Made in Japan
Tokyo’s stock market got its correction -- by accident. Now the bull run can resume, driven by domestic demand, not exports.
To the staid club that is corporate Japan, Takafumi Horie, former president of Internet portal company Livedoor Co., was a troublesome upstart. To others, he was an antiestablishment hero. The 33-year-old University of Tokyo dropout with the spiky hair and the tart tongue built a business empire worth $8 billion at one point, and some even credit him with having saved Japanese baseball during a financial crisis. But he also introduced the hostile takeover in Japan with his brash, though unsuccessful, indirect bid for Fuji Television Network, the country’s largest commercial TV station.
Horie, who liked fast company and fast cars -- he owned a turquoise Ferrari -- relished tweaking the old guard, and he even ran for office against a ruling-party stalwart, with Prime Minister Junichiro Koizumi’s backing.
But on January 16, government investigators raided Livedoor’s Roppongi Hills offices looking for evidence of securities law violations. A week later Horie was arrested. The inquiry centers on alleged stock market manipulation and accounting irregularities.
News of the still-ongoing investigation sent Livedoor’s stock plunging. More alarmingly, it sparked a major sell-off in Japanese stocks, especially technology and Internet companies. In two days the Nikkei 225 index lost nearly 5.7 percent, falling to 15,341. The Tokyo Stock Exchange Mothers index, which tracks growth stocks, plunged 22.4 percent in that same period.
Yet eight days later the Nikkei had more than recovered its losses. On January 27 the index closed at 16,460.68, its highest level in 5 years. The Mothers index, however, remains off by 23.2 percent.
After three years of gains -- the Nikkei rose 25.8 percent in yen terms in 2003, 8.0 percent in 2004 and 41.5 percent in 2005 -- investors wondered if the scandal-related sell-off signaled a fundamental shift or a fleeting change in investor sentiment. The conclusion of most stock pickers: The correction was a healthy one that probably poses no serious threat to Japan’s bull market. Perversely, Horie’s arrest may have been just what the market needed.
“The Japanese stock market -- and especially the more speculative, high-priced stocks listed on the Mothers exchange -- had become very overbought,” says M. Campbell Gunn, manager of the $484 million-in-assets T. Rowe Price Japan fund. “A correction was both overdue and welcome.”
But what is fundamentally different about this latest installment of the long bull run, portfolio managers say, is that more than ever the Japanese economy, and therefore the stock market, is being driven not by exports but by reviving domestic demand. Thus managers are overweighting industry sectors that stand to benefit from that resurgent appetite -- in particular, banking, real estate and consumer goods.
“This is the first Japanese economic recovery driven by domestic demand,” asserts Sherene Ban, a product specialist for the J.P. Morgan Japan Fund, which has $199 million in assets.
After so many false dawns, the Land of the Rising Sun is at last recovering. Following 15 years of crippling deflation, the Japanese economy is seeing welcome flickers of inflation. The country’s inflation rate, negative since 1998, is currently zero. GDP expanded an estimated 2.6 percent in 2005, after a 2.3 percent gain in 2004. Consumers are shopping again: Japan’s retail sales have shown positive year-over-year growth for the past two months. The country’s long-troubled banking system is benefiting from years of restructuring. Even real estate prices are beginning to inch upward.
“The Japanese economic expansion has proven to be extremely durable and not wholly dependent on external demand,” says Kathy Matsui, chief Japan equity strategist for Goldman Sachs. She notes that the average return on equity for the companies in the Topix index has increased from 0 percent in 2003 to nearly 11 percent today. Matsui thinks it could more than double over the next five years.
To be sure, investors have cause for concern. The yen is rising, and the spike in oil prices is proving devastating for Japan, which imports almost all of its energy. Economic growth is slowing in the U.S. And, some skeptics say, Horie’s arrest suggests that Japan may be less transparent and less shareholder-friendly than bullish investors had hoped.
“We look at these violent market events as opportunities to accumulate target positions that have become cheaper, but for no fundamental reasons,” says Mark Headley, manager of the $368 million-in-assets Matthews Japan Fund, which follows a growth-at-a-reasonable-price, or GARP, value discipline. In the week following the Nikkei dive, Headley added to the fund’s holdings in property, retail and consumer stocks.
He began betting on Japan’s economic recovery in early 2003. “We felt that everything that could go wrong in Japan was already priced into the market,” he says. The combination of banking and tech stocks propelled Headley’s fund to a 59 percent gain in 2003.
Today he is bullish on the financial sector. “We think Japanese banks still have further to go,” he says. “They continue to benefit from the restructuring of the past few years and an upturn in the domestic economy.”
Headley is also overweighting retail stocks. Stocks of many domestically oriented companies, however, sell at 30 to 150 times earnings, multiples that he considers unrealistic. “Investors are pricing in a rip-roaring recovery,” he says.
Goldman Sachs’ Matsui points out, however, that Japan’s high multiples should be viewed in light of the country’s zero rate of inflation.
Headley has been buying exporters like Canon and Sharp Corp., which have been trading at relatively reasonable multiples. “This was a defensive move, and so far it has backfired,” he admits. Exporter stocks underperformed the market in 2005. “When you factor in the currency weakness, it’s been particularly painful,” Headley grants. The yen declined 15 percent against the dollar last year.
Still, Headley has no plans to sell the export-stock holdings. “We consider top-down factors, but we are essentially bottom-up investors,” he says. And most of the stocks that score highly on the fund’s GARP model are exporters that have yet to participate in the rally. “These stocks are depressed because of concerns about a drop in U.S. consumer demand,” Headley says. “But companies like Sharp and Canon also have a lot of exposure to the Japanese domestic economy, which is picking up.”
Gunn, who runs T. Rowe’s Japan fund from Tokyo, is less enthusiastic about the country’s export-driven industries. He sees them getting squeezed by lower-priced global competitors (read China, South Korea and Taiwan). Thus he is underweighting autos, machinery and electronic components. One notable exception: Nidec Corp., a manufacturer of disc-drive components that Gunn believes has a competitive edge over lower-cost rivals. He bought Nidec three years ago when it was trading at $31.20; in late January the stock was trading at $88.49. Gunn thinks it could hit $100 in two years.
In general, he looks for companies with prospective earnings and cash flow growth of at least 15 percent a year over the next three years and with above-average return-on-equity and cash-flow-return-on-investment ratios. “Companies that are above average on both of these measures usually have a superior product, excellent management or both,” he says. “Or they are benefiting from favorable industry trends.”
Banks comprise Gunn’s largest industry concentration, accounting for 15 percent of the Japan fund’s assets (compared with 12 percent of the MSCI Japan index). “Higher interest rates, lower credit costs and increasing fee income will allow the country’s banks to show profitability increases for at least the next three years,” Gunn says. He especially likes regional banks, like Bank of Yokohama. “They are benefiting from the pickup in the local economy and experiencing strong demand, particularly for mortgage loans.”
One of the few exporters in the J.P. Morgan portfolio is Toyota Motor Corp. The fund bought the automaker’s stock in February 2005 at ¥4,175 ($39), attracted by its strong profits -- a 13.6 percent ROE -- healthy free cash flow and dividend yield.
Even as the Big Three U.S. automakers have slashed jobs, Toyota has been honing its popular product line and efficient manufacturing systems. It has been gaining market share in both the U.S. and Europe, and J.P. Morgan’s Ban believes that the trend will continue.
The shares, which represented 5 percent of her fund’s assets at the end of December, traded at ¥6,080 in late January. Ban foresees Toyota’s dividend rising from 1.23 percent to 2 percent over the next year, which would make it half a percentage point higher than the yield on Japanese government bonds.
“We think this will prompt pension funds to begin snapping up these shares sometime soon,” says Ban. She may be right.