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Sell China, Buy Japan

By Alex Dumortier, CFA - Updated Nov 11, 2016 at 5:37PM

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

When this article was first published last October, this was my opening salvo: "If you're still wondering whether the Chinese share market is experiencing a bubble, allow me to settle the matter for you: It is." That message apparently hit a raw nerve with some readers and I have since received some colorful emails, including one in which the author suggested it was "obvious" that I had been paid by "the Japanese" to write the article. However, this is how the two exchange-traded funds I referred to performed in the interim:

Country ETF   

Total Return

iShares MSCI Japan Index 

(3.4%)

iShares FTSE/Xinhua China 25 Index

(21.9%)

Outperformance of Japan ETF

18.5%

Data from Yahoo! Finance as of May 1, 2008.

Furthermore, based on closing prices, the China ETF was underperforming the Japan ETF on 129 days out of 131. While it's very likely that China will produce a lot of terrific investments over the next half-century, investors who weren't careful about the price they paid recently for a ticket on the "China Express" have found the ride pretty bumpy.

A better ride
Meanwhile, next to this emerging giant lies Japan, which maintains a very low profile as the world's second-largest economy. "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 such increase in 16 years! In the three largest cities -- Tokyo, Osaka, and Nagoya -- offices and commercial property prices rose a healthy 10.4%. In February, Bloomberg reported that U.S. investment bank Morgan Stanley purchased Citigroup's (NYSE: C) Tokyo headquarters for ¥48 billion ($456 million). Morgan has made $18 billion in real estate investments in Japan over the last decade. Merrill Lynch (NYSE: MER) is currently raising $2.5 billion to $3 billion for an Asia-Pacific real estate investment fund that will target investments in countries including Japan.

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

Valuable intangible assets protected by strong property rights
It's perhaps no surprise that, according to IFI Patent Intelligence, half of the top 10 U.S. patent winners in 2007 were U.S. companies, such as IBM. However, Japan has four companies in the top 10, and 13 in the top 25, with companies such as Seiko Epson (No. 13) beating out U.S. competitor Texas Instruments (NYSE: TXN) (17).

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 Sachs 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.

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.

JFE Steel, which was formed by the consolidation of NKK and Kawasaki Steel in 2003, 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."

JFE defines success in blunt terms; that's no different from Japanese TV manufacturers, who must maintain their technological lead if they are to keep fending off Dell (Nasdaq: DELL) and Hewlett-Packard. To maintain its superiority, JFE has an arsenal of 1,000 people in R&D who produce some 1,800 patent applications per year! In auto manufacturing, Toyota stays on its toes by practicing continuous improvement -- part of its recipe for catching General Motors (NYSE: GM) at the top of the global automakers' ranking in 2007.

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 can get heady, and we recommended selling our position in China Mobile well before the recent Chinese market rout 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.

This article was first published Oct. 23, 2007. It has been updated.

Alex Dumortier, CFA, has a beneficial interest in Dell, which is an Inside Value recommendation. Dell is also a former Stock Advisor selection. The Fool is all about disclosure.

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