End of bumpy road hoves into view

Japanese equities are undervalued – and have been for a decade – but earnings continue to rise. When domestic investors’ confidence returns, it could herald a dramatic market turnaround.

Amid the uncertainty characterising global financial markets, it may seem an interesting time to even ponder the question of a potential Japanese market turnaround, let alone be so bold as to try to provide foundation.

Certainly, ever since the Japanese banking crisis of 1998, investors, many and varied, have bet on the fact that Japan’s battered stockmarket had hit rock bottom, hoping to scoop up bargains as bear finally turned bull. They bet and they lost. Yet while the recent Japanese market has continued to ease alongside other major global markets – albeit to a lesser extent – there remains much to draw encouragement from.

Importantly, the Japanese economy is better insulated from the global credit crunch, and similarly the housing market slump that is seriously affecting America and Europe. But Japan has not avoided catching some of the fallout. Overseas investors have been the most active players in Japanese equity markets over the past few years. The ensuing flight to safety has hit equities hard.

Another positive is that an element of resilience is beginning to underpin the market. March 17 marked the recent bottom for the Japanese market, and while other major markets recovered from similar slumps, they then proceeded to shed all and more of their gains. The Japanese market, crucially, has not fallen back to these lows. For sterling-based investors, Japan has provided a relative haven, as the value of the yen has appreciated against sterling.

Economically, Japanese GDP grew strongly in the first quarter of 2008, before contracting in the March-June quarter. Technically, a recession is defined as two consecutive quarters of GDP contraction, and Japan may still escape from recession. But even if it does not, the recession is likely to be mild and short.

Pessimists point towards the resignation of the prime minister, Yasuo Fukuda, as yet another nail in the Japanese economic coffin, yet this is not necessarily as damaging as it might at first appear. More important will be the upcoming general election, which must be held before September 2009.

Given the divided legislature, the election is likely to generate much excitement, potentially stimulating market optimism.

While soaring commodity and energy prices have created fears of inflation across most of the world, Japan is one of the few countries that would welcome rising prices to enable it to escape from years of deflation. Headline consumer prices turned positive in August, notching up 2.3% annual growth.

Even stripping out fresh food and energy prices, to get a truer picture of underlying pricing trends, the news here was good. Prices are finally showing signs of rising, if only by 0.2% each year. Similarly, industrial production has shown a rebound since the second quarter lows and, interestingly, inventories have remained relatively low, indicating that the slowdown is mild and may have already bottomed.

Also, corporate Japan remains healthy. The past six years of earnings expansion has been used to pay down debt and strengthen balance sheets. Companies have shrunk their corporate debt from 130% of GDP in 1991 to 78% today. This puts them in an enviable position to cope with a cyclical slowdown and means investors can draw confidence from the fact that dividends are unlikely to be cut.

In addition, the strength of Japanese balance sheets means that companies are likely to use their excess cash to enhance returns through mergers and acquisitions and share buybacks. Already we have seen several international acquisitions by Japanese companies such as Takeda Pharmaceutical’s almost $9 billion (£5.1 billion) purchase of Millennium, an American biotech, and Ricoh’s agreement to buy Ikon Office Solutions, also of America.

But perhaps the most compelling reason to be excited about the prospects for the Japanese market is valuation. Japanese equities have endured a remarkable de-rating over the past decade, and this has accelerated since 2006, during which time the market has fallen by almost one-fifth – yet earnings have continued to rise.

Price/earnings ratios are broadly in line with the international average, while other measures such as price/book, price/cash-flow and EV/Ebitda (enterprise value/earnings before interest, tax, depreciation and amortisation) ratios are at considerable discounts to international levels. On an historic basis, investors have not seen such low valuations in the Japanese market for more than 30 years. They suggest the downside is limited, while the potential is enticing.

Having said all this, a key consideration for the future is who will buy Japanese equities. Foreign investors have dealt with countless disappointments and frustrations over the past three years. Evidence suggests that international portfolios are indeed underweight in Japan but, importantly, are also looking for opportunities to increase exposure. Pressure from foreign investors over recent years has led to enhanced corporate transparency and vastly improved standards of governance – key stumbling blocks for some potential foreign investors in the past.

More importantly, however, could be what domestic investors decide to do. Flows into foreign equity and bond markets have decreased, and the strength of the yen and government bond market suggests this cash is being parked in low-risk assets. At some point, domestic investors will be confident enough to take advantage of the increasingly attractive yields offered by domestic equities. When they do shift, the funds available are substantial. According to Bank of Japan data, since 2003 Japanese investors have placed about $150 billion into foreign shares and $800 billion into overseas bonds.

Of course, bumps in the road remain, but the signs are encouraging for Japan. Having endured weak economic and market performance for a long time, the turnaround many have waited for might finally be upon us. Get ready – it could be big.