TCS Daily

Japanese Stock Growth?

By James K. Glassman - April 30, 2002 12:00 AM

A visitor to Tokyo just can't believe that this is what a decade of stagnation looks like.
Restaurants are full, shops are bustling, construction cranes are all over the place. Yet on Thursday, a government report showed that Japan's economy had "contracted by a real 1.2% in the final three months of 2001 ... confirming that the nation went through its deepest recession in the post-war era last year."

The numbers are absolutely rotten. Land prices in the six largest Japanese cities have dropped 11 years in a row (down a total of 84%). The Nikkei 225-stock index has collapsed from 39,000 to 11,000 (think of the Dow dropping from its current 10,000 to 2800 and you get the idea). Unemployment has doubled in a decade, government debt has soared to 150% of gross domestic product (vs. 33% in the United States), banks are saddled with more than $1 trillion in bad loans, and government bonds were downgraded this month by Standard & Poor's Corp. to the same level as those of Cyprus.

This recession has been going on for a year and a half, and the Economist magazine's poll of forecasters says it will continue. Of the 15 major industrialized countries, Japan is the only one where they predict GDP will decline this year.

Some of Japan's attempts to change its ways have, frankly, been pathetic. When I was in Tokyo earlier this month, the big story on the TV news was that Mizuho Financial Group -- which became the world's largest bank through a merger of Dai-Ichi Kangyo Bank, Fuji Bank and the Industrial Bank of Japan -- had made a gigantic mess in a changeover that had been planned for 18 months. At least 2.5 million transactions were fouled up as the new institution tried to reconcile operations from three computer systems. The problem: Instead of consolidating, the banks' managements insisted on maintaining their autonomy.

American investors who bailed out of Japan in the late 1980s did the right thing. Japan Equity, a closed-end fund that trades on the New York Stock Exchange under the symbol JEQ, dropped 38% in 2000 and another 22% in 2001. The Japan Fund, a once-popular U.S. mutual fund, fell 34% last year. Its total assets have dwindled to just $2 million, according to Morningstar.

Practically everyone is writing off Japan. The Wall Street Journal reported Tuesday that things are so bad that policymakers in the United States and elsewhere aren't even complaining that the decline of the yen gives an unfair advantage to Japanese companies. Japan is now viewed as "feeble," "a badly wounded giant."

But, despite all this bad news -- indeed, because of it -- Japanese stocks look attractive. One of New York's smartest money managers told me last week that he had just put together a portfolio of 10 solid Japanese companies and was happily buying shares. Federal Reserve Chairman Alan Greenspan told Congress recently that "Japan is beginning to show signs of stabilization." And, in a stealthy way, Japanese shares are rising. Through April 24, the Dow Jones Japan index was up, in dollar terms, 8% for the year -- by far the largest gain among developed economies. Japan Equity Fund has jumped 17%.

While Japan Redux is an intriguing and potentially profitable theme for investors, be mindful of the risks. Investing abroad is always tricky. In Japan's case, not only have stock prices declined in the past decade, but in recent years, the value of the yen has plummeted against the dollar. It is hard enough to pick winning stocks, but to pick winning currencies can be even tougher.

Often, a large Japanese company will have an interlocking relationship, called keiretsu, with other companies, and when you invest in its shares, it is difficult to tell what you are buying -- or whose liabilities you are assuming. In addition, Japanese corporations' books are notoriously opaque. The giant exporting companies -- such as Sony Corp., Canon Inc. and the automakers -- all trade on U.S. exchanges as American Depositary Receipts (that is, like normal stocks, denominated in dollars). They have to meet U.S. accounting rules, and their numbers can be trusted. Buying shares directly on the Tokyo Stock Exchange through a broker is more risky.

Also, remember that throughout a decade of stagnation, Japan's economy and its stock market have briefly climbed, only to fall back again. But this time may be different. Evidence is that at least one prominent critic of Japan has dramatically changed his view. David Malpass, chief international economist for Bear, Stearns & Co., told clients April 19: "We are now constructive on Japanese equities. ... We think time is working for Japan, not against it."

The signs of recovery are minuscule, but this is a game in which fortunes are made, not after everyone else has caught on (as they have with South Korea, for example), but well before. The data still show Japan as a basket case, but Malpass believes that the nation's worst problem may be heading for a solution.

That problem is monetary. Since 1999, Japan has been experiencing deflation -- that is, declining prices. What's wrong with lower prices? Imagine that you want to buy a refrigerator and notice that the price has been cut from $500 to $450. You may decide to wait to see if it drops some more. The next month, it's $420; the month after, $390. You keep waiting and waiting, and meanwhile the appliance store goes out of business.

Deflation can be demoralizing and appear nearly intractable. Inflation can be cured overnight with high interest rates, but trying to fix deflation can feel -- in an expression popular in the 1930s, when deflation ravaged much of the world -- like "pushing on a string." In addition, declining prices of assets such as stocks and real estate have spooked Japanese families so much that they stash their money in government postal savings accounts, which now store $2.5 trillion -- money that could, in a more healthy economy, be used to fund new businesses or the expansion of old ones.

Malpass -- along with other economists, including my colleagues John Makin and Allan Meltzer of the American Enterprise Institute -- believes that deflation can be licked fairly easily if the Japanese, who are well aware of the problem and how to fix it, would stop being so stubborn and inflation-phobic. What Japan needs above all is a dose of higher prices. Makin says that the Bank of Japan (equivalent to our Federal Reserve) should simply set a public target for inflation and run monetary policy accordingly; Meltzer, in a recent Financial Times article, advised, "Depreciate the yen" -- which would have the same effect.

There is evidence that the process has begun. "Commodity prices are rising," Malpass writes. "If sustained, the price increases will spread, breaking the deflation spiral and supporting a better economic and equity market outlook." The Tokyo consumer price index actually rose in March, and Japan's metals index has soared 16%.

Understand, however, that Japan is a speculation. Malpass says he "would like to see clearer confirmation in the form of a rise in bond yields." Japan's 10-year government bonds are still yielding just 1.4%, about the same as a year ago and lower by nearly four percentage points than U.S. bonds.

Also, lack of liquidity (that is, money sloshing around) isn't Japan's only economic woe. I was in Tokyo in early April to give a speech, admonishing executives to improve their corporate governance -- not an arena in which the Japanese excel. Most companies are still run for the benefit of managers, not shareholders. Consider a kind of racketeering called sokiaya that has been in the news lately. In a sokiaya scheme, gangsters buy stock and demand payoffs in return for not disrupting shareholder meetings by asking embarrassing questions. Such a scam would be laughed out of U.S. boardrooms, but in Japan, some corporate executives (Kobe Steel is an example, according to a recent legal settlement) are so frightened of dissent that they pay millions of dollars in hush money.

Then, of course, there is the matter of those gigantic bad debts that banks, with the collusion of the government, don't have the courage (or the capital) to write off. Japan is also absurdly over-regulated and -- especially compared with the United States, Britain, Korea and China -- over-taxed. But the Japanese are smart and diligent, and Prime Minister Junichiro Koizumi may yet cut pork-barrel spending and bring the banks in line. Once the monetary pall lifts, the economic scene should brighten considerably. Then, the Japanese can get to work improving corporate governance and fiscal policy and reforming their unresponsive one-party political system.

But even without a quick economic solution, Japan offers enticing investment opportunities -- at least according to Sanford C. Bernstein & Co., a New York money-management firm with a reputation for caution. Bernstein reduces risk by searching out good companies that are cheap. Says a recent Bernstein report, "While the foreign markets are in a slump, company managements aren't sitting on their hands and watching it play out. Throughout Europe and even more-traditional Japan, companies are restructuring (just as U.S. companies did in the early Nineties) to focus on shareholder value."

Honda Motor Co., Japan's third-largest automaker and the world's largest motorcycle maker, is one of Bernstein's major international holdings. Shares have jumped 50% since their low after the Sept. 11 terrorist attacks, but Honda still trades at a relatively low price-to-earnings (P/E) ratio. Bernstein sees profits rising by 10% in each of the next two years.

Morgan Stanley includes Honda among its 40 "competitive edge, best ideas" stocks -- its top picks from around the world. Only one other company based in Japan -- Sony Corp., the consumer electronics giant -- makes the list, compared with 26 based in the United States and 12 in Europe. The leading Japanese selection for the Value Line Investment Survey is Nissan Motor Co., whose stock has more than doubled since September but still trades at a P/E, based on projected earnings for this year, of less than 10. For a diversified Japanese portfolio, consider Japan I-Shares (symbol: EW), an exchange-traded fund on the American Stock Exchange, or any of several Japan-focused mutual funds, including Matthews Japan and T. Rowe Price Japan, which get recommendations from the No-Load Fund Investor newsletter, and Japan Stock, and Fidelity Japan, which receive good ratings from Morningstar. Japan Stock's holdings include Fuji Photo Film; Toyota, which may be the best auto company in the world; NTT DoCoMo, the high-tech telecom firm; and Bank of Yokohama (all but Yokohama trade in the United States as American Depositary Receipts, or ADRs).

Fidelity also offers the highly volatile Japan Small-Company fund, which at last report owned a bundle of retailers that should benefit from an economic rebound. They include Yamada Denki, which sells small appliances; Shaddy Co., with 3,000 catalogue-sales outlets; and Don Quixote, a discounter that is fighting Japan's oppressive commercial rules with extended hours and cut-rate prices. (None of the three trades as an ADR.) Is Don Quixote an apt metaphor for those venturing into Japanese stocks today? Maybe. But my suspicion is that this could be a battle that gritty, patient investors can actually win.

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