Japanese equities are some 72% off their 1989 peak but as reform takes effect and the consumer starts to spend again there are plenty of investment opportunities in the market
Investing in Japan has been a salutary lesson for anyone with a long memory. The market, as represented by the Nikkei 225 index, is still 72% off the peak reached at the end of 1989. Yet, the rallies have been powerful too. The Nikkei jumped by 50% between October 1998 and March 2000, and has risen by more than 40% since March last year.
The problem, of course, has been that most of the rallies in the market have proved short-lived. As the euphoria has died down, the market has resumed its decline, which has instilled scepticism about whether Japan can ever emerge from the mire of terminal decline. Will the sun rise again?
Today, we are a long way from the bubble of the 1980s, when the Nikkei 225 hit 40,000. It is now closer to 12,000. The biggest distortion was in the property sector, where it was said at one time that the land of the Imperial Palace in Tokyo was worth more than the entire state of California.
For three decades, Japan enjoyed remarkable rates of real economic growth: a 10% average in the 1960s, a 5% average in the 1970s, and a 4% average in the 1980s. But the effects of the collapse in property value at the end of the 1980s persisted for longer than anyone would have expected, and Japan enjoyed an average real rate of growth of just 1.7% last decade.
Yet, in spite of its recent problems, Japan remains a significant player on the world stage. It is, after all, the world's third largest economy, after the US and China, the second most technologically powerful economy, after the US, and the Japanese equity market still represents 10% of the MSCI World index. The question most investors ask today is why they should invest in an economy plagued by deflationary pressures, where the government has a huge debt to contend with, already approaching one and a half times the size of the economy, and where the demographics are so unfavourable. The proportion of the population approaching retirement age is, famously, rising fast.
The answer, of course, is that the news is getting better. During the fourth quarter of 2003, business fixed investment growth was revised from 5.1% non-annualised to 6.3%, or enough to lift the pace of economic expansion from 7% to almost 8% if everything else remained unchanged.
Inventories were also revised lower, resulting in a net decline in economic growth from 7% on an annualised basis to 6.4%, still the fastest pace of growth since the second quarter of 1990. The nominal pace of economic growth was revised to 1.7% on an annualised basis, down from 2.6% originally.
With prices weakening for such a long period, consumers and companies alike become increasingly reluctant to spend money. After all, why buy something today if it will be cheaper tomorrow? With signs that economic growth is finally re-emerging, we believe there is likely to be an acceleration in capital spending, led by Japanese companies.
In the case of the consumer sector, total real household spending rose by 1.3% in January when compared to the previous year. On a nominal basis, before looking at price inflation, this was a rise of 1%. Spending rose by 1.5% from December on a seasonally adjusted, real basis. Wage and salaried households spent 3.4% more, while self-employed or retired households cut spending by 1.9%.
Tokyo department stores sold 0.3% more clothing, food and other goods in February than a year earlier, the first sales gain in 27 months. Sales in stores open at least one year rose to ¥139.2bn, or US$1.3bn, in February, led by increased buying of food and clothing. This was the first gain since November 2001.
As the economy begins to show signs of rebounding, confidence among Japanese consumers is starting to rise, spurring the spending that accounts for more than half of economic activity in the country.
Sales at retailers such as department stores and supermarkets rose by a seasonally adjusted 4.5% from December, the biggest gain in almost seven years. In February, sales of clothing rose by 5.1% from the same month a year ago, led by Spring coats and jackets. Sales of food rose by 3.4%.
At the same time, land price deflation is easing, having been a significant contributor to the decade-long stagnation in the Japanese economy. Central Tokyo office vacancy rates were unchanged in February from January, at 8%, while monthly rents averaged ¥17,823 per 3.3 square metres, down 7.7% from a year earlier.
According to the results of the government's annual land price survey, at January 2003 the average nationwide land price fell by 6.2% year-on-year, somewhat slower than the 6.4% decline posted last year, but still the 13th consecutive yearly decline since 1992. In Tokyo, however, the severity of the price declines has eased, and the number of survey locations in central Tokyo showing year-on-year price rises has steadily increased. In provincial areas, land prices continue to record sharp falls, but the pace of declines has slowed in Nagoya and Osaka. We believe the standard land prices for 1 July, to be announced in mid-September, are likely to show even clearer signs of land price hikes in Tokyo, and slowing price drops in other major cities.
The economy has been in decline for so long that many investors cannot remember the last time they were overweight Japan in their global portfolios.
Many research houses and the large investment banks have cut their research coverage of Japanese companies. Yet, as Japan gradually wakes from its decade-long slumber and the economy moves from a cyclical rebound to sustained recovery, there will be exciting opportunities for investors.
The reduced coverage of Japanese companies by broking houses means that investors prepared to spend time to investigate less well-known companies have scope to add significant value. Meanwhile, the prevailing negative sentiment means that good news on the economy or from individual companies will tend to come as a positive surprise to investors.
One company we have favoured has been Fast Retailing, which sells low-cost casual clothing under the Uniqlo brand, both in Japan and overseas. New management have turned the company around after an over-ambitious expansion programme. We purchased a holding in the company one year ago in the belief that it is reinvigorated and no longer deserves to trade at a lower share price valuation than its peers. Performance has been excellent to date, both in absolute terms and against the benchmark.
We expect to see many more stock-specific opportunities arising in this environment but not all stocks or sectors will recover at the same pace. At the same time, there are likely to be some stocks that continue to be dragged down by outdated business practices, high levels of debt, or inflexible management.
Investors looking to increase exposure to Japan should, therefore, look for portfolio managers with the flexibility at both the stock and the sector level to be able to take advantage of opportunities as they arise, and not be tied too closely to the benchmark. As ever, careful stock selection will be the key for those looking to continue to generate satisfactory performance for investors.
