Is Japan the New Europe?

While Europe may not be tottering on the brink of financial disaster anymore, the long-term structural challenges facing the continent are numerous. Jittery investors responded to the unfolding crisis by dumping European stocks and beating down the euro to within a few inches of its life.

In the wake of Europe's struggles, many international investors are looking elsewhere around the globe for more attractive opportunities. Unsurprisingly, emerging markets have been one of the primary beneficiaries of that diverted attention, but there's another more surprising area of the globe that has suddenly piqued investors' interest.

Awaken the sleeping giant
Japan certainly doesn't conjure up images of a racy, red-hot country on a growth spurt, but this Pacific nation has been quietly gaining in the global asset race. In the first half of the year, Japan-focused mutual funds put up some of the best performance among all foreign categories. According to Morningstar data, while Europe-centered funds are down 13.3% year-to-date and the average world stock fund has lost 8.3%, Japan funds have only given up 5.9%.

Six months of outperformance does not a long-term trend make. But many global fund managers are now turning to Japanese stocks that look relatively more attractive, relative to European names. They are snapping up well-run multinational companies with minimal debt structures, in the belief that these names will outperformed in a sluggish recovery period.

There's also hope that Japan's new prime minister will take action to cut the nation's heavy debt load, including cutting taxes to spur growth. And while Japan's stock market has been nothing short of a disappointment over the past decade or two, hope is swelling that that trend will reverse in the immediate future.

Not out of the woods yet
So is Japan gearing up to be the next Europe, taking the lead among developed nations around the globe? Well, let's not get ahead of ourselves just yet. I find it rather ironic that it takes a massive financial crisis in Europe for Japanese stocks to suddenly start looking attractive again. Let's be clear: Japan stock funds have been a bit of a black hole in recent history. Even Matthews Japan (MJFOX), a very well-run fund, has lost an annualized 4.8% over the past decade, and that fund ranks in the top third of its category over that time!

Japan faces numerous structural challenges that will weigh on growth in the coming years. A crushing debt-to-GDP ratio that is nearing 200% isn't exactly a recipe for robust recovery. By way of comparison, recently troubled Greece's debt-to-GDP ratio was only 115%. Add in to that mix a growing elderly population and falling birth rate, Japan's heavy reliance on exports, and bogged down government reform, and there are plenty of strikes against Japan staging a roaring, or even marginal, comeback.

I think many investors will ignore these danger signs and that we'll begin to see money flowing into Japanese stocks and funds in the near future. There's a good chance that this will result in at least a mini run-up for the Japanese market. But investors should be cautious about jumping on this train.

Good in small doses
That said however, I don't think investors should ignore Japan, either. Japan is still the world's second-largest economy (although China is breathing right down its neck), and I wouldn't advise shunning such a global superpower. I don't think investors need dedicated exposure via a Japan-focused fund, but if you decide to go ahead and buy such a fund anyways, stick to low-cost exchange-traded funds like iShares MSCI Japan Index (NYSE: EWJ  ) or the SPDR/Russell Nomura PRIME Japan ETF (NYSE: JPP  ) and keep them to a very small portion of your total international allocation. Meanwhile, most folks should get an adequate dose of Japan-style exposure from their broader-market foreign ETFs and actively managed foreign mutual funds.

And even if Japan as a whole isn't slated for wild economic growth, there are still individual stocks that could boost your portfolio. Multinationals Honda (NYSE: HMC  ) and Canon (NYSE: CAJ  ) both boast sales growth rates far in excess of their respective industry averages and have earned a 5-star rating from our CAPS community.

Likewise, manager James Moffett of the highly rated Scout International Fund (UMBWX) sees long-term opportunities in several Japanese companies, including top 10 holding Nidec (NYSE: NJ  ) , a manufacturer of precision motors for various tech devices. The stock has recovered from a painful loss at the end of 2008 and has seen shares rise almost 40% in that time. Moffett's portfolio also includes semiconductor manufacturer Kyocera (NYSE: KYO  ) , another five-star CAPS-rated stock with a healthy balance sheet and strong financial positioning in its industry.

While we're likely to hear a lot more about potential growth opportunities in Japan in the coming months, be sure to take these admonitions in stride. Japan may not trail the world in economic growth as it has the past two decades, but neither is it likely to top the charts for any extended period of time.