Sell China, Buy Japan!

The biggest economy in Asia you don't hear about!

Alex Dumortier
Alex Dumortier, CFA
Oct 23, 2007 at 12:00AM
Other

If you're still wondering whether the Chinese share market is experiencing a bubble, allow me to settle the matter for you: It is. The MSCI China A Index has risen more than 166% year to date, for example. That's a lot.

While it's very likely that China will produce a lot of terrific investments over the next half-century, investors who aren't careful about the price they're paying for a ticket on the "China Express" may find an uncomfortable ride ahead.

A better ride
Meanwhile, next to this emerging giant lies Japan, which maintains a very low profile as the world's second-largest economy. At a glance, it looks like a bargain compared to China:

Country ETF    

P/E

iShares MSCI Japan Index (NYSE:EWJ)   

22.2

iShares FTSE/Xinhua China 25 Index (NYSE:FXI)

31.3

Data from iShares.com as of 9/28/07.

"Humbug," you say. "Japan is perpetually emerging from the slump that accompanied the end of the property and share bubble at the close of the 1980s." Admittedly, the Land of the Rising Sun has cried wolf quite a few times in the past decade when it comes to pulling its weight in the global economy. However, in The Japanese Money Tree, Tokyo-based economist Andrew Shipley argues that Japan is now on the verge of a sustainable economic rebirth that will produce enormous profits for prepared investors.

Signs the sun is up
According to The Economist, commercial property prices rose nationwide in 2006 -- the first increase in 16 years! In the three largest cities -- Tokyo, Osaka and Nagoya -- offices and commercial property prices rose a healthy 10.4%. This month, Goldman Sachs (NYSE:GS) launched a $1.1 billion joint bid for a Japanese real estate investment firm. The firm has invested around $17 billion in Japanese property since 1997.

As Shipley points out, Japan has some remarkable advantages that position the country well to compete in a global economy and with China, specifically:

Valuable intangible assets protected by strong property rights
According to its 2006 Intellectual Property report, Fujitsu has approximately 84,000 registered patents and pending applications! (By comparison, the IBM (NYSE:IBM) patent portfolio contained approximately 40,000 patents in 2004.) In 2005, more than 60% of Fujitsu's patent applications were filed outside Japan. Furthermore, in a ranking of 70 developed and emerging economies according to their International Property Rights Index, Japan was 13th. (China was near the rear at 45th.)

Although Japanese firms have been adept at creating intangible assets for quite some time, they are managing (and monetizing) these assets much more systematically than they did in the past. Shipley spoke to one former Goldman financier who thinks that this presents investors with a fantastic opportunity, and he's willing to make a career bet on this change. Nick Ricciardi founded an equity research firm that focuses on the value of intangible assets, and he believes that the share prices of Japanese firms with high intangible assets don't reflect their growth prospects. He's excited about his research; after all, "almost nobody else is doing this," he says.


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Focus on higher-value-added industries and products
Ricciardi also stresses that Japan is keenly aware of the increasing threat from China as a seemingly insatiable center for low-cost production.

The JFE Steel Group, which was formed by the consolidation of NKK and Kawasaki Steel in 2002, shows that companies in "high-cost" Japan can be competitive, even in an old-world industry like steel. Critical to its success is its product strategy, labeled "only one, number one."

In practice, that means continuously developing and marketing products with excellent profitability potential that are "based on technology that is unique (the only one) or simply the best (the number one) in the industry."

Just like Jack Welch's strategy at General Electric (NYSE:GE) to exit markets in which it wasn't in the top two in terms of market share, JFE's "only one, number one" strategy frames the struggle for success in blunt terms. To maintain that differentiating superiority, JFE has an arsenal of 1,000 people in R&D who produce some 1,800 patent applications per year!

Take your gains where you can get them
Now that I've sung Japan's praises, let me be quite clear: At our Motley Fool Global Gains international investing service, we wouldn't think to exclude a market like China from our radar. But the valuations are heady, and we recently recommended selling our position in China Mobile (NYSE:CHL) because of valuation concerns. Just remember that wild enthusiasm can spell disaster for investors.

If you're looking for international markets that offer better opportunity with less volatility risk, consider Japan and some of the other companies we've highlighted in our service. To take a look at these picks, click here to join Global Gains free for 30 days. There is no obligation to subscribe.

Alex Dumortier, CFA, has no beneficial interest in any of the companies mentioned in this article. The Fool is all about disclosure.