The Japanese economic soap opera continues.
Once a seemingly indomitable force that gave the U.S. economy a run for its money during the 1980s, Japan in the last two decades has offered instead a steady stream of bad news-from a real estate crash and long-running deflation to grossly underperforming equity markets and recent recalls by Toyota. And soon enough, Japan will lose its perch as the world's second-largest economy to its ascendant and also seemingly indomitable neighbor, China, further fueling the impression that Japan is a country on the wane.
But not so fast. Before the "flash crash," Japan's equity market this year was tops among major Asian countries. Post-downturn, the Nikkei's 0.8% loss as of May 14 trailed only South Korea's 0.8% gain.
Japan has given investors plenty of false hope in recent years, so why should they believe the current rally? After all, the country has horrible demographics, uninspiring projected growth rates and staggering government debt.
Yet it also possesses top-notch companies with great products and a knack for innovation. And it shares a continent with some of the world's fastest-growing economies brimming with expanding ranks of wealthier consumers itching for the types of products Japan excels at.
Japan has a lot to offer from an investment perspective if one tunes out the macro noise and dials in the right channels. "What we're seeing in Japan is a market of stocks, not a stock market," says Matthew McLennan, head of the global value team at First Eagle Investment Management and a co-portfolio manager of the First Eagle Global and Overseas funds. "People talk about Japan as having an older population demographic and an economy that's lost its edge. But when you look at it from the bottom up standpoint, it's quite vibrant."
McLennan cites Japanese leadership in such areas as optics, robotics, electrical sensors, miniature motors, gaming equipment and semiconductor equipment. "Japan has a lot of intellectual property that's very relevant to the industrialization and development of Asia," he says. "We don't think that's getting fully valued when we look at many of the companies in these fields. Japan is still one of the cheapest equity markets in the world."
McLennan notes that Japan recently traded around 1.3 times book value in the MSCI Japan index, while the MSCI World index, tracking developed markets, traded at about two times.
Value Trap?
Given Japan's 20-year melodrama of economic woes, its market has reasons to be cheap.
"All of those companies that tie into domestic consumption and activity in Japan look like great value," says Martin Jansen, senior portfolio manager at ING Investment Management. "But I think they're a value trap because I don't see any catalysts that provide return on capital. That's been a structural problem in Japan-valuations are low because profits have been so low."
Jansen says secular headwinds will be around for a long time, and the only way companies can compete is by significantly cutting costs and restructuring to boost their return on capital. "And I see little of that happening for companies catering to the Japanese domestic market," he says.
Jansen runs two ING funds--the International Index Plus and the closed-end International High-Dividend Equity Income funds, the first of which is market weighted while the second is underweight in Japan. He likes big global exporters such as Sony, Canon and the automakers, which he believes will get a boost from the recent weakening of the yen.
Jansen says investors are reaping some benefits from Japan's gradual improvements in corporate governance and shareholder friendliness. "Japan as a dividend play is still below the global average, but it's not as bad as it used to be," he says. Jansen notes that the recent global average dividend yield on the MSCI World index was 2.7% while it was an average of 1.6% for the TOPIX, or Tokyo Stock Price Index, a widely followed index of domestic companies listed on the Tokyo Stock Exchange.
John Maxwell, portfolio manager of the Ivy International Core Equity fund, also underweights the country in his portfolio: He recently held a 15% stake in the country, while his bogey, the MSCI EAFE index, has 22% in Japan. "That suggests I'm not terribly bullish, but at least I'm not terribly bearish," Maxwell says. "Generally, I don't see long-term exposure to Japan as a long-term investment thesis."
He says part of the country's decent performance year to date is only relative to its lag performance last year, when Japan's capacity utilization and industrial production drastically declined and the strong yen hampered its exports. Maxwell favors globally competitive Japanese multinationals-particularly in the industrial goods and automobile sectors, along with some consumer electronic companies. "It's a market where we want guys who are disciplined by the global forces versus just being in Japan," he says.
Among his fund's recent large holdings was Mitsui & Co. Ltd., a conglomerate with stakes in a range of global businesses including commodities, iron and steel and infrastructure projects. Another large holding was Mitsubishi Electric Corp., an industrial conglomerate with a lot of business in Asia that is involved in power systems, transmission distribution and industrial automation.
Maxwell says Mitsubishi has been a consistently well-run company with lots of cash. "It's like a mini-General Electric or Siemens," he says.
Land Of The Sinking Sun
Japan's tumble is staggering considering where it was in the 1980s. Back then it was mighty Japan Inc., a well-oiled, centralized economic machine orchestrated by the Ministry of International Trade and dominated by the "keiretsu," a clique of family enterprises and corporate alliances based on cross-ownership of businesses and mutual dependence.
That system was behind Japan's international buying binge, including its purchases of high-profile American assets such as Rockefeller Center, Columbia Pictures and Pebble Beach Golf Links in California, home to this year's U.S. Open. Back then, Japan produced the same type of fear and awe that China does today.
But Japan's clubby setup and inbred system created excesses that ultimately imploded the economy. According to The Bubble Economy by Christopher Wood, a book chronicling Japan's speculative rise during the '80s and spectacular crash during the '90s, it wasn't uncommon for Japanese bank stocks to have price-to-earnings ratios between 60 and 100, and by 1990 the total value of all land in Japan was 50% more than the value of all the remaining land on Earth.
Naturally, the bank and real estate sectors started crashing big time in 1990, creating a "lost decade" (more like two decades) where the Nikkei plummeted and deflation reigned. Deflation remains a problem, and even though Japan's zero-rate policy ended in 2006, interest rates remain so low they can't be cut enough to stimulate the economy.
On the fixed-income front, Japan government bonds provide measly returns. According to Nomura Securities, the five-year bond is expected to yield 0.85% this year and 0.95% next year, while the ten-year bond's expected yield is 1.55% this year and 1.65% next year.
Meanwhile, Japan's high fiscal deficit and net public debt (more than 10% and 105% of GDP, respectively, in 2009) raise concerns about fiscal sustainability, according to the International Monetary Fund.
Furthermore, the IMF's forecast for Japanese GDP growth is 1.9% this year and 2.2% next year (it sank 5.2% in 2009). That slightly trails the organization's expectations for the industrial Asia category (including Australia and New Zealand) and vastly underperforms Asia as a whole (which the IMF expects to grow 7.1% in both 2010 and 2011).
And then there are Japan's demographics. It is forecast that by 2050, people over age 65 will constitute 40% of Japan's population, and the overall population is expected to shrink from 128 million in 2005 to 95 million by 2050. As a result, social welfare spending is projected to jump from 18% of the national budget in 1992 to 27% by 2025, which would stress the country's finances.
But when life throws you lemons, you make lemon meringue pie. Taizo Ishida, lead portfolio manager at the Matthews Japan and Asia Pacific funds, says the private nursing home industry stands to cash in on the aging population. He believes the population drop will continue, but perhaps not as precipitously. The birth rate decline has bottomed out, he says, in part because the government is trying to address issues such as the lack of child care and preschool programs, problems that make it tough for working women to have babies.
Another way to alleviate the population decline would be to relax Japan's stringent immigration policy. Japan is home to roughly 2.2 million foreigners-more than half of them Chinese and Koreans. But immigration reform is a tough sell in Japan, and politicians haven't embraced the issue with alacrity despite warnings that the falling population will hurt Japan's long-term economic health.
Not All Doom-n-Gloom
Ishida is mindful of the woes afflicting the country, but his focus is less about Japan's macro issues and more about companies plugged into growth trends.
"At the end of the day, we invest in companies, not countries," he says. "We favor Japan over China now, and it's because of the companies. Many Japanese companies are transforming from domestic- and U.S.-driven to Asia-focused."
One example, he says, is a company called Pigeon Corp., a baby-care company with a growing footprint in China that's a top ten holding in the Matthews Japan fund. Ishida says the company went to China about a decade ago and hit the jackpot by marketing its glass baby bottles to large hospitals around the country, creating a high-end product image appealing to Chinese consumers.
Ishida says the company is growing 20% a year and that 35% of its profits now come from China, thanks in part to the higher margins found there. He adds that Pigeon has two plants in China, and is now heading into India.
He also likes a company called Nidec Corp., a Kyoto-based maker of motors, machinery and electronic and optical components that go into products ranging from hard disk drives to automotive components. Ishida says the company is cashing in on the growing reliance of small electric motors in vehicles.
"One of the big themes for Japanese companies is energy efficiency," Ishida says. "They've always been good at innovation and creating new markets. I'm more hopeful about Japanese companies in the next ten years versus the past 20 years because they have so much technology to offer in areas like energy efficiency, including nuclear technology."
Take What They Give You
Matthew McLennan, the First Eagle portfolio manager, says his international equity funds have sizable Japanese stakes because that market played right into the funds' hands.
"Because our philosophy is all about capital preservation, we almost backed into our Japan holdings because we see them embodying below-average valuation risk, [because they] have solid business models with relevance to tomorrow, and have prudent management teams," he says. McLennan adds that the defining features of many of the Japanese companies in his funds are their strong balance sheets and cash flows, along with their strong global market positions.
One such company is Shimano Inc., a maker of cycling, fishing and rowing equipment; McLennan says Shimano owns more than 60% of the global market share for high-end brake and gear components for bicycles. And only about 20% of the company's sales are in Japan.
He says Shimano's worldwide focus means that Japan's macro problems shouldn't weigh on the company's long-term outlook. "Japan's negative taint lets us buy companies like Shimano at a decent price," McLennan says. "When you think about being a long-term investor trying to find good businesses at good prices, you're likely to find mispriced assets in a country or region where sentiment is negative."
And few countries come with as much negative baggage as Japan.