False dawn or new beginning?

Japan has been in a bear market for 14 years. This has not stopped Tokyo-listed shares from flattering to deceive on numerous occasions during this period. In 1999, for example, the market looked like it had started a sustained recovery. Instead, it has always finished at a lower value than that at which it began its short-lived rally. From its peak in 1989, the Nikkei plummeted from 39,000 points to less than 8000 in April 2003.

Japanese equities, however, are once again attracting the attention of international investors. There has been a 40 per cent growth in the Nikkei 225 from mid-April to rise above 11,000 in September. During this five-month period, Japan outperformed US, European and UK equities. The rally was aided by foreign investors heading back in the belief that the situation is different from previous false dawns. Japanese investors, however, have not been in such a hurry to buy domestic equities.

Change for the better

There are two main explanations currently being offered for why the situation in Japan has really changed for the better. These are the reverse of why the stock market has been in a bear market for the past 14 years – an adverse demand/supply situation for equities and poor corporate profits.

It is argued that the demand and supply balance has been improved through the Bank of Japan buying Ą1200bn (E14bn) of shares from banks at the end of last year and the start of 2003. The amount of shares sold by banks is expected to halve this year and again in 2004. There is also optimism that life companies will stop selling shares because some of their exposure to equities has fallen to as low as 5 per cent.

As well as an improvement in corporate profitability, companies have started to buy back shares as they can now hold them in treasury.

This is linked to the improvement in company cash flow through restructuring, cost-cutting and the disposal of non-core companies. It has been reported that many companies have as much as ¥10bn in cash, which they are using to pay down debt, increase dividends and buy back shares. This has helped increase share prices.

European optimism

It is not only fund managers that have become more optimistic about the outlook in Japan. While not as bullish, European distributors share some of the increased optimism. Kobus Human, managing director of Amsterdam-based Insinger Asset Management, says: “The situation has changed in Japan to some extent. There has certainly been an alteration in perceptions.”

Mr Human recognises that there has been some important restructuring in the world’s second largest economy – even in the banking sector. He adds that there was good value in Japanese equities in the spring after the long bear market. Martin Currie Japan and Polar Capital Japan is his favourite fund for the region.

Wolfgang Spang of Stuttgart-based intermediaries Economia, says he is “very optimistic” about the outlook for Japan. “I believe it is a turnaround situation. Investors have started buying Japanese equities again, companies are making profits and restructuring.”

“The culture of responsibility has changed as well. Previously, companies would have a group discussion about decisions. After a long discussion, they would come to a conclusion but no one would take responsibility for the decision. Now managers are adopting western styles of management and are taking responsibility for decisions.” Mr Spang selects Invesco GT Japan Enterprise as his preferred Japanese fund.

Yoko Tilley, manager of Fidelity Funds Japan Fund, says companies that can deliver sustainable strong earnings growth over the mid to long term have several key characteristics.

‘Many of the companies in the portfolio have a dominant market position within

their industry’

Yoko Tilley, Fidelity

“They usually have a strong competitive position within a growing business segment,” says Ms Tilley. “Many of the companies in the portfolio have a dominant market position within their industry, supported by technological advantage and a quick response to change. Their business generates strong or improving free cash flow due to strong pricing and purchasing power. Their ability to increase market share and profit margins is another key factor.”

Positive cash flow

Gladys Lau, who takes a bottom-up approach to managing the Pioneer Japanese Equity fund, which has about 100 holdings, stresses the importance of companies’ balance sheets and positive operating cash flow when deciding whether to invest in Japanese stocks.

‘With the improved economic environment, firms are able to turn around their profits and restructure their balance sheets’

Gladys Lau, Pioneer

She says: “These are the basic qualities of a company as well as the quality of management.” Ms Lau points to Nissan as an example of the restructuring that has taken place in Japanese industry. She says the fact that the restructuring only took place after the catalyst of a takeover (by Renault) shows these events can prove to be an investment opportunity.

The improved economic environment has led to a change in the type of companies that Ms Lau might invest in. “Previously, I would focus on companies with good profits and the better track record. But now, companies are able to turn around their profits and restructure their balance sheets. This is presenting more investment opportunities in companies and sectors.”

Ms Lau says restructuring began more than three years ago. “Most companies have addressed their balance sheet issues, reduced their gearing and sold cross-shareholdings. Now Japan is entering the second phase of restructuring. This involves companies growing their sales and profits. The selective shift of manufacturing production to China will benefit Japanese companies. Furthermore, the decision to move pensions back to the government has led to a one-off selling of equities which will not be repeated.”

The threats to a Japanese recovery, says Ms Lau, remain deflation and the high levels of government debt, although companies have been reducing their borrowings. Her fund has underperformed the Nikkei 225 index over one and two years.

Stefan Fischer, manager of the Deka-Lux Japan fund, says 60 per cent of his performance – well ahead of the Nikkei over three years – is the result of selecting stocks. Another 20 per cent comes from asset allocation of the portfolio and the final 20 per cent from market timing. Mr Fischer adds that stock selections are made by 30 analysts while he decides market timing and asset allocation.

The real thing

While Mr Fischer admits the Japanese market had three rallies in the 1990s that could not be sustained, he also believes the situation is different this time. He attributes this to the restructuring of companies as well as growth in both the global and Japanese economies. “The inflation environment is not as tough as it was and there appears to be price stability in Japan.

“Inflation should rise to between zero and 2.5 per cent, which would be helpful for the economy and provide a real risk premium for equities that have a dividend yield of 1.1 per cent against 0.4 per cent by 10-year treasuries.”

Mr Fischer does not believe the government debt will pose a problem for economic growth because of the high savings rate in Japan.

‘Aggregated net profits of Japanese non-financial firms will reach new highs in this financial year ending March 2004’

Ernst Glanzmann, Julius Baer Japan

Ernst Glanzmann, manager of the Julius Baer Japan Leading Stock fund, thinks the bear market may have come to an end earlier this year. He argues that the banking crisis of 1997 and 1998 prompted company managers to start the restructuring process.

“The first fruits of these efforts are now becoming visible to a broader investment community,” says Mr Glanzmann. “Aggregated net profits of non-financial firms will reach new highs in this financial year ending March 2004 and the average return on equity will approach levels not seen in other

major economies,” he says.

“The equity market neglected this fact for too long. This spring, valuations fell to levels not seen for more than 20 years. The market had to rectify this at some stage.”

‘The economy is now in a cyclical upswing but with a moderate recovery over the next six to 12 months’

Hideo Ueki, UBS

Hideo Ueki, head of Japanese equities at UBS Asset Management, is more cautious than some other managers but believes there will be a “moderate recovery” over the next six to 12 months.

He says that given the “fragility of sustainable economic recovery in Japan because of the sole dependence on a US recovery and the structural supply-demand gap, the current level of the stock market is a bit ahead of where it should be in terms of valuation”.

If, however, there is a stronger US economic recovery and the improving corporate governance in Japan results in rising profitability and cash flow generation, the “Japanese stock market still has some way to go”.

Mr Ueki adds: “Despite the fact that the majority of major companies are still paying back debt in Japan, some have started capital expenditure for both maintenance and research and development, which should result in solid private investments.

“While we do not have high expectations about public spending due to severe fiscal problems, the consumption trend is likely to be flat following rising welfare and medical payments. The Japanese economy is now in a cyclical upswing but with a moderate recovery over the next six to 12 months.”

Further questions

The Japanese stock market was clearly under-valued in the spring but the rise of more than 40 per cent has raised doubts about current valuations. There are further questions over the strength of the economic recovery in Japan, particularly if there was another downturn in the global economy.

While the restructuring of corporate Japan has undoubtedly made a sustained recovery more likely than at any other time during the past 14 years, investors still need to be cautious about the proportion of their portfolio they allocate to Japanese equities.