Japan has been in a deep economic slumber for about 15 years, but it is beginning to show signs of life.

“There’s a lot of upside potential in Japan, and it could have many years to run,” says Pauline Lee, director of I. G. Investment Management (Hong Kong) Ltd. and a member of the Hong Kong team that manages about $1 billion in Asian assets for Winnipeg-based Investors Group Ltd. Lee, manager of Investors Japanese Equity Fund, is cautiously optimistic the worst is over; she is positioning the fund to take advantage of positive changes.

“Although it has not lived up to its potential for many years,” Lee adds, “Japan is the world’s second-largest economy after the U.S. and largest stock market in Asia.”

Japan has been struggling since a massive bubble in both real estate and stock market values burst around 1990. The Nikkei 225 index peaked at 38,900 points in 1989. At a recent level of just above 13,000, it has managed to climb one-third of the way back to its former peak from the painful lows of less than 8,000 when the market crashed. The recent 13,000 level has not previously been seen since mid-2001, and the market is reacting to positive political and economic events.

Japan’s reformist prime minister, Junichiro Koizumi, was re-elected in September by an overwhelming majority in an election that saw one of the highest voter turnouts in years. Koizumi is a charismatic personality known as the “rock star prime minister” after he distributed a CD of his favourite Elvis Presley songs when he took office in 2001.

He is proceeding with his ambition to privatize the massive Japanese post office. The move will be accomplished over many years and will have reverberations throughout the economy. Japan’s post office is the biggest financial institution in the world, and does a lot more than deliver mail. It is also a massive deposit-taking institution with some US$2 trillion in deposits and US$1 trillion in insurance assets. The 130-year-old institution is also a huge employer, with some 270,000 people toiling at 24,000 branches throughout the country. Market-watchers expect its banking and insurance divisions will be sold off.

“The Japanese banks, brokers and insurance companies will be major beneficiaries of the privatization of the post office,” says Lee, who is fluent in Japanese. “There will be a massive inflow of money into private financial institutions.”

Since 2000, Japan’s banks have been allowed to sell investment trusts and insurance products. Lee expects money will flow out of no-interest deposits held at the post office and into higher-return securities such as business and real estate investment trusts. She is investing in the market leaders in financial services, including Sumitomo Mitsui Financial Group and Mitsubishi Tokyo Financial Group Inc.

“The message to the man in the street, who is fed up with old-line party politics, is that the new government stands for reform and will broaden beyond the post office to other areas that will reinforce the interests of the stock market,” says Lee.

Stock market daily trading volumes have already accelerated to levels not seen since Japan’s pre-1990 heyday and, even without the reforms, the economy is already showing signs of a turnaround. Recent figures show the economy growing at an annualized rate of 3.3% in the second quarter, which Lee says is three times the original government estimate and twice the street estimate. Commercial properties are also showing their first price increases in many years, she says. The unemployment rate has dropped to about 4.4% from 5.5% in 2001.

“Most of the growth is coming from private-sector consumption and increased capital spending within Japan,” she says. “The growth is domestically driven — in contrast to the past, when it was either export-driven or boosted by public expenditures on public works such as roads, bridges and dams. We’re seeing a more sustainable, better quality of recovery than in the past. When consumers feel secure in their jobs, they’re willing to spend.”

Lee prefers the market leaders in any sector; big brand-name holdings in the fund include Takeda Chemical Industries Ltd., Nintendo Co. Ltd. and Canon Inc. She is still playing the export theme in her portfolio, however, and the giant automakers Toyota Motor Corp. and Honda Motor Co. are in her top 10.

@page_break@There is a strong appetite for Japanese cars in the U.S., where they comprise about one-third of all cars sold, but China is becoming an increasingly large car consumer as its population becomes wealthier and the country builds up its road network. Lee notes that Toyota has been the largest corporate income earner in Japan for the past several years. The fact that Japanese cars are highly fuel-efficient will work out well for the manufacturers if oil prices remain high, she says.

Japan is also a large supplier of machinery and equipment to China’s massive building boom. Although Chinese demand is primarily for capital goods, Lee expects demand will spread to consumer goods at some point. China’s population is 1.3 billion people, and their consumption is increasing.

“China has taken over from the U.S. as Japan’s biggest trading partner. And while Japan has typically relied on the U.S. consumer, the Chinese consumer could be equally powerful,” Lee says. “Urbanization and Chinese demand for cars will be good news for Japanese manufacturers. There is also growth potential in other countries in Asia, including India.”

After earning a bachelor of social sciences degree from the University of Hong Kong, Lee began her career in 1987 with a Japanese brokerage firm based in Hong Kong called New Japan Securities Co. In 1990, she moved to Wardley Investment Services (now called HSBC Asset Management) and shifted to fund management, specializing in Japanese equities. In 1993, she took her investment-management skills to Sweden-based Carlson Investment Management Far East Co., for which she worked as a director until 2000, when she became a founder and partner of I.G. Investment Management (H.K.).

In addition to managing Investors Japanese Equity Fund, Lee is also co-manager of Investors Global Consumer Companies Class, Investors International Small Cap Class, Investors Global Infrastructure Class, Investors Global Financial Services and Investors Pan-Asian Growth.

Lee likes to keep about 70 stocks in the Japan fund’s portfolio, although she concentrates heavily in the top 10, which make up a combined 30%-40% of assets.
Typically, she allocates 3%-4% to each of her top 10 holdings, with smaller weightings in the rest of the portfolio. Although her core holdings are large-cap companies, she won’t hesitate to buy attractively priced small-cap stocks. There is no hard and fast limit on sector weightings, but she tends to stick fairly close to the Nikkei index.

“We use the index as a guideline and as part of our discipline, and would have to have good reasons to overweight or underweight a sector,” she says. “We seek out the best value opportunity in each sector.”

Turnover tends to be lower in her top holdings than in the rest of the fund, although Lee will trim around the edges when stock prices get ahead of a company’s underlying value, and she will also increase her holdings when prices drop.

“Although valuation is a good guide, if the market is riding on momentum or there is too much money chasing too few stocks, we may hang on a little longer to take advantage of the trend,” she says.

Lee’s Japan fund has underperformed the index for the past year, showing a 4.13% loss for the year ended Aug. 31, while the Morgan Stanley Japan index gained 1.36% in Canadian dollars. For the five years ended Aug. 31, Lee’s fund lost 10.9%, while the index fell 7.9%.

“There have been a lot of false starts in the past decade,” Lee says. “The market
makes a move up, then it finds a new bottom. My goal has been capital preservation, and I’ve therefore preferred the more defensive stocks. In some cases, I took profits early and share prices carried on beyond the fair value level. My conservative positioning has actually hurt the fund recently, as the lower-quality stocks have seen bigger moves coming off the bottom.”

Although there is new optimism in Japan, there are still concerns, she says. An aging population is creating a growing burden on the health-care system, although, Lee says, there could be opportunities in medical insurance, nursing homes and drugs. Japan has 120 million people, and population growth is relatively flat.

Despite the changes in Japan, some still see better opportunities in other Asian markets with younger populations and higher growth rates.

Dan Hallett, president of Windsor-based Dan Hallett & Associates Inc. , prefers funds with a broader investment mandate, such as the Pacific Rim or global. He says even a fund tracking the MSCI EAFE index (Europe, Australia, Far East) would have a 25% weighting in Japan. On a global basis, Japan’s stock market weighting in the MSCI world index is 12% — coming in second after the U.S., which has 47%. “It’s a long process for an economy of [Japan’s] size to turn around,” he says. IE