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SPECIAL
Saturday, Feb. 4, 2006


REPORT ON JAPAN

The 6.8-billion-yen question

Stocks are cheap, corporate profits are booming, yet the Japanese still keep more than half their savings in cash. Are opportunities ripe for foreign investors? ANGELA BARNES takes a look

Japan's benchmark Nikkei 225-stock average has been creeping higher the past several months, sparking renewed hope that the long-suffering Japanese stock market may finally be on the road to recovery.

But even at 11,966.69 (the 11-month high set in early March), the Nikkei remains far below the 38,916 peak established on Dec. 29, 1989.

It looks considerably healthier than the low of 7,608 set in April, 2003. It rallied off that low through to April, 2004, and then backed off a little as the Japanese economy went through a soft patch. The benchmark index resumed its advance toward the end of last year.

But will the market, which has seen strong volumes lately, continue to climb? That is the 6.8-billion-yen question.

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Cynics will undoubtedly point to previous rallies that petered out and to the fact that the gains in the market are being fuelled by foreign investors. Corporate Japan and, more particularly, Japanese banks are by and large still busy selling, albeit at a reduced pace. But believers -- and there are many of them -- point to improvements in the Japanese economy and in corporate balance sheets and profits.

Any attempt to assess the prospects for the Japanese market naturally starts with the Japanese economy. Japan experienced a huge real estate and stock market bubble in the late 1980s. When it burst, it plunged the economy into a major and prolonged slump and forced a major reworking of the economy and the corporate sector.

There are signs that the economy may finally be on the right track, although not yet firing on all cylinders. That's good news for the Japanese stock market, as it is highly sensitive to the momentum in the economy.

William Garnett, director of Japanese equities at Henderson Global Investors in London and a co-manager of the Mackenzie Select Managers Japan Capital Class Fund, describes the Japanese economy as "moving from a dysfunctional position to a functioning one" -- a transition that has taken "rather too long" to materialize. Even the labour market appears to be improving, with some companies reportedly questioning whether they cut too deeply when they pruned their employment rolls.

The Japanese consumer, who accounts for over 60 per cent of gross domestic product, is still largely missing in action, although there is reason for optimism: Tighter labour markets mean more bargaining power for employees.

Credit for the improvement seen so far is generally given mostly to the corporate sector. Corporations have cut costs, paid down debt, rationalized their operations, sold off unprofitable divisions, cleaned up their balance sheets and bolstered profits as well as their returns on capital. And business spending seems to be picking up.

Operating profits are estimated to have risen 12 per cent in the fiscal year that ends on March 31 and that will take them to the third consecutive record high. In other words, corporate profits are better today then they were in 1989 even though the Nikkei is a shadow of its former self. Profits are expected to rise still further next year if the economy improves as expected.

Better profits means more free cash flow, some of which has begun to find its way to shareholders. Many Japanese companies "are becoming much more shareholder friendly; we are starting to see much more share buybacks; we are starting to see companies increasing dividends; we are starting to see companies actually talking about improving to the return to shareholders," said Mark Grammer, lead manager on the Mackenzie Universal Global Future Fund in Toronto.

However, the changed attitude likely stems more from a sense of self-preservation than from altruism. "For the first time ever, companies are vulnerable to a hostile takeover; so almost whether they like it or not, they find themselves obliged or compelled to do more for shareholders," said John Millar, director of Edinburgh based Martin Currie Investments Inc. He manages the BMO Japanese Fund.

The hostile bid by Internet services provider Livedoor Co. Ltd. for Nippon Broadcasting System Inc., which if successful would give Livedoor control over Fuji Television Network, underscores the new reality. The bid, which has so captivated corporate Japan, also serves as a reminder that many Japanese companies are quite cheap. Mr. Garnett suggested that about 30 per cent of Japanese stocks are trading below book value.

The Japanese market as a whole is also cheap, both historically and in comparison with other markets around the globe -- a fact not lost on foreign investors. But domestic Japanese institutions have been big sellers of the market over the past 10 years as they unwind cross-ownerships. For their part, individual Japanese investors have steered clear of the market. "Fifty-five per cent of personal financial assets are just in cash," even though the yield on cash is zero, Mr. Garnett noted.

Over the next quarter, 10-trillion yen worth of 10-year deposits individuals have placed with the Japanese postal system mature. With corporations more shareholder friendly and with deflation seemingly receding, "you have got to think there is a chance that some of these funds will make their way into the market," he added.

If even a small portion of the domestic assets not at present held in stocks "came into the equity market, you would have a very positive impact," Mr. Millar said.

He has over weighted the machinery issues and other stocks that stand to benefit from renewed capital spending in the BMO Japanese Fund. The fund also have a heavier than market weighting in the financial services sector, including credit card issuers. "Credit card penetration is very much lower in Japan than it is in North America or Europe," he said.

And he continues to like the Japanese auto makers, such as Honda and Nissan, "because they continue to gain market share in North America without having to pay aggressive incentives and because they have a very good growth story on their doorstep."

But he is leery of some so-called defensive sectors, such as food and utilities, in part because they are still at the cutting edge of deflation. Furthermore, he notes the Japanese population is forecast to peak next year and then start to shrink.

Among the individual stocks he singles out for mention is Canon Inc. It's a global leader with a very strong position in photocopiers and printers. Furthermore, Canon is still making a very good margin on its digital camera business, Mr. Millar added.

Mr. Grammer has over weighted the Japanese banks. The Mackenzie Universal Global Future Fund also holds a stake in Ichiyoshi Securities Co., which caters to the middle income and higher income individuals. The fund also has an over weighting in capital investment companies. A holding in that sector is Keyence Corp., which makes products such as fibre-optic sensors for industry.

Among the stocks that Mr. Garnett finds attractive are Nippon System Development Co. Ltd., a software firm that stands to benefit from increased spending on information technology, and Nippon Telegraph & Telephone Corp., Japan's leading telecommunications company. Shares of NTT, which owns NTT DoCoMo Inc., Japan's largest cellular phone operator, have a free cash flow yield of around 10 per cent, he noted. "It is unusual to get such a high free cash flow yield when the long bond yield is 1.5 per cent."



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