After 15 years of battling weak markets and a sluggish economy, Japanese companies are showing signs of renewed strength. Although their progress may not be as quick as investors would like, the outlook is decidedly more promising, with an increasing number of businesses reporting rising profits and dividend payout ratios.

“Return on equity has been improving quite dramatically in Japan,” says Charles Edwards-Ker, portfolio manager at Toronto-based TD Asset Management Inc. , “although it’s still not quite at the same level as it is in Europe and the U.S. — which is why Japan is still so much cheaper on a price/book ratio [basis].

“We do think Japan is on a sustainable growth path,” he adds. “The banking system is getting back to normal and we’re seeing positive loan growth, which will be a sign that the economy is normalizing after this 15-year stock market recession.”

One positive indicator is that the dividend payout ratio — as monitored by the Topix index, which tracks 1,700 companies — has increased to 27% from 19% three years ago. “This is very important to investors,” says Edwards-Ker, “and we feel that Japanese companies are going to increase it to between 32% and 35%.”

Also on the rise is the average dividend yield for companies listed on the Topix index. At 1.48%, it is close to surpassing the 1.5% 10-year government bond yield, something that Edwards-Ker says is a very promising sign: “This has only happened three times in the past 15 years or so. Whenever the dividend yield has been higher than the bond yield, that is usually a pretty bullish and positive signal for the stock market. We very much welcome this new change in attitude of paying dividends at last and trying to increase them.”

In addition, Japanese companies are starting to buy back shares, says Stephen Way, senior vice president and portfolio manager of global equity funds at Toronto-based AGF Funds Inc. One example is pharmaceutical company Astellas Pharma Inc. of Tokyo.

But, says Edwards-Ker, more mergers and acquisitions — particularly hostile ones — are needed in order for Japanese companies to increase profitability.

The recent improvement in Japan’s economy — which has been driven by business capital expenditures and exports — has led to a drop in the unemployment rate and to a slight improvement in consumer spending, although not by as much as money managers would like to see.

The hope has been that the low unemployment rate, combined with economic growth and the end of deflation, would lead to wage increases and, in turn, stimulate consumer spending. But, so far, the latter two developments have not occurred.

“At one point, it looked like wages were starting to turn,” says Justin Nightingale, assistant vice president of global equities for Montreal-based Natcan Investment Management Inc. and manager of Altamira Japanese Opportunity Fund, sponsored by Altamira Investment Services Inc. of Toronto. “But it hasn’t happened yet.”

Adds Edwards-Ker: “There has been minimal wage growth so far, despite a very strong job market, and this affects consumption greatly. You have had these phenomena in which the aging population is retiring on higher salaries than the younger generation coming in, and overall remuneration is not going up. It really is the missing link in the economy.”

Unfortunately, business investment is now starting to show signs of weakness, which could frustrate the hopes of wage increases and stronger consumer spending. Capital expenditures fell for the second quarter in a row in the quarter ended Sept. 30. If export growth also weakens in the face of slower global growth, says Way, that would be another negative.

The Bank of Japan has lowered its estimates for growth in real gross domestic product for the fiscal year ending March 31 to 1.8% from 2.1%. The forecast is for growth of 2.1% or more in fiscal 2008, but Edwards-Ker feels that forecast might still be a little high.

For the 12 months ended Nov. 30, the Topix index has outperformed the S&P 500 composite index by 4%-5%: for five years, it was ahead by 21%. Way, who prefers the Topix index to the more widely quoted Nikkei index because the former includes more companies, says these figures contradict the common perception. “The average person would assume that Japan has been a dead dog and the U.S. has been better,” he says. “But that is not the case.”

@page_break@Although Way was underweighting Japan vs the MSCI index six months ago, he would overweight it now. The Japanese stock market is trading around 17 times earnings, compared with 14 times earnings in the U.S and 12 times earnings in Europe.

On the other hand, the uncertainty in the world economy resulting from the U.S. slowdown and the global credit crunch has caused Edwards-Ker to become more defensive in his outlook. In December, he took action by rebalancing his portfolio. “We have set more to neutral weights,” he says. “In particular, we have decreased our cyclical exposure from overweighted down to neutral and we have increased our pharmaceutical exposure from underweighted back up to neutral.”

With the improvement in the Japanese economy over the past few years, Way points out that the domestic banks are slowly getting back into shape and are much healthier than they were five years ago. But overall, the level of Japanese bank profitability is still low compared with other banks around the world, and Way doesn’t own shares in any. “Despite the fact that they are doing better than they were,” he says, “from a global perspective, I can get better valuation elsewhere.”

Japanese banks were only modestly affected by the asset-backed commercial paper crisis. This is mainly because the banks were still shell-shocked from their problems of the 1990s. “The banks have been cleaning up for the past decade,” Way says. “So, I don’t think they really went out on a limb too aggressively to buy the paper that was being sold in the U.S. investment banks.”

The 1990s were also a time of major deflation in Japan, with real estate prices falling by 70%-80%. But that, too, has passed. “For the first time in many years,” Way says, “we are seeing property prices nationally starting to rise.”

As a result, the Bank of Japan is forecasting mild inflation of 0.4% this year, compared with zero in 2007. That’s positive, but isn’t enough to move interest rates.

“We see no rate hike in the next three months,” says Edwards-Ker. “It is possible, in the latter part of 2008, to see another 25-basis-point increase or so. But the inflation benchmark for Japan is 0%-2%, so 0.4% isn’t even halfway.”

Prime commercial property prices have risen aggressively in the past 18 months. The vacancy rate in Tokyo is less than 2%, causing rents to rise by more than 10% a year.

REAL ESTATE EXPOSURE

Nightingale favours companies that have indirect real estate exposure. “There are a couple of companies that have large accessory real estate that they are working down or companies who are redeveloping their real estate,” he says. “Those areas are always interesting.”

A different way to play the property sector is with the real estate income trust market. One that Edwards-Ker favours is Mid REIT Inc. “In the recent market turmoil, the REIT market is being sold down very heavily,” he says. “You can now find dividend yields anywhere from 5% to 7%.”

Generic drugmakers are also turning money managers’ heads. For the first time, the Japanese government is promoting generic drugs, which tend to be much cheaper for the population, says Edwards-Ker: “The use of generic drugs has been very low in the past, and with the aging population and rising health bill, it would make immense sense for Japan to start promoting the use of generics more actively than it has done so far. This is an area with high interest.”

Way owns Astellas Pharma, which is not only buying back its shares but is also relatively cheap, from a global perspective. In addition, as a domestically-oriented company, Astellas is not vulnerable to a U.S recession. “It has some U.S. export exposure,” he says, “but people are still going to buy drugs even if the U.S. is in a recession.”

Edwards-Ker is also looking closely at Japanese companies with a strong focus on green issues. In the past 15 years, Japan has started to take a leadership role in environmental concerns and conservation. Tokyo-based technology company Horiba Ltd. and Daiseki Company Ltd. in Nagoya are just a few of the environmental companies that Edwards-Ker has started to follow. IE