Despite a strong start, 2009 is likely to be unexciting for Japanese stocks. The spread of the U.S. financial contagion around the world, a climbing yen and a still struggling domestic economy are all exerting a continuing drag on Japanese companies.

Still, the prospect of a mid-
year recovery could provide opportunities for clients hoping to participate in the world’s second-largest economy.

Mark Grammer, vice president of investments with Toronto-based Mackenzie Financial Corp., says now is the time to buy into Japan. Although he expects corporate earnings to fall in the next few quarters, investors have already priced that possibility into the market.

“If you invest in quality companies at a time like this — when the 10-year return [for world stock markets] is at the lowest it has been in 150 years — you should be rewarded,” he says, adding that economic growth in the first half of 2009 will be negative, but will be positive in the second half.

Others are more cautious. Stephen Way, senior vice president and portfolio manager of global equity funds with Toronto-based AGF Funds Inc., says that while conditions are improving somewhat for investors, the future remains bumpy: “There is still a lot of uncertainty, and the markets reflect that. But the opportunity to make money in Japan is much better than it has been in the past five to eight years because valuations have come back so much.”

Way continues to have a neutral position in Japan in the two global equity funds he manages and hasn’t added any new names to their portfolios. The funds’ holdings are diversified across several sectors: in general, they include companies that he believes are well equipped to weather the slowdown, including Astellas Pharma Inc., Canon Inc. and Keyence Corp, all based in Tokyo.

Erwin Hidalgo, the Hong Kong-based manager of Investors Japanese Equity Class fund, sponsored by Winnipeg-based Investors Group Inc., also favours survi-vors in this environment. These include companies with strong balance sheets that dominate their markets, are able to generate new business and are “income inelastic earners” — firms that are relatively insulated from downward economic shifts because consumers can’t easily cut back on the products and services they provide.

But Hidalgo also keeps an eye out for opportunities among companies that are big consumers of commodities: “The recession is putting an end to this commodity supercycle and now you are seeing lower costs for all companies, but especially [for] commodity users.”

For Japan, the global slowdown has wielded an unusually heavy blow because domestic demand, battered by the country’s seemingly intractable recession through the 1990s and the first half of this decade, has not grown as expected.

“We had hoped that the domestic economy would morph into something that would become more important in Japan and [that] consumption in Japan would increase,” says Hidalgo. “But that just hasn’t happened.” One of the main reasons is continued weakness in wage growth, he says, “which has really hurt Japan’s consumption levels.”

Declining demand in the region is also having a big impact, Grammer says: “With the slowdown occurring in China, you are now getting a direct impact on Japan, so I don’t expect to see export growth of much more than a couple of per cent for next year, at best.”

Japan’s exports aren’t getting any help from the yen, either. In October 2008, the currency reached a 13-year high against the U.S. dollar. And fund managers aren’t counting on it coming down in the near future.

Another issue is a decline in business investment by even the largest of Japanese companies, which Hidalgo says is “the biggest reason for the recession. Companies have started to cut back on spending.”

Japan also continues to struggle with an aging population and baby boomers getting ready for retirement. That’s a potential bur-den for government. On the other hand, corporations could potentially benefit from the demographic shift: as older, more expensive employees leave the workforce in large numbers, many are likely to be replaced by younger, less expensive workers.

“The [demographic] transition that has been taking place over the past two years has been positive for corporate profits, and we have seen profit margins in Japanese companies rising over the past few years,” says Way. Although those profits have probably declined with the most recent slowdown, both domestically and overseas, they should increase once the global economy returns to health.

@page_break@Another plus is that many Japan-ese companies have remained cash-rich. Normally, that is not attractive to investors but, in this environment, says Grammer: “These deleveraged companies are looking quite attractive. And so the names that I have in Japan, I am feeling pretty comfortable with [in terms of] the long-term prospects.” IE