Why I'm the last of the Tokyo bulls

A friend, Edward Cartwright of KGR Capital, is in Japan at the moment. He has just sent me an e-mail saying he is finding it a bit depressing. He can't see much going right. The markets have gone nowhere for months and smaller companies with a domestic bias in particular are performing horribly.

Sentiment has turned nastily negative as a result. Fidelity's Japan Smaller Companies fund saw its assets grow from $900m (£453m) to $2.5 billion in 2005 when everyone loved Japan. Today the fund is back down to $900m.

Things are just as bad in the Japan hedge-fund sector, where the 89 equity hedge funds Cartwright follows have lost, or been asked to return to investors, 40% of their assets over the past six months. Those with any money left are busily rebranding themselves as pan-Asian hedge funds.

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Investing in Japan: reasons to be bearish

To the bears which these days includes almost everyone this all makes complete sense. Why, they say, would anyone want to put their money in Japan when every single other market in the world is doing substantially better? The Nikkei index is doing nothing at all, yet the Dow Jones has just seen its strongest run in decades, most of Europe's markets appear to be in the middle of real bull runs and emerging Asia is making people more money than they could ever dream of picking up in Japan.

Cartwright sums up the prevailing mood: Japan, he tells me, "is a slow boat going nowhere" in an otherwise very racy world.

I don't buy this. Sure, Japan is a slow boat. But it isn't going nowhere. Investors in Japan, having spent 15 years or so working in a dismal market environment, are natural bears (I learnt my own particular brand of pessimism in Tokyo) so it doesn't take much to make them start looking longingly at the high-growth markets across the water in Korea and beyond.

And right now there is a seemingly endless list of miserable data for those with bearish tendencies to hang their hats on. Exports are stagnant; wages, having been in an upward trend, are once again static; housing starts, having picked up last year have now slowed again, and there is a growing consensus that the business cycle is peaking.

Cartwright asked me if I didn't feel the same misery when I was in Tokyo last week. The truth is that, while I know that he has an excellent record of calling the Japanese market over the past few years, I didn't.

I spoke to a huge variety of people friends from my Tokyo student days, a former ambassador to the UK, a lot of taxi drivers, an old fund-manager client from my stockbroking years, some thirty something friends and it all left me feeling pretty positive.

Investing in Japan: market sentiment will turn around

Overall growth is perfectly reasonable at 2.4% and corporate Japan is in great health. Years of restructuring have left firms awash with cash and their profit margins and return on equity have both been rising nicely. Last year profits as a whole rose about 12%. Even more encouraging, however, is the fact that the behaviour of Japan's big shareholders really is changing. And companies are becoming increasingly willing to engage with shareholders and private equity.

The other thing I think is worth recognising is that this is a peak year for baby-boomer retirement more of them will be heading for their golf clubs than in any other year. This will make Japan's wage bill go down (younger workers are cheaper) and should also boost spending the thing all the bears have to see before they can even begin to think about cheering up.

Japan's retirees don't just get a pension, they get a lump sum from the firm as they leave, too, and the hope is that they will spend it (Nomura Securities is so excited about all the cash on the way that it has been opening new branches in anticipation). This will push up consumer spending and even, with a bit of luck, prices.

If prices in general move into positive territory after years of deflation, I think we can expect sentiment in the market to turn round pretty quickly.

It will also allow the Bank of Japan, which is desperate to raise interest rates to normal levels, to finally do so. This in turn might upset the yen carry trade (whereby most of the world appears to be borrowing in yen at the current absurdly low rate to buy high-yielding investments abroad) and force the grossly undervalued yen to move to more normal levels too. These would both be good things.

One final thing I want to say in Japan's favour is this: by no measure could it be described as being in a bubble. You can't say that about many markets these days.

So, if you want to join me in my very contrarian view on Japan, what might you buy? If you are feeling very brave you might want to go for a small-cap fund. Smaller companies have fallen massively over the past year or so and there is now good value to be had. This hasn't gone unnoticed I heard in Tokyo that some of the bigger US-based small-cap funds have already started looking but now might be a good time to get in before anyone else thinks to do so.

First published in The Sunday Times 27/5/07