After the Nikkei reached a six-year high last week, many investors are wondering whether they should start a position in Japanese assets. Japan's massive monetary easing, fiscal stimulus, and structural reform have helped Japanese stocks grow about 50% this year, doubling the S&P 500's year-to-date gain. Simultaneously, the Japanese yen weakened 18% this year. Japan's central-bank stimulus package is the main driver of both the yen's weakness and the stock market rally, but this stimulus effect is wearing off given that inflation is picking up, and that stocks are reaching historical maximums. How will Japanese stocks perform going forward?
Let's take a look at three Japanese ADRs and how well they could withstand a correction in the Japanese markets.
North America counts
First, we have well-known automobile maker Honda Motor (NYSE: HMC ) .
The company reported a strong second quarter, with earnings per share growing 43.4% and consolidated net sales growing 27.3% compared to the prior-year quarter. Operating profit surged 70% as well, although this was driven by currency translations.
In May, Honda announced plans to invest $70 million for building a new plant in Ohio to manufacture its new Acura NSX. It then announced in August that it will invest an extra $250 million to expand its engine plant and build two training centers in the same state. The company is increasing its exposure to America, where it's working on infrastructural developments. Along with General Motors, Honda aims to develop next-generation fuel cell vehicles, which should bring in good profits if Honda becomes a market leader. North America is the automaker's biggest market, with 447,000 units sold there during the recent quarter versus 180,000 in Japan. Its exposure to a downturn of the Japanese economy is reduced as a result, and Honda will actually benefit if the yen continues its downward trend.
Still pretty exposed
Second, we have a major investment bank, Mitsubishi UFJ Financial Group (NYSE: MTU ) .
The company reported a 45% year-over-year rise in net income, which reached about $5.16 billion this second quarter. Fee revenues grew as well, on top of 3.3% sequential growth in deposits. Both of these are good signs for a financial institution.
Mitsubishi UFJ has a strong new business model with a diversified product mix. The company is looking at enhancing its broad financial-service capabilities on a global basis and regenerating the Japanese market. Moreover, its strategic alliance with Morgan Stanley will expand its scope into new geographies and businesses. This is a smart initiative, as Mitsubishi UFJ has been trying to offset the persistently weak loan demand in Japan.
By pursuing global growth opportunities, the bank is lowering its exposure to the Japanese economy. However, in fiscal 2013, international business represented about 33% of the company's revenue, so local exposure is still significant.
Finally, we have the well-known Japanese company Canon (NYSE: CAJ ) .
The situation with Canon goes beyond the dynamics of the Japanese economy, as the company managed to remain a leading global supplier of photographic equipment, copiers, printers, and lithography equipment. This is especially true in regard to its core office and consumer segments.
Half of Canon's total sales and operating profits come from its office segment, which sells multifunctional devices, copiers, and laser printers. Despite the fact that this business model generates attractive returns today, businesses are reducing the use of printers in favor of digital mediums (such as tablets and smartphones) and managed printing services.
So what about the company's exposure to Japan? Well, 28 of its 45 plants are located in the country, though 80% of sales comes from overseas. This generates mismatches between costs and revenue, and in the end a weakening of the yen increases its competitiveness. More importantly, though, the company will need to adapt to the changing business of tomorrow. One way of doing this would be to build out its own managed printing services and invest in continuously upgrading its leading lineup of printers.
Since inflation has started to go up and the yen has weakened quite enough already, it is unlikely that the Bank of Japan will increase its monetary easing. Given these circumstances, it is hard to foresee another catalyst for Japanese stocks to continue rallying as they did throughout this year. A short-term correction could affect these companies' stock prices as well.
Honda is performing well, and its exposure is higher in North America and Asia. Sales in these two markets will definitely drive the company's stock price in the medium term.
Considering that more than 66% of Mitsubishi UFJ's revenue comes from Japan, it would be wise to keep an eye on Japanese economic forecasts. The company could take a hit in the event of a slowdown.
Regarding Canon, the company will remain solid in the short term and even medium term. However, it will be important to monitor the evolution of its office segment sales, which represent half of what the company makes.
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