Four small Japanese stocks to buy now

The recent market panic in Japan led to a rush for the doors. But calm has been restored, and plenty of exciting opportunities remain for investors especially among the market's small caps.

There has been nothing like this in 40 years in Tokyo. On Monday last week, the world's second-largest stockmarket was sitting happily on fresh gains of 25% made in three months.

All of a sudden there came the news of allegations of improprieties at an internet company called Livedoor, which prosecutors duly raided. This triggered sales by a mass of small investors, many of them new to the market. By mid-week, the Tokyo Stock Exchange was at panic stations. Officials finally slammed the market shut in mid-session on the afternoon of 18 January to halt what Reuters called "a stampede of sell orders".

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Since then, calm has been restored. So what do investors do now? The good news is that while Livedoor has been found to be not quite the right place for your cash, there are still some exciting new companies either in sight or coming into view in the Japanese market.

Japan is in many ways still the same massively industrial society it has long been (and it is, of course, still the largest economy in Asia), but that doesn't mean that it doesn't also have a constant fresh supply of entrepreneurs and of new firms coming forward to list: there will be some 150 to 200 initial public offerings (IPOs) this year.

There is also one zippy maverick innovator in financial markets well worth keeping an eye on: Masayoshi Son, the founder of Softbank, a financial holding company. Son, now 48, is the real king of the heap in Tokyo when it comes to innovative internet entrepreneurship the controversial Takafumi Horie of Livedoor was never much more than a side show. He is sometimes considered a divisive soul in a society where his Korean ancestry makes him an outsider. But this hasn't prevented him and his team from creating exciting companies, one after another.

He has also proved himself adept at teaming up with top-class US firms as can be witnessed in his partnerships in Japan with internet broker E*Trade and with Morningstar of Chicago, a fund rating agency. E*Trade Securities (code number 8701), which Son floated on the Jasdaq new company market in November 2004, is an excellent example of what Son is achieving in Japan. Owned by Softbank's SBI Holdings, which is in turn run by Yoshitaka Kitao, E*Trade is now Japan's largest online broker, both in terms of number of accounts and by assets under management.

"Kitao-san is a kind of genius," according to Edwin Merner, president of Atlantis Investment Research and a veteran of Japan's investment scene. He creates an atmosphere where his people focus not just on market share (the traditional Japanese obsession), but also on profits. The company forecasts revenues for the year to March 2006 at 40.5bn ($368m). That's up by 49% on the previous year. It estimates net profits for the current year to be 9bn ($82m), up by 46%.

The stock trades on a p/e of close to 90, a price that anticipates a heroic growth in earnings at E*Trade in the years to come, but that heroic growth is not an impossibility: it will come if the firm's market share keeps on rising (as it should) and Japan's private investors continue both to multiply in numbers and to keep shifting to e-broking (which, again, they should). Still, there is one fly in the ointment for investors who like the sound of E*Trade. The shares currently change hands at 1m each (that's over $9,000), which means that if you only want to put a limited amount of cash into the market, they probably aren't for you.

But there are many other opportunities in the market. The Jasdaq (where start-ups tend to be listed in Japan) is home to nearly 1,000 small firms in a huge range of sectors and industries. It is now trading not far off its all-time high of 2,000, thanks partly to the fact or so we are told by Tokyo's brokers that there has been a certain amount of oil money sniffing around the small caps over the last year or so, something that would help account for the recent surge in trading volumes. There's no reason why this shouldn't continue, nor why more foreign money shouldn't find its way into the smaller end of Japan's market.

In Japan, tiddlers have usually made their way to market without the benefit of bank financing (this has been hard to come by during the economic downturn of the last 15 years) and having had to hack it on their own all the way up. They are therefore now tough creatures and should do very well as Japan's recovery continues. Below, we look at four Jasdaq-listed firms that might make a good way of buying into that recovery.

Few brokers are familiar with small Japanese companies and commissions payable by UK investors can be high as a result. One solution to this may be to buy through HSBC, which has a large, active Tokyo office, and has long been interested in small caps in Japan.

Four Japanese small caps to buy now

Buffalo (ticker 3352)

Any visitor to Japan will quickly discover that every driver in the country is besotted with gleaming "car navigation" electronic maps that scroll down to show exactly where you are in what street, and where you can go.

Buffalo is a leading supplier of such gadgets in the Tokyo area. Based in Saitama, an adjoining prefecture, it has kept costs down, and its recent numbers look good. Sales surged by a third in the two years to March 2006, and will next year pass the $l00m mark. Net profits, however, have still to take off they were just $3m this year.

Buffalo has already attracted one foreign investor registered with a Bank of Bermuda account, and this could just be the shape of things to come. Earnings per share are due to rise from 16,700 this year to l8,370 next year.

Chimney (3362)

Every evening in Tokyo sees hordes of sarari-men' (white collar workers) heading off for the nearest eatery. This high level of non-stop demand means that if it keeps firm control over its costs and manages to hang on to its staff, a restaurant chain can fast turn into a money-spinner.

Chimney, listed only a year ago, has 300 restaurants in the Tokyo area. Business is booming, with sales nearly doubling in the year to last December and just passing the $200m mark this year, with net profits of $7m all but quadrupling in the two years to 2005. Foreign investors already hold the shares and, on a current p/e of close to 15, Chimney is attractive on the assumption that earnings keep on rising as they should.

Handsman (7636)

As everyone who has travelled in the provinces of Japan knows, it is here that you see the country at its best. The air is better, the people are happier than in the big cities and sometimes you can find corporate gems that the people of Tokyo have overlooked.

Handsman is a DIY outfit, which unlike most Jasdaq companies boasts a website in both Japanese and English. The firm, which listed in 2000, is spreading itself all over the southwestern island of Kyushu. It has just opened an eighth store in Fukuoka, the busiest city down there.

Handsman is ploughing earnings into new stores, and making net profits of just $3.5m in its current year to June on sales of just over $150m. The p/e stands at 18, but if growth comes through as expected (the firm is forecasting earnings per share to rise from 80 this year to 113 next year), it is justified putting the shares on a price to earnings growth (PEG) ratio of only 0.54 times (anything under 1 is generally considered to look cheap by value investors).

Kyoritsu Printing (7838)

Tokyo is home to hundreds of little printing shops, all too many of which seem to make almost nothing by way of profits. Kyoritsu, a family-owned and managed firm that listed on the Jasdaq just a year ago, is a valiant exception to this rule. Kyoritsu's sales are creeping up and should end the year to March 2006 not far off $300m with net profits up by close to a quarter at $12m. It's not a brilliant story yet, but the firm is growing nicely, with earnings per share expected to rise from 36 this year to 43 next (a rise of over 16%) something that makes the relatively high current-year p/e of just under 20 times look reasonable and which puts the shares on a PEG ratio of 1.2 times.

Those interested in seeing the numbers for nearly 1,000 other Jasdaq names, plus thumbnail sketches of the companies in English, should order a copy of Toyo Keizai's standard Japan Company Handbook' for the Second Section of the Tokyo Stock Exchange. This contains materials on Jasdaq firms at the back. See www.toyokeizai.co.jp/english/jch/ for order details.

By Henry Scott Stokes