Japanese stocks performed relatively well in 2004, with the median fund returning 5.9%, but conditions are proving to be much tougher this year. Fund managers attribute the struggle to market anticipation of an economic slowdown, which is prompting some to be less upbeat about the short-term outlook.

“The general economic news out of Japan has been somewhat weaker than what domestic investors and companies had been expecting,” says Mark Headley, manager of GGOF Japanese Value and president of San Francisco-based Matthews International Capital Management. The malaise is being driven by concerns about the high cost of crude oil and worries about further hikes in U.S. interest rates. “There has been about six months of somewhat negative news, which is reflected in lower consumer and corporate confidence. We had anticipated a recovery driven by corporate spending. Right now, though, we are drifting sideways.”

Headley argues that Japan lacks a strong sense of momentum and still frets about one of its key trading partners, the U.S.
“We’re still awaiting the day when Japan has a self-sustained bull market driven by domestic economic performance. That theory is based on the notion that you are getting a better regulatory environment and companies are managing themselves better,” he says, noting that there has been some progress as more companies are bottom line-oriented and
shareholder-friendly.

A value-oriented investor, Headley is focusing on companies that are more progressive and are best positioned to benefit from longer-term trends within Japan. As a consequence, he’s overweighted in areas such as financial services, retailing, innovative service providers and export-oriented technology companies that are restructuring. About 50% of his 40-name fund is in large-cap stocks, followed by 30% in mid-caps and the balance in small-caps.

One prominent stock that has been in the fund since 2002 is Mizuho Financial Group Inc., one of the world’s largest banks. “It’s a proxy on a restructured Japanese banking system and a way to participate in the reflation of Japan’s economy,” he says.
Banks are beneficiaries of asset reflation because they are major owners of real estate, he adds. At 15 times 2006 earnings, the stock “is not as cheap as [those of] some of the damaged banks, but we are avoiding those,” says Headley. Mizuho’s earnings are expected to grow about 10% in fiscal 2006.

While the fund has a bias toward domestic plays, there are also a number of export-oriented firms. One favourite is Sharp Corp., the consumer electronics giant. The firm is concentrating its efforts on making flat-panel televisions, says Headley, and is aiming to dominate that segment. “There are very high barriers to entry and there will be only two or three successful competitors.
Sharp definitely has the potential to be one of those,” he says. “Management has been more proactive than most Japanese firms at reducing non-core activities.” A long-term holding, the stock is trading at ¥1,680, or 18 times its 2006 estimated earnings.

Corporate profits have been improving but the economy as a whole has been stagnating, says Charles Edwardes-Ker, head of Japanese equities at London-based TD Asset Management Inc., who oversees TD Japanese Growth Fund. Consensus estimates have lately revised 2005 GDP growth downward to 1.1% from 1.4%. “There have been global headwinds, such as rising oil prices, although Japan is less vulnerable than it used to be,” he says.

Still, he says, the market is reasonably valued and is trading at 1.6 times book value, or at the lower end of the historical scale, which has ranged from 1.5 up to 2.5 times book value. “The market is well supported at these levels. We assume some very modest re-rating to about 1.7 times, based on improvements in corporate profitability,” he says, noting that returns on equity jumped to 8% in fiscal 2004, vs 6.6% in 2003. Equally positive, he says, dividend yields, currently 1%, are gradually moving up and may match or better current bond market yields of 1.35%.

There are some negatives that are a drag on the market, he admits. Edwardes-Ker points to the proposed but failed merger of Mitsubishi Tokyo Financial Holdings Inc. and UFJ Holdings Inc. As well, he was displeased at how the business establishment responded to the attempt by Livedoor Co. to take over Nippon Broadcasting System by finding new ways to create poison pills: “There is a lot of value in Japan, which should be unlocked. When you see more successful M&As, that’s a signal for re-rating the markets, but it looks as if it will be delayed for the time being.”