The Tokyo stock market peaked January 1990 at a level of 39,000 on the Nikkei 225 Stock Index. It then began a long, jagged decline before reaching its nadir at around 7,600 in April 2003. From there, it rose fairly steadily to more than 12,000 before sliding back to more than 11,000, with the general weakness in world markets, just about 50% higher than its low.
With Japan's stock market still some 70% off its peak, it looks like a strong buy for value investors. But before we get to some specific Japanese investments, let's look at the currency issues and macroeconomic factors that have had an impact on Japanese markets.
The currency factor
In international investing, as well as the stock market itself, you have to look at currency. The Japanese yen, which was valued at 160 yen to the U.S. dollar at the Japanese stock market's zenith in 1990, appreciated steadily against the U.S. dollar until 1995, when it peaked at 80 yen to the U.S. dollar. (It sounds confusing, but lower numbers mean a more valuable yen). With the dollar's strength in the late '90s, the yen then dropped, bottoming out at around 133 yen to the U.S. dollar in early 2002. Now it has risen to 110 yen to the U.S. dollar, an increase of about 20% over two years, which can be added to Japanese stock returns if you're a dollar-based investor.
Japan's great strength is its export sector. The country runs a large balance of payments surplus, and in light of the U.S. deficit, the yen should be generally strong against the dollar. Still, investors should be aware that the Bank of Japan fights any sharp rise in the yen by buying U.S. Treasuries.
The economy
Unlike the U.S., Japan has suffered more than a decade of asset price deflation -- in stocks and real estate -- despite an easy-money policy that has lasted since the mid-1990s. All traces of overvaluation and an economic bubble have been washed out of the system. Of course, commentators warn continually of the possibility of deflation and of the debt overhang in the Japanese banking system, but just as at the top of a bubble all risks are ignored, so too near the trough of a downturn do all risks seem insuperable.
At this stage, the overhang of bad debts in the Japanese banking system is easily manageable. The bubble real estate loans of the late 1980s are now at least 14 years sour and, for the most part, have been written off long ago. Three of the top four banks reported profits in the year to March 2004. Today's bad debts relate to industrial and service-sector companies, such as the supermarket chain Daiei, that have run into difficulty because of overexpansion in the 1980s and a decade of stagnation thereafter. In such extreme circumstances, even sound companies will get into difficulty.
In the next five years, Japan will face the economics of an aging population -- the same problem the West expects to confront in the mid-2010s. By 2005, one-fifth of Japan's population will be 65 or older. Meanwhile, fertility has dropped to 1.3 children per woman, well below replacement level. Like most advanced societies, Japan has an actuarial problem in its social security system, with the labor force slipping by 0.7% per annum between now and 2025. However, Japan's problem is occurring a decade ahead of everybody else's schedule.
Fiscal deficit plagues the Japanese economy and is largely due to infrastructure spending schemes to prop up the ailing construction industry, attempts to lift Japan out of recession, and a prolonged economic downturn that has reduced revenues. At its peak in 2002, the Japanese fiscal deficit was 10% of gross domestic product (GDP); the country's public debt is now 140% of GDP.
However, in late March, Moody's raised Japan's debt rating to AA+ -- only one notch below the AAA maximum. The Japanese budget for 2004 increased public spending by only 0.4% in nominal terms, far below the 3% to 4% likely increase in GDP for the year. Since the country's tax system has "bracket creep," which increases tax yields more than proportionately as incomes increase, the budget deficit will likely decline sharply and continue falling as long as the economic expansion persists.
The future looks bright
The long-term future for Japan is beginning to emerge, and it is largely attractive:
- The economy will continue to expand at a moderate rate, and the stock market will continue to outperform the U.S. and most European markets, though it could decline if the U.S. market takes a sharp drop.
- The banking sector will continue to deal with its problems, helped by an increasingly solid capital base and the return of many of its marginal borrowers to soundness.
- The yen will tend to rise as the Bank of Japan slows its frantic purchases of U.S. Treasuries.
- Japan will manage its expanding aging population fairly easily as its society adjusts to seniors working later in life and younger people paying higher Social Security contributions.
- The extraordinary strength of the Japanese export sector will diminish, but the domestic economy, no longer handicapped by an appallingly expensive distribution system, will enjoy a sustained and well-earned boom, fueled by imports that become ever-cheaper in yen, yielding attractive returns to investors in domestic service industries.
How to invest
Individuals can invest in Japan by purchasing the American Depositary Receipts (ADRs) of major Japanese companies listed on the New York Stock Exchange or Nasdaq and by investing in open-end mutual funds.
An alternative to the open-end mutual fund is the exchange-traded fund (ETF), representing the Morgan Stanley Capital International Japan (AMEX:EWJ) stock index and traded on the American Stock Exchange. What's the advantage of an ETF? Arbitrageurs tend to keep the ETF price closely in line with the value of the underlying shares, which, in this case, represent a broad-based index of Japanese shares, so there is no significant premium or discount risk as you would have with a closed-end mutual fund. Morgan Stanley Capital International Japan was recently trading at $9.67, with an expense ratio of 0.84%, relatively low for an international-pooled investment.
There are three substantial broad-based, no-load mutual funds specializing primarily in Japan that carry an expense ratio of less than 1.5% and are available to retail investors. The Vanguard Pacific Index Fund (FUND:VPACX), established in 1990, with an expense ratio of 0.3%, seeks to match the MSCI Pacific Free Index, of which more than 80% represents Japan. It is down just less than 1% per annum over the five years to April 30, but has seen a healthy return of 53% over the last year.
Next, the Fidelity Japan Fund (FUND:FJPNX), with an expense ratio of 1.03%, invests at least 80% of its assets in Japanese debt or equity securities. That fund has a return of 3% per annum over the last five years and 56% over the last year. The T. Rowe Price Japan Fund (FUND:PRJPX), with an expense ratio of 1.38%, invests at least 80% of assets in a wide range of Japanese industries and companies. This fund also has been flat over the last five years, but its focus on growth seems to be paying off. It's up 73% over the year to April 30. All three funds have redemption fees to deter short-term trading, which is a particular problem with Asian funds whose markets are open in the U.S. during the night.
It is also worth looking at one of the very few mutual funds concentrating on smaller Japanese companies that cater primarily to the domestic Japanese market. The service and consumer sectors in Japan are notoriously weak and will benefit from restructuring and development, thus providing considerable upside potential compared with the already efficient exporting sectors, which may also be affected by a strong yen. The Fidelity Japan Smaller Companies Fund (FUND:FJSCX) has no load and a relatively low expense ratio of 1.12%, given its investment portfolio. It has also well outperformed the Japanese market over the last five years, rising 11% per annum, with a stellar rise of 90% over the year to April 30. (Remember, just a year ago, the Tokyo market was just beginning to recover from a 20-year low.)
Companies to watch
Turning now to individual companies, there are 155 Japanese companies with ADRs listed in the U.S., according to Morgan Guaranty, the leading ADR agent. This list includes virtually all of the well-known names in international business. Companies like Toyota (NYSE:TM), Hitachi (NYSE:HIT), Bridgestone (OTC BB: BRDCY), and Canon (NYSE:CAJ) compete with great success against U.S. competitors General Motors (NYSE:GM), General Electric (NYSE:GE), Goodyear (NYSE:GT), and Eastman Kodak (NYSE:EK). Unlike smaller markets, such as India, generally there are not significant premiums for the ADRs over the domestic price of the underlying shares.
Although Japan's population is aging, the country's export markets include countries such as India and China, which are having healthy economic and demographic expansion. Furthermore, just as Hollywood has established dominance in the movie business, Japanese companies also have established supremacy in the market for video games, a business that continues to increase its hold over the leisure time of young male consumers.
While the rising yen may threaten Japanese export margins, the economics of the video game industry, in which variable costs per game are low, suggest that increasing volumes can easily offset this. Hence, an investment in the video game industry, if carried out at a reasonable price, is likely to prove attractive in the long term. David Gardner has picked Electronic Arts (NASDAQ:ERTS) and Activision (NASDAQ:ATVI) repeatedly for Motley Fool Stock Advisor. Electronic Arts has returned 77% since May 2002; Activision is up 162% since March 2003. Other players include Take-Two Interactive (NASDAQ:TTWO) and THQ (NASDAQ:THQI).
Nintendo: the pure play
However, the largest pure play in the video games industry is unquestionably Nintendo (OTC BB: NTDOY). Although Sony (NYSE:SNE) PlayStation 2 and Microsoft (NASDAQ:MSFT) Xbox have been remarkably successful with consumers, video games are only a modest part of its business. Nintendo, on the other hand, maker of the GameCube console and GameBoy handheld game system, is a video game pure play, with sales in the 12 months to March 31, 2004, of 510 billion yen ($4.8 billion) of which half are from the U.S. Approximately 58% of Nintendo's sales were hardware, mostly hand-held, and 42% were software, of which about two-thirds was for hand-held systems.
Nintendo's dominance in the hand-held systems area is particularly interesting since the same technological developments that will allow 1 gigabyte of memory to be on a cell phone by 2006 also promise substantial further enhancements in this segment.
Each ADR of Nintendo represents one-eighth of a common share, so its recent ADR price of $11.60 (down from $30 when ADRs were created in 1991, despite Nintendo's steady growth since then) represented less than a 1% premium over the Tokyo closing share price of 10,420 yen.
At first sight, Nintendo nevertheless looks rather expensive. Consolidated net income in the 12 months to March 31, 2004, was 33 billion yen ($292 million), or $0.26 per ADR, putting the company on a price-to-earnings ratio of 45.
However, Nintendo suffered greatly in earning terms from the strength of the yen against the U.S. dollar over the year. According to internationally accepted accounting principles, Nintendo's dollar-denominated assets, totaling $5.4 billion, were revalued into yen at the new exchange rate, producing a net foreign exchange loss of 68 billion yen, or $610 million.
However, this isn't real money. First, it doesn't represent cash. Second, if Nintendo had been a U.S.-based company with exactly the same mix of assets and operations, its yen assets would have been revalued into dollars at the end of the year, producing a foreign exchange gain instead of a loss.
If we add back the foreign exchange loss, net of the effective Japanese corporate tax rate of about 40%, we get revised net income of approximately 74 billion yen ($0.58 per ADR), and a P/E ratio of 20, which is much more reasonable for a growth company of this kind. Nintendo's price-to-pretax cash flow ratio was approximately 12 in the year (full financial statements have not yet appeared). Nintendo has little debt and its total consolidated liabilities, including trade payables, were 17% of its net worth as of Sept. 30, 2003.
Whether you're interested in individual stocks, ETFs, or funds, Japan works, and there's money to be made from its recovery.
If you're looking for more, read Martin Hutchinson's view on investing in India . Or take a risk-free trial of Motley Fool Stock Advisor, where Fool co-founder David Gardner often zeroes in on Japanese game makers like Activision and Electronic Arts.
Fool contributor Martin Hutchinson is a banker and journalist with more than 25 years of experience in emerging markets. He is also the author of Great Conservatives. Details can be found on GreatConservatives.com. He owns modest holdings in the Vanguard Pacific Fund and the Fidelity Japan Smaller Companies Fund. The Motley Fool is investors writing for investors.
