Over the past 15 years, the Japanese stock market has had more false starts than a high school track meet. Last April, for instance, the Nikkei 225 index hit a high of 17,563, up 9 percent from the start of the year, and then proceeded to collapse by 20 percent in the next 60 days. The smaller domestic companies took an even bigger thumping.
Investors have jumped in any number of times since the market famously crashed in 1990, looking for a recovery in the world's second-largest economy and an opportunity to retrace the Nikkei's shocking 80 percent high-to-low decline. Each time, persistent deflation and the corrosive effects of an inefficient economy have cost the optimists dearly.
Could 2007 be the year that Japan finally emerges from its slump? Bob Doll thinks so. In his annual forecast, Doll, top equities guru for BlackRock, argues that Japan's stock market could be a top performer in 2007, based on accelerating nominal growth and reasonable valuations. He's not alone. Chuck Clough, former chief strategist for Merrill Lynch and now head of an eponymous hedge fund, has ridden the Japan rollercoaster in the past few years. After enjoying a 40.2 percent gain in the Nikkei in 2005 (tempered by a declining yen), Clough suffered from his exposure to Japan in 2006, when the Nikkei was ahead only 6.9 percent and the broader Topix index was up only 2 percent. Notwithstanding the disappointing recent results, he is unreservedly bullish. “I like the Japanese market a lot,” he says. “For the remainder of the decade, we think it will be the best performing of all the developed countries' markets.”
Ridding the System of Zombies
Clough's enthusiasm stems in part from his conviction that Japan's corporate sector is becoming fundamentally more profitable. The banking industry has finally resolved its bad loan issues, in his view, and Clough further points out that the market valuation for Japan is less than that of rival developed countries.
Doll also highlights the change in Japan's corporate culture. “The language used by Japanese companies today has changed,” he says. “They talk now about margins and earnings, not just about gaining market share.”
The road to economic health started in earnest in 1999 when the Bank of Japan announced that banks could no longer support “zombie” companies, as Clough puts it. “They cut off funds to companies that were basically bankrupt and forced the good ones to restructure,” Clough says. “By 2002, cash was building up on corporate balance sheets. Asset deflation during this period meant that the changes didn't show up in net income. Operating earnings improved, but were offset by asset charge-offs.”
This gradual improvement in corporate profitability has yet to trickle down to the consumer. Wage increases have been modest, leading to real disposable income gains of less than 2 percent per year. Because of Japan's high savings rate, household expenditures have most recently been in negative territory.
That could be about to change. Unemployment is running at about 4 percent, or low enough to begin exerting some upward pressure on wages. Real estates prices are inching up, and bonuses are climbing as well. Also, Clough maintains that the younger generation in Japan may be more inclined to spend. He points to the existing housing stock in Japan, which is antiquated and in need of repair, as a likely target.
Bottom line for Clough: Japan accounts for about 19 percent to 20 percent of global gross domestic product, while its equities markets make up only 9 percent of the world's capitalization.
Campbell Gund, head portfolio manager for T. Rowe Price's Japan Fund, takes a more cautious line. In his view, the drop in small-cap stocks last year was just a correction for the overly ebullient returns in 2005. He is not especially optimistic about returns in 2007, especially for U.S. investors, who are likely to be hit by a weakening yen.
Like most investors in Japan, Gund divides the market into two categories — the large export firms and the typically smaller companies that are more reliant on the domestic economy. “The yen is at a 20-year low,” Gund says. “The export companies have a phenomenal tail wind. They can price aggressively or make more money.” His favorites in this group would be the large auto companies and the imaging firms like Canon and Ricoh.
The domestic side of Japan's economy is trickier, he suggests. Gund sees the Japanese consumer as still traumatized by the downward spiral in property prices, which has nearly matched the collapse in the stock market. Consequently, he thinks an upturn in inflation may be required to jump-start the consumer. A recent report that core consumer prices only rose 0.1 percent year-over-year in December sent the Tokyo market skidding lower. Overall, Gund thinks the domestic companies may still be as much as two years away from a cyclical growth spurt.
Welcome, Private Equity
David Ishibashi, co-manager of the Matthews Japan Fund, is betting otherwise. Ishibashi points out that, for the first time in 20 years, corporations are investing in new plants in rural areas of Japan, in part because they see opportunities to export product to the many growing Asian nations, including China.
One of the areas most appealing to him has been companies that are benefiting from a recovery in real estate values, such as REITs and real estate consultancy K.K. Davinci. Clough prefers to invest in the banking sector, singling out Bank of Yokohama and Nomura as likely beneficiaries of a strengthening local economy.
As to overall valuations, Gund is cautious. “There is still too much fat in Japanese companies,” he says. “Return on equity is much lower than elsewhere, because corporations are overcapitalized.'
That sounds like an invitation for bargain-hunting private equity buyers, and, indeed, buyouts are on the rise. The Carlyle Group announced in July that it had raised $1.87 billion for takeovers in Japan, its second fund and the largest of its kind to date. They have company. Takeovers of Japanese companies by private equity firms totaled $16.9 billion last year, according to Mergermarket data, up from $11.1 billion in 2005 and $3.8 billion in 2004.
“The Japanese are deathly afraid foreigners will come in and take them over,” Ishibashi says. “They should be afraid other Japanese companies will buy them out. Value will be released in a uniquely Japanese way, but will include joint ventures, mergers and buyouts. Corporations will reform to avoid being bought.”
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