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Investment cheer amid the gloom

It is proving to be another interesting year for followers of the Japanese economy. The year 2000 was of course when investors were punished heavily for once again believing that Japan had turned the page on 10 years of asset price retreat. The Nikkei, having moved up from 14,000 to 20,000 in a nine month period from early 1999, retraced all that ground and more last year. And this has not just hurt foreign investors. In an extraordinarily unfortunate learning process, the market’s plummet coincided with a successful attempt by mutual fund companies, to lure new Japanese private investors in to the market.
So it may take some time to regain the confidence of investors, but nonetheless, analysts are now suggesting that in global terms, Japan is one of the best value markets at this point.
The market will clearly remain under pressure within a weaker global environment. The Japanese market remains geared to global growth and indeed most of the major indices have significant weightings in technology overall.
So any weakness in the NASDAQ continues to have an impact on Japan and it is very clear that, as a proxy for global sentiment, the NASDAQ must rise to bring some stability to the Japanese stockmarket. The price action in the market since the start of 2001 has been encouraging for growth investors. Undoubtedly, most of the western style managers that wish to have exited the market, and have been net sellers of the traditional western style Japanese stocks such as Canon and Sony which will ironically benefit from any further Yen weakness.
Overall, expectations for Japan are less bearish for the second quarter, which reflects a more positive view of equity markets in 2001. Managers would be more positive if they could see signs of some radical change, but if the last 10 years have taught us anything, it is that the pace of reform is never as fast as foreign investors would like.
Hamish Dingwall, manager of the Baillie Gifford Japanese Fund, suggests there is little scope for optimism on the Japanese market or economy in the near term. He argues that there continues to be confusion over the economy with poor quality of data and diverse estimates for 2001 GDP growth (ranging from 3.0% to -0.5%).
Despite this, Dingwall notes that real change is occurring in the corporate sector (results have been impressive - a sign of ongoing success with cost-cutting and restructuring). Furthermore, the market is cheap relative to its past history. Dingwall suggests the loss of momentum in the domestic economy as it veers away from its recovery path, along with external weakness threats, may focus Japanese companies to redouble their restructuring efforts.
Managers of Japan stock portfolios have had to show much resilience in the face of hostile market conditions. Naturally, many of them retain a bearish outlook. Masato Kawada, manager of the INVESCO GT Japan Enterprise Fund aims to achieve long- term capital growth by investing in small to medium sized Japanese companies, predominantly equities listed on the TSE Second Section and regional stock exchanges.
Having attracted considerable interest from investors on the back of excellent returns in 1999, Kawada’s fund suffered an extremely disappointing year in 2000, in common with every other fund manager with a similar brief. But Kawada is an experienced hand and he has remained focused on identifying companies with the ability to grow despite the difficult economic conditions. For example, the manager favours network integration and software development companies such as Fuji and Soft ABC, which he feels will produce continued earnings growth.
However, for the short term, his outlook is increasingly bearish, suggesting Japan’s upside is limited until firm change can be effected at a political level. This he feels, is quite possible. He feels the general election in July could unseat the ruling LDP and that even if there is a hung Parliament, the political change will come that may finally result in the absorption of the banks’ bad loans and other measures to free up domestic capital, both private and corporate.
Kawada feels the continued unwinding of cross share-holdings and introduction of international accounting standards across Japan will also be detrimental to the market in the short term.
David Scott, manager of the JF Japan OTC Trust, is another manager with a small cap bias who has been forced to follow a high cash stance in the last few months. He continues to believe in technology on a three to five year outlook, but currently feels many of the technology names remain overpriced. Scott feels confident that companies delivering earnings growth will begin to return to investor radar screens as interest rates move lower and the growth environment in Japan becomes clearer. Stock-picking is the key; as Scott says: “Many companies are simply telling analysts what they want to hear (the restructuring story) but we are seeing selective improvements in ROE.” The retail sector is favoured presently, with strong franchise electronics retailers increasing market share. JF’s forecast is for a strong positive momentum for earnings for the rest of this year and moving into 2002. The global slowdown will have an effect, but not to such a great extent, especially in view of the Yen depreciation.

Scott, and others such as Martin Batty, manager of the Mellon Newton Japanese Equity Fund, remains bearish on the outlook for the Japanese banks, which he feels, are intrinsically unattractive. The valuations are nonsensical compared to global peers and they are still very vulnerable to the further unwinding of cross shareholdings.
Batty, expects to see stockpicking add the most value in 2001 as it becomes clear that there are few, if any, sectoral safe havens as the performance of individual companies diverges.
Campbell Gunn, CIO at Meiji Dresdner in Tokyo, says that Japan’s situation is one of relative attractiveness for global investors, and with zero interest rates, there are better growth opportunities. Gunn suggests that Japan will take its time in sorting out its problems and that the rewards for this approach are a greater social cohesion.
It is hard to disagree with this view when one considers the leading candidates for leadership of the country, which is why the bullish talk about the benefits of restructuring needs to be treated with caution.
In the short term, the Japanese team at Goldman Sachs in Tokyo remains relatively cautious, with concerns focused upon the scale over the US slowdown, high risk of earnings disappointments and poor market conditions. Furthermore, the team fears an excess of Japanese paper coming on to the market during the next few months, with a number of IPOs planned and continued unwinding of cross-shareholdings. The obligatory changes in accounting principals, to mark to market, (initiated in April) also raise further concerns.
However, the team appears confident that the Japanese stockmarket is finally nearing the bottom. Before the market took flight in 1999, Goldmans were recommending caution and they this time around they haven’t altered their view.
Will Garnett, manager of the Henderson Horizon Japanese Fund, points out that the price anomalies between value and growth have moved to extremes and represent the reverse of 2000 when growth was overpriced. He maintains his view that the Japanese market is oversold and will bounce. The restructuring of corporate Japan is ongoing and will accelerate as global economic growth slows and trading conditions deteriorate.
Marc Desmidt the new lead manager of the Mercury ST Japan Equity Fund, feels the market will suffer against adverse demand supply conditions, as cross share holdings are unwound and new issues abound Desmidt’s outlook for Japanese component manufacturers remains strong, although exposure to the semiconductor cycle has been reduced. Exposure to the financials sector remains underweight relative to the benchmark. The manager has been disappointed with bank restructuring efforts and fears there may be further skeletons in the cupboard.
However, Desmidt is confident that earnings for the second half of the fiscal year should remain strong and is happy with the attractive valuations currently found in the market. Overall, the team is confident that higher bankruptcy levels and the unwinding of cross-shareholdings should, over the longer term, help create a more competitive economy and a more dynamic market where companies are more willing to raise returns for shareholders.
This is a common theme among fund managers. They can all find something positive to say, should the reforms and restructuring take place. Increased competition and a greater focus on returns to shareholders will be a direct result of these changes, if they can be applied in a concerted way, which has not been the case up to now. A lot rests on the outcome of the elections and Japan’s ability to act out the reform and deliver the benefits. The fund managers, although almost all are still highly cautious, do all seem to be finding reasons to be cheerful.

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