So many investors have been bypassing Japan in recent years that stocks are now at their cheapest level for 20 years. For those searching for long-term capital gains, a contrarian position in Japan may be just the thing, especially now with many investors concerned about the weakening popularity of the ruling political party.

The political outlook is uncertain following the poor showing by the ruling Democratic Party of Japan (DPJ) in the Upper House election in July, when the DPJ lost its majority in the Upper House. Consequently, any major policy moves by the government will require temporary alliances with smaller parties, making significant fiscal reform unlikely in the short term.

Dede Prabowo is Portfolio Adviser in the Japan Team at Atlantis Investment Management says, “Recovery from the recent global slump remains on course and, as a result, many economists have upgraded their forecasts for real GDP growth to 2-2.5% for the current fiscal year (ending March 2011) and around 2% for the next fiscal year. Indicators to watch in the coming months include:

 •         Exports After collapsing in 2009, exports are on a steady rebound, rising 43.3% year-on-year in the first quarter of 2010 and 33.2% in the second. Although exports account for just 14% of Japan’s GDP, the trickle-down effect of exporter earnings on the economy is significant. The local press has been concerned with the potential negative impact of the persistently strong yen, but we expect the yen to stabilise to more favourable levels once global economic conditions normalise.

•         Consumer Spending Interest rates are expected to remain low for some time due to deflation. Certain sectors are doing well thanks to government stimulus measures to boost sales of energy-saving products such as cars, electrical appliances and housing. Consumer spending, which accounts for 58% of real GDP, was up 0.6% year-on-year in the fiscal year ended March 2010.

•         Capex Japan’s larger corporations are in excellent financial condition, with lots of cash and low leverage. We expect First Market companies to experience a 60-80% jump in net income this fiscal year. There is also talk of a cut in the corporate tax rate. This will enable companies to increase capex, something we hope to see starting this autumn.”

So who should be investing in Japan? By any measure, Japanese stocks are cheap and the downside risk looks limited. Prabowo says, “The PBR is currently 1.1x for First Market stocks and 0.6x for the Second Market, while the estimated market yield is around 2% (versus the 10-year JGB yield of only 1.06%).  PER is around 15-16x March 2011 earnings and 12-13x projected March 2012 earnings. Japanese equities seem undervalued especially for value/growth investors who can be patient and average down on weakness. We believe that rising corporate earnings and dividends will pull investors back into the Japanese market and get it moving again. 

Nikko Asset Management CIO John Vail believes that Japanese companies remain at the forefront of technological innovation. “One Japanese company has developed technology for speeding up recharging, an area fraught with difficulty. It has added holes in insulating materials and made such improvements as using low-cost natural graphite, resulting in recharges that are 50% faster. Even with the standard household electricity of 100 volts, the battery can be recharged about 10 hours instead of around 15. That’s the sort of technological innovation that Japan made its name for. There are so many good stories that don’t get reported.”

Vail also suggests that, in terms of stock market returns, Japan doesn’t have that much to apologise for, at least to foreign investors. To counter all those who feel that Japan has not been a great place to invest, he says: “I feel I should point out that in the last decade Japan has outperformed US and other major world markets in dollar terms, in most years by a significant margin. Over five years, by measure of MSCI Japan, the return is 1.7% in dollar terms. The US is slightly negative over the same period. And in five of the last 7 years, Japan has outperformed the US.”

Once you decide on an allocation to Japan, how do you make money? Prabowo says, “There is no magic formula. We are fundamental research-driven investors; primarily bottom-up but also paying attention to the big picture. At Atlantis we invest in companies, regardless of their size, that we expect to deliver above average earnings growth over the medium term and that are trading at low valuations. This currently includes cyclicals, with a focus on globally competitive firms whose stock prices have been beaten down by the stronger yen and worries concerning the global economy. There are many pockets in the mature economy where we can find companies that are growing as well as potential winners from ongoing consolidation. The current market and political hiatus provides an excellent opportunity for long term investors to invest in strong and growing Japanese companies now selling at bargain prices.”