
All of these changes contribute to rising productivity, says Merrill Lynchs Koll. He expects productivity growth of around 2.8% a year over the coming five years, up from the 1.5% average of the past decade. He believes that will help fuel annual growth of around 2.5% on average in the coming five years, compared to 1.2% over the past decade.
Buying in
So where should you invest? Buying shares of purely domestic Japanese companies is a challenge for individual investors since it is still difficult -- or expensive -- to get access to the Japanese stock exchange. You typically have to limit yourself to Japanese companies that have American depositary receipts (ADRs) trading on U.S. exchanges. These are certificates issued by U.S. banks representing a specific number of shares of a foreign stock. Here are some worth considering.
Toyota Motor (TM, news, msgs), with popular new models like the Prius hybrid helping the company make further inroads in the U.S., grew earnings by 34% in the third quarter. The auto company continues to invest heavily in new plants in both the U.S. and Japan. It rolled out a new Camry model in March and has two new Lexus models, the new Scion xB and the Yaris compact coming later this year. The market is underestimating the scale of earnings growth, says Noriyuki Matsushima, an analyst at Nikko Citigroup, an investment bank that is a joint venture between Citigroup (C, news, msgs) and Nikko Cordial.
Near-term, he expects pressure on the stock as Shinsei Bank, a bank in Japan, sells its position.
Nissan Motor (NSANY, news, msgs) has had a dearth of new models. But that's going to change later this year when it rolls out the Versa hatchback and a new Sentra. Thats one reason AIM Internationals Jason prefers Nissan to Toyota. The other reason is the stock is a lot cheaper. Nissan trades for under 10 times projected 2007 earnings, compared with 15 times for Toyota.
Matsushita Electric Industrial (MC, news, msgs), which makes consumer electronics products under the Panasonic brand, should continue to benefit from the popularity of plasma display TV screens. They control the market, and thats a growing market, says AIMs Jason. The company is also seeing brisk sales in factory automation equipment.
Small and midsize companies often rebound the fastest in economic recoveries. For exposure to this sector in Japan, Jason looks to Orix (IX, news, msgs), a financial services and leasing company that caters to smaller companies. ORIX is also a play on the revival of Japan's real estate market. They bought a lot of distressed assets and they are turning them around, says Jason.
Finally, Softbank (SFTBF, news, msgs) makes sense as a play on an increase in Internet advertising as the Japanese economy recovers. Softbank is a major provider of high-speed broadband and Internet-based phone service, and it owns a big stake in Yahoo!'s (YHOO, news, msgs) Japan unit. In 2007, Softbank plans to launch a mobile phone network.
The risks
The Japanese government has borrowed a huge amount of money -- debt now valued at about 85% of the countrys GDP. In contrast, U.S. federal government debt is worth about 64% of its GDP. This huge level of borrowing in Japan could mean government spending will get pinched if interest rates rise sharply.
Its an ominous problem, given Japans aging population.
As early as 2010, more than 21% of the Japanese population will be 65 years or older (compared with, for example, 13% in the United States). Japanese women, on average, have 1.3 children, but a country typically needs a birth rate of about 2.1 to keep its population from shrinking, points out Fariborz Ghadar, director of the Center for Global Business Studies at Pennsylvania State University's Smeal College of Business.
Another worry: As Japan's economy strengthens, a sense of complacency could give old-school forces an opening to fight change. Indeed, some analysts sensed this kind of resistance behind the arrest of Livedoors Horie. He dabbled in politics and he built Livedoor in part through a series of aggressive acquisitions. As someone who symbolizes Japans new rough-and-tumble style of capitalism, he makes a good target for anyone who wants to fight against change.
Finally, Japanese day traders are back in the Japanese market in a big way. Thats often a sign of a market top. More likely, it means you can expect further volatility near-term if any bad news shakes jittery day traders out of holdings -- volatility you can use to build long-term positions.
At the time of publication, Michael Brush did not own or control shares of companies mentioned in this column.
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