Signs familiar

Can Japan finally achieve a sustained stockmarket recovery? Every year or two investors seem to get excited about the prospects for the Japanese market. After suffering anaemic growth – and often outright recession – since 1990, the hope is that Japan will enjoy a period of consistently strong performance.

Japan fund managers now seem to be going through another one of their excited phases. Many talk positively about the country’s prospects. Given the frequent disappointments in the past it is easy to be cynical. But because Japan has not lived up to expectations before does not necessarily mean that all will go wrong this time.

There are several reasons to be positive about Japan. It can certainly benefit from a relatively strong world economy. In particular it is in a good position to capitalise on the rise of China as an economic power. The trade and investment links between the two countries are strong.

But there are also positive signs within the country. The banks seem finally to be tackling their bad debt problems, and corporations are awash with cash. The unwinding of Japan’s system of interlocking share-ownership could also make its companies more competitive.

Assessing the prospects for a sustained market recovery means examining several different factors. The economic environment is certainly important, as is progress on reform within the corporate sector and the extent to which banks are dealing with bad debt.

On the economic front, the first quarter of 2004 seemed to herald the start of a more promising, structurally based recovery. Many perceived early signs that the economic problems that have plagued the country since 1990 were ending. Japan might not regain its previous status as the fastest-growing large economy but it could certainly do better than the past decade-and-a-half of misery.

Statistics from early last year looked hopeful indeed, with gross domestic product up 5.6% at an annual rate in the first quarter, according to official figures. Consumption was also on the increase this time last year, up 1% on the last quarter of 2003.

However, after its strong start, 2004 ended up being nowhere near as healthy as many had hoped. Economic figures for the fourth quarter of last year were much lower than expected, with consumption falling 1.7% year-on-year in October. The poor finish to the year culminated in the announcement that, technically, the country had fallen into recession again after GDP dropped by 0.5% at an annual rate in the fourth quarter of 2004.

This setback has left many wondering if the latest recession is a sign that the Japanese economy has stalled once again, and what effects this will have on the market. The recession was probably caused by a combination of seasonal and structural factors. According to several economists, some are more worrying for the economy than others.

The simplest explanation for the shrinking economy was that GDP data Cfrom the third quarter was revised downward and became negative as a result. This was because of the introduction of chain-linked deflators to the GDP calculation, which, unlike the previous fixed-base indices, act to rebase GDP every year, according to the Japan Research Institute.

Charles Dumas, director and head of the world service at Lombard Street Research, attributes the recession to more serious factors. In the second quarter, the drop in GDP was partly the result of a cut in public sector investment, he says. In the fourth quarter, however, growth fell because of inventory liquidation, aimed at correcting an excess, as well as negative net exports and low consumer spending. He adds that a recession brought about by low consumer spending is often bad news, especially for one of the world’s biggest economies. While Japan should not stay in recession, he argues, it will also not have very strong growth this year.

“Growth will be positive this year, but weak. Export growth will slow and there are still problems with imports and continued restraint of government spending, which will mean very little growth in 2005 – maybe 1.5-2%,” says Dumas.

According to Edward Lincoln, senior fellow at the Council on Foreign Relations in Washington DC, the recession will not greatly affect prospects for 2005. He says: “In Japan, people are disappointed that the economy wasn’t doing as well as the government said in 2004. However, this is a temporary pause, not at all like the recession in 2001. Japan will be back into positive growth territory early this year.”

Lincoln agrees a drop in consumer spending was probably the main contributor to the recession. He adds, however, that an unusually large number of severe typhoons and earthquakes in Japan were the root cause of a drop in spending last year. The country also experienced unusually warm weather in November and December, which affected retail sales of winter clothing.

On the positive side, economic data released in early 2005 has been slightly more encouraging. This has prompted several economists and fund managers to forecast that, instead of falling further into recession, 2005 may finally be Japan’s year for more sustainable, structural recovery. This time, many hope growth is based more on domestic demand than on exports.

Industrial production was up 2.1% in January compared with the previous month. The Japanese Ministry of Economy, Trade and Industry, however, says that production has remained flat and is set to decrease in February and March. Retail sales figures for January were also up 2.2% compared with the previous year.

This time around, says Lincoln, the positive figures are based on structural factors rather than being overly reliant on the benefits of exports. “This time last year, there was considerable optimism in Japan, especially from the government. Their optimism was misplaced. Last year’s recovery was cyclical and export-driven, rather than structural, and then exports slowed down.” Lincoln adds that, structurally, Japan is now in a better position than it was two years ago. “Debt has been reduced, corporate balance sheets are in better shape and corporate profits are rising,” he says.

Takehiro Sato, an executive director of Morgan Stanley based in Tokyo, in a recent report says better leading indicators have led the group to change its outlook for the Japanese economy, forecasting an early recovery. He adds that the economy will begin to improve at the beginning of the second quarter, rather than in the latter half of the year, as previously thought. Sato expects Japan to have returned to stable growth by mid-2006.

Japan’s Mitsubishi Research Institute has taken a more neutral approach, forecasting that the country will be in an adjustment phase until September. This will be followed by a more gradual move towards recovery.

Fund managers tend be more optimistic about the outlook for Japan than economists. Most Japan and global fund managers are bullish or, at worst, cautiously optimistic about the Japanese market. Many expect Japanese companies to continue their positive performance regardless of any economic fluctuations in 2005.

This may sound familiar, as many were also bullish about the Japanese market in early 2004. However, Japanese corporations are even more attractive now than they were then, says Scott McGlashan, manager of the JOHCM Japan fund. “This time last year, the market was overbought and was looking at a 10% correction. The situation has improved now; the dividend story looks more real,” he says.

Dumas agrees, saying: “Both stocks and bonds remain attractive. Japanese business is at last beginning to disgorge cash and real yields are good.”

Andrew Rose, head of Japanese equities at Schroders in Tokyo, argues that Japanese companies were attractive investments last year and will continue to be so in 2005. “In terms of the macroeconomy, things look somewhat better this year. In the corporate sector, we are seeing positive profits and valuations that were attractive a year ago and still are,” he says.

Thankfully, for many investors, the recession also proved to have little impact on the market, according to Anja Balfour, manager of the Framlington Japan fund: “When they revised the GDP figures, the markets had already discounted the change.” Rose adds that “this was a strange sort of recession, brought about because they had changed historic data. I don’t think the market was particularly concerned – in fact, it has gone up.”

Another reason for optimism in the Japanese equity market has been managers’ view that Japan’s economic fluctuations and the performance of its companies are increasingly diverging. Many companies are thriving in the less-than-ideal economic environment.

Individual companies and some sectors appear to have distanced themselves from the problems of the economy, largely because of ongoing improvements in the business culture. Daniel Lockyer, manager of the iimia Accelerated fund, says the index will not perform spectacularly this year, but individual funds and companies will surprise on the upside. “The recessionary environment actually helps us, as it means you can stockpick and find value, especially in the small-cap sector,” he says.

McGlashan adds that changes such as the level of the market and the correction of the three excesses (labour, debt and capacity) in corporate Japan have eased economic worries and restored profitability. “Some people have looked at the market and decided it doesn’t look positive. But the corporate sector is still robust and listed companies are still able to profit, given the macroeconomy. This wasn’t the case 10 years ago.”

In 1996 McGlashan, then manager of the Invesco Perpetual Japan fund, had been ready to tell investors to sell their investments in Japan because of the economy’s structural problems and limited growth potential. However, while problems such as public sector debt still exist, he says valuations have come down significantly from 60x earnings in 1996, to less than 20x at present.

Michael Lindsell, investment adviser to the Close Finsbury Japanese Equity fund, shares the same view. “Our strategy is not dependent on Japanese growth or growth in China; we are just looking at individual businesses within our portfolio,” he says.

It is no surprise that most managers are seeing Japanese corporations and the market in a positive light this year. Indeed, last week the Nikkei 225 reached its highest point since last April, at just over 11,966. This time last year the Nikkei was hovering around 11,500, even in the presence of more favourable economic data at the time.

Arguably, the main factor drawing investors to the Japanese market this year is the results of years of corporate restructuring and debt reduction. According to many managers, the probability that Japanese companies will offer higher dividend payouts is much more likely than in previous years.

Many Japanese companies have an excess of cash in their balance sheets, sometimes as much as 20% of a company’s market value, says Lockyer. “Everyone is wary of Japan because they don’t like the big well-known names. However, many companies have lots of cash in their balance sheets, which is being paid out in terms of yield or put into shares.” Lockyer adds that firms will probably use the cash this year to buy back shares, for special dividends or for dividend payouts, which will attract more investors. “The Japanese market offers opportunities to invest in fundamentally cheap companies with net cash and growing streams of net cashflow,” he says.

Investors also hope to benefit from the significant unwinding of cross-shareholdings among Japanese companies in recent years. In the decades following the second world war the economy was divided into several large corporate groups known as keiretsu. Each keiretsu would consist of several corporations linked to each other by cross-shareholdings and other business ties. For example, Sumitomo Bank would lend largely to other Sumitomo companies, and firms in the group would give preference to each other when doing business. It is hoped that the recent unravelling in such relationships should make Japan a more competitive environment.

The demise of the keiretsu has brought a shift in corporate priorities. “Corporations have now begun to unwind cross-shareholdings and have invested money back into their companies to make better use of capital,” says Lindsell.

The vast reduction in cross-shareholdings has also made access easier for foreign investors, and they have put a priority on dividend payouts. According to Hamish Dingwall, manager of the Baillie Gifford Japanese fund: “This long-term trend has had an interesting effect on corporate behaviour. Shareholders are now interested in getting a return. There wasn’t this pressure before, but it is a positive thing.” Iimia’s Lockyer adds: “The new shareholders are demanding an increase in value. Companies need to attract these new investors now that the cross-shareholdings are gone.”

Balfour says the Japanese economy now seems finally to be moving into the second stage of economic recovery. “Corporate successes are now flowing into people’s pockets. Consumption looks set to increase, while the savings rate has started to fall.”

Most fund managers who invest in Japan concede, however, that there are still several macroeconomic risk factors that could have an adverse effect on the market this year. How companies weather these elements of risk may show whether the market is truly as uncorrelated to economic fluctuations as many hope.

A significant slowdown in either the Chinese or American economy – two of the main drivers of Japanese growth in early 2004 – continues to concern managers. A drop in demand for exports from China is the main worry. Sharp growth in the China’s economy in recent years has fuelled a significant increase in Chinese imports from Japan. With GDP growth of 9% in 2004, according to the International Monetary Fund, China recently replaced America as Japan’s main trading partner, says the Japan Statistics Bureau. Some fear that a sharp slowdown or hard landing by the Chinese economy this year will curb exports, ultimately affecting Japanese companies.

JO Hambro’s McGlashan says that, even though Japan may not be growing, it is not suffering. However, he adds that it would suffer if there were a serious slowdown in the US or China.

Framlington’s Balfour adds that because there is still significant demand from China for basic materials from Japan, if China slows it will inevitably affect Japan.

Schroders’ Rose says that “a very sharp slowdown in exports would be negative for Japan. The country is not yet at the stage where it can grow without exports.”

However, Alex Lyle, head of managed funds at Threadneedle Investments, expects “strong growth in China this year, which will be an engine for growth in Japan”. Dingwall of Baillie Gifford adds: “China and the US have been a risk area for a couple of years. However, the US market is currently driving demand for automobiles, while China hasn’t really slowed. Demand is still pretty strong.”

Threadneedle recently increased its overweight position in Japan in its International fund and topped up its Japan equities weighting across all of its managed funds. “Japan is more attractive than America. The US will have slower earnings growth, while its valuations look expensive relative to Japan,” says Lyle.

However, Japanese corporations have not performed well enough to convince all managers of the merits of Japan in 2005. For John Richards, chief investment officer at SG Asset Management, the macroeconomic risks involved with investing in Japan were enough to warrant downgrading the sector to neutral in 2004. “There are lots of good companies in the country, but the big macro factors will be driving investment attitudes.” He adds that Japan has done well out of the China boom, but things aren’t getting any better. “Japan remains a scary prospect because of deflation, currency fluctuations and a decrease in consumption. “We are happy to be there, but there is really no reason for Japan to outperform.”

While economists share the concerns of fund managers over a hard landing in China, a continuing slowdown in private consumption is one of the main factors they fear will affect a structural recovery. Wages in Japan are still constrained, down 1% year-on-year, according to Dumas. He adds that this is extraordinary, given that Japan had a slight boom this time last year. “The chief hope for recovery must lie with wages and salaries,” he says.

The Council on Foreign Relations’ Lincoln says a longer-term dilemma for Japan is falling household income, driven by a fall in employment as well as sliding wages. “Why are consumers spending more if income is falling? People aren’t saving as much and how long it can continue is questionable.”

Morgan Stanley’s Sato adds that while demand for exports from China will probably slow down by next year, the healthy progress made by the corporate sector will eventually result in increased household income.

Opinions on what will happen to both the economy and the market over the course of the year remain mixed for now. However, many still feel that, as previous bouts of sporadic growth have shown, there are several potential scenarios that could play out this year.

Faith in companies on the rise
Many Japan and global fund managers are favouring Japan on a company-specific level rather than a market level. Those investing in the country are generally planning to invest in more stable, non-cyclical businesses that consistently deliver real returns.

A reduction in bad debt has meant financials are currently a favourite of many managers investing in Japan. Alex Lyle, head of managed funds at Threadneedle, favours financials as “we do see consumption picking up as well as an end to deflation. This will be beneficial to the banking sector.”

Hamish Dingwall’s Baillie Gifford Japanese fund has the largest percentage of its portfolio allocated to financials. UFJ Holdings, parent company of UFJ Bank, one of the largest in Japan, is currently the fund’s second-largest holding. Dingwall also favours consumer lenders to outperform this year.

For Scott McGlashan, manager of the JO Hambro Capital Management Japan fund, financials and property are favourites and will prosper together as “the bad debt problem of banks will improve further if property stabilises.” McGlashan says the Mizuho Financial group has performed particularly well this year as it has worked hard to reduce its legacy of bad debt.

Michael Lindsell, manager of the Close Finsbury Japanese Equity fund, has recently avoided banks in the traditional sense. He says “banks are not revealing the true size of their bad debts, historically and today”. Lindsell adds that banks have not historically been run with shareholders’ interests in mind. He has instead opted for a less traditional option in the financials sector, taking a strong position in Takefuji, a consumer finance company. The firm acts as a lender to Japanese consumers at relatively high interest rates.

Lindsell also sees software companies with repeatable business as favourable investment areas. Nintendo is his fund’s largest holding, as the company is operating with a 10.8% cashflow yield and has proven itself capable of winning repeatable business over the last 13 years. Canon is another favourite, with its printer division providing repeatable business through the sale of ink cartridges and paper. The company has strong cashflow, with nearly ¥1 trn (£5bn) on its balance sheet. Canon also increased its dividend payout by 30% last year.

For Lockyer of iimia, large Japanese multinationals may not be the best option in 2005 because of the economic uncertainties in America. “People don’t do the research with the Japanese market. They go straight for companies like Sony and Toyota, but these are global growth companies that are linked to the US. We like the domestic stories in Japan: entrepreneurial mid- and small-cap companies,” he says.