Investors betting on a recovery in Japanese stocks are not easily discouraged. After three short-lived rallies in the 1990s, they are again hoping that the market will finally pull itself out of its decade-long funk.
Fund managers with a mandate to invest here have some reason for quiet optimism for the new year. Many big names, like Nippon Steel and the Pioneer Corp, are trading near 10-year lows, making Japan one of the cheapest industrialized markets. Bargain-basement prices are leading to mergers and takeovers that were previously unimaginable, as evidenced by a deal that would give Roche of Switzerland a majority stake in Chugai Pharmaceutical. Waves of companies are announcing revampings, encouraging investors.
As the year turns, though, the pessimists have the upper hand. Investors, encouraged by the election of a tough-talking prime minister, Junichiro Koizumi, bid up stocks in April and May. When his reform bandwagon stalled, stocks resumed their decline, propelled by mounting banking problems, falling semiconductor prices and the events of Sept. 11. The Topix -- an index of all top-ranked companies on the Tokyo Stock Exchange -- fell 19.6 percent this year, its eighth one-year decline since 1990.
Mutual funds that invest dollars in Japan fared even worse because of the yen's 16 percent slide against the dollar. Through mid-December, these equity funds were down more than 30 percent, the largest decline of any international category, according to Morningstar, a magazine that covers the mutual fund industry.
Another bad year
As Koji Nishigaki, president of NEC, the electronics giant, said recently, "I want to forget this year as soon as possible." Unfortunately for Nishigaki, whose US$44 billion company delayed listing on the New York Stock Exchange this year, next year does not look much better.
The economy has fallen into its fourth, and perhaps deepest, recession since 1992, pushing the unemployment rate to a high and sapping consumer spending. Exports and government spending are sputtering as the US economy falters and as Koizumi tries to rein in debt. The Bank of Japan expects the economy to shrink about 1 percent both this year and next.
In recessions past, Japan ramped up exports, pumped taxpayer money into the economy and cut interest rates. With those options mostly exhausted and the banking system in shambles, investors hope that Koizumi, who wants to overhaul the tax code, deregulate crucial industries and force banks to write off bad loans, can overcome the forces allied against him.
But the prime minister will probably disappoint investors, whether he succeeds or fails. If he has his way, Japan will fall deeper into recession as deregulation and loan write-offs drive up bankruptcies. If conservatives kill Koizumi's program, investors are expected to sell stocks in the belief that lawmakers are not serious about fixing structural problems. Judging by the pace of reform in past administrations and the string of defeats that Koizumi has already suffered, the Japan bears have history on their side.
"Don't hold your breath for quick reform in Japan -- particularly of bank bad debts -- or you will both underperform and die before it," David Roche of Independent Strategy, an investment firm based in London, said in a recent report.
But there is a silver lining: Because of their woes, banks, contractors and real estate companies make up only 11 percent of the Topix, about half of their weighting in 1998. So even if the government mismanages the bank cleanup, the effect on the broader market is more limited than it was during the previous recession.
More important, plenty of big Japanese companies are still partly insulated from the domestic economy, and many of their stocks are more affordable than at any time in the last 15 years. Matsushita Electric Industrial, Toshiba and Fujitsu are trading at well below their peaks, yet have little debt, strong brands and well-trained work forces. All of them have announced job cuts, factory closures, and plans to spin off or trim unprofitable divisions. Nishigaki at NEC, for instance, announced plans to eliminate more than 10,000 jobs, close overseas factories, and emphasize software and services over memory chips. Toshiba is also promoting high-margin networking and wireless products and moving low-end refrigerator and air-conditioner lines to China.
Toshiba turnaround
"Toshiba reminds me of General Electric 20 years ago," said Robert Sasaki, managing director at Bear, Stearns in Tokyo. "I don't know if they have the will to do what `Neutron Jack' did," he said of John F. Welch Jr., GE's former chief executive, who scrapped unprofitable businesses and kept the winners. "But they definitely have the opportunity."
The cost-cutting is expected to nearly double Japanese companies' return on equity, to 2.8 percent next year. While that is just one-eighth of what American companies earn, estimates by Goldman, Sachs show that the change would be enough to lift the Topix above 1,200, about 20 percent.
Despite Japan's troubles, its consumers are still the world's second wealthiest, behind those in Luxembourg, on a per capita basis. Companies that can tap into these deep pockets have a good shot at weathering the downturn.
"Consumers have the spending power -- it's purely a matter of catching their fancy," said Mark W. Headley, portfolio manager of the US$330 million Matthews Japan fund, based in San Francisco. Among his top 10 holdings are Monex Securities, a Japanese online broker; Belluna, a mail-order clothing company; and USS, which manages used-car auctions. The fund has lost more than 40 percent this year.
There is even promise in slow movers like Nippon Telegraph & Telephone, which has lost more than half its market capitalization in 18 months. NTT, the former state-run monopoly, controls 88 percent of the local fixed-line market and dominates broadband, data and software services. The government's plan to sell off more of its 41 percent stake in 2002, some analysts reason, will force the company to make deep cuts to please shareholders.
And then there are perennial winners like Toyota Motor, Honda Motor, Nintendo, Canon and other exporters that make the bulk of their profits overseas. Through the 1990s, these companies geared their operations to turn a profit even when the yen strengthened. The dollar's recent break through ?130 means exporters will earn even more when they repatriate profits. Toyota and Honda make an estimated ?10 billion (US$77 million) for each one-yen increment above their break-even point of 110 to the dollar. These automakers have a huge impact on parts suppliers, materials makers and advertisers, so their success can cause broader rallies.
Consumers must buy
"Even though exports are a small part of the economy overall, the market needs something to turn it around," said David Semaya, president of Merrill Lynch Investment Managers in Tokyo, which handles US$10 billion of US money in Japan.
The first half of 2002 will likely be rough. Analysts expect profits to plunge more than 30 percent in the October-to-March period, about twice as much as in the previous six months. Once those declines are out of the way, stalwart investors can again focus on the companies that can make their way out of Japan's economic wilderness.
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