Why now is the time to buy into Japan

Japan is looking a little lacklustre - which makes this a great time to buy in, says Merryn Somerset Webb. And the Japanese property market is looking especially attractive, even as Western property heads swiftly south.

...which makes this a great time to buy in and especially to the Japanese property market, which is on the up and up, while Western property heads swiftly south, says Merryn Somerset Webb

On Monday this week the Michelin restaurant inspectors made an announcement: in its first ever guide to Tokyo it has awarded the city more Michelin stars than it has ever given anywhere else.

London has 50 stars. Paris has 98. But Tokyo has 191. That's eight three stars, 25 two stars and an amazing 117 one stars. It's official, says Jay Rayner in The Guardian: "Tokyo is belly heaven".

This story was everywhere on Monday and Tuesday I heard it on a late night Radio 4 talk show, then read it in all the papers on Tuesday and then had to put up with endless emails from smug Japanese acquaintances reminding me of how revolting the food is in London.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

But amid all the talk about sweet spider crab legs seared on hibachi grills and the seasonal sourcing aspects of Japanese river fish, most people missed a much more important Japan-related story; namely, that for the first time in years the dividend yield on Japanese stocks (as measured by the wider index, the Topix, rather then the narrower Nikkei) moved higher than the yield on Japanese government bonds. This is a very big deal, says Jonathan Allum of KBC. This is the only measure with an "unblemished track record of spotting times to buy".

On every other occasion this has happened the market has soared, ending 30%-40% higher than when the rally kicked off (see chart below). In the last week of May 2005, for example, the dividend yield overtook the bond yield. Two weeks later the Topix bottomed. It then rose 48% in the following nine months. Much the same happened in 2002 and 1998.

And this time? Things started well. On Tuesday the market's bench market index, the Nikkei, ended the day up 1.1%. But then on Wednesday it fell again, ending the day down 2.46%. So what next? Might this be the start of another 40% run, or are things so awful in Japan (one of the world's worst performing markets so far this year) that even this signal should be, as it was mid-week, ignored by rational investors?


Investing in Japan: it's been a bad year

Things haven't been good to investors in Japan recently (bad news for my pension, which is stuffed full of Japan-related funds). The Nikkei is down 18% since its peak in 2006 and 13% since January alone.

Over the last year, Japan-focused hedge funds, unable to drum up any interest at all in their wares, have been shutting down in droves; and you'd be hard pushed to find anyone, bar its most devoted fans, with a good word to say about the market at all. More global investors say they are underweight Japan than have done since the really dark days of mid-2002 and mid-2003.

So what's gone wrong? On the face of it plenty. The bulls (myself included) keep waiting for inflation to return to Japan. But it never does. Instead, there is still mild deflation, a situation hardly helped by the fact that the Bank of Japan (BoJ), which is terrified of asset bubbles, has raised interest rates twice recently.

More irritatingly, Japanese consumers, despite expectations to the contrary, insist on keeping their wallets shut: with wages static and prices not rising, they see no reason to spend.

The political situation is also a tad chaotic. Since the very popular Junichiro Koizumi (under whom we saw the great 40% rally of 2005) retired, the country has had to suffer Shinzo Abe. Abe ended up in hospital with exhaustion before being relieved as prime minister by Yasuo Fukuda, who appears to be as lacking in charisma and credible plans for reform as most other Japanese politicians.

Investing in Japan: better places to go?

However, the main problem is not really any of these things. It is simply this: global and domestic investors think they have better places to go with their money. Global equity investors can't see the point of a market where, on average, earnings are growing at a mere 7% a year, when they can make killings piling into China and India instead. And domestic investors just want yield.

So why invest in Japan, where interest rates are still under 2%, when they can change their yen into US or Australian dollars, pounds or euros and more than double the interest they're pulling in?

The subprime situation hasn't helped either. Japanese banks don't appear to be much caught up in the whole thing, but as John Millar, manager of Martin Currie Japan Fund, points out in Investment Week, almost 70% of trading volume on the Japanese market comes from foreigners and they've been selling financial stocks indiscriminately while domestic buyers have been doing nothing. The result? "Down, down, down."

Then there is the yen, which as we suggested it would back in February - has been rising at quite a clip. It is up 12% against the dollar and 6% against the pound since February. And every tick up in the yen means a tick down in the profits of those export-orientated firms that get paid for their products in foreign currencies.

Investing in Japan: it's miserable but buy anyway

So with all this misery, why are we bothering to write about Japan? Because whatever the headlines might say, it has been a good place to have your money for the last four years (over the past four years the Nikkei has actually doubled) and should continue to be so.

Why? First because corporate Japan is very healthy. Earnings have risen every year for the last six years and rose over 10% in the first half of this year alone. Profits should hit a record high for this year, for the fifth year in a row, says Jonathan Allum. One third of Japan's top companies are debt free and the banks, the problem at the heart of the last 15 years of intermittent recession, are looking good, with their non-performing loan books finally cleared and new lending on the up.

At the same time, things aren't all bad for the economy, which is currently growing at 2.6% and rising, something that doesn't look too shabby when you note that the US Federal Reserve now says it expects the US to grow at only 1.8% next year.

Sure, consumption still hasn't really kicked off yet, but there are suggestions that it soon will. Spending is all about attitude and until recently the Japanese have had the wrong one. Unemployment has been high and wages static (which encourages saving); while prices have been falling, something that makes people postpone shopping (why buy now when everything will be cheaper in a few months' time); and house prices have been falling, which makes everyone feel poorer.

But all these things are either changing or about to. Employment is getting tighter (see chart below) and the retirement of highly-paid baby boomers means there should soon be more cash to go round the rest of the work force.

Analysts from Bedlam Asset Management, recently back from Japan, report that all the firms to whom they spoke see the labour market tightening, while "several commented that they expect wages to start rising from the beginning of the next financial year" (ie, April 2008). Graduates are in "hot demand", particularly in the financial sector.


Investing in Japan: prices are rising

Inflation expectations are changing too. All sorts of prices from taxi fares to mayonnaise and McDonald's hamburgers are rising for the first time in a decade, and the BoJ reports that a growing number of people expect them to keep doing so. All this should allow other firms to raise prices, boosting their profits and hopefully the wages they pay. But more importantly, property prices are rising, which makes people feel well off. That in turn makes it easier for them to spend (just look at what's happened in the US over the last decade).

Add it all up and already, says Bedlam, "there are tentative signs that consumers are loosening their purses" they're "undoubtedly buying more expensive brands" than they were. At Isetan, the Selfridges of Tokyo, sales are improving steadily and the men's department in particular is "booming". This is a good sign, as "men are typically last in the family food chain".

There is also reason to believe that Japan is, to a degree, sheltered from the credit-bubble fall out and especially from recession in America. The most recent numbers show US exports down over 9%, but exports to China up 17%; to Russia up 28%; to Brazil up 45%; and India up 55%, says Bedlam. Overall, 48% of Japan's exports now go to Asia.

Investing in Japan: cheap, very cheap

But here is the best news about Japan: it's cheap. Very cheap. Today, Japanese stocks trade on a p/e of only 15 times about the same as those in the US on which everyone appears (bemusingly) to be so bullish.

And that's with earnings growing faster than those in the US and interest rates significantly lower. Japan's stockmarket value as a percentage of its GDP is also "among the lowest of the G7 nations", says Barrons, and it is "certainly the cheapest on a price to book value basis."

Then there are the dividends. The Japanese market has always been known to pay pathetically low percentages of profits to its investors, but that's slowly changing. Currently, around one fifth of earnings are paid out (its 30% in the US), but the amount is nonetheless rising at 20% odd a year. Add it all up and, according to Goldman Sachs, Japan is now the cheapest it's been for 33 years.

Of course, just because the market is cheap doesn't mean it will go up. Markets are forever overshooting on the up and downsides (check out the UK housing market!), so there is a chance that, as Allum puts it, the market is "both cheap and destined to go lower". But there is reason to think that some of the money waiting in the wings might soon make it into shares.

First, there are the retail buyers. For years now they've seen better opportunities abroad than in their own markets: not only have they made better capital gains and yields almost anywhere outside Japan, but they've also made currency gains as the yen has fallen.

But with Western markets now all over the place, they're getting less of a return for taking more risks than ever: overseas markets are no longer a one-way bet, nor, for that matter, is the yen.

And home looks good the market is as cheap as it has ever been and, for the Japanese at least, comes with no currency risk. Note that, according to Japan fund manager Scott McGlashan, since 1973, "most periods of equity-market strength have coincided with a stronger yen".

Then there are the domestic institutional investors the pension funds and insurers. This lot hold vast amounts of funds (remember how old Japan's population is) and it will only take a few of them to notice that they can get a better yield in equities than bonds, and then to act on it, to cause a huge jump in the market.

More buying could come via consolidation: when markets are obviously cheap and the cost of funding a buy out (the interest rate) is below earning and cash-flow yields (and even dividend yields in Japan), predators are never slow to appear.

Note that bank stocks moved this week in anticipation of mergers as a US private-equity group moved to take a big shareholding in Shinsei banks, while management buyouts are currently being seen in Japan for the first time.

If you step back and take a good look at Japan, it is clear that almost every possible negative is already priced into the market, something that suggests it must be at, or near, a bottom and one neatly signalled to us by the cross of the equity and bond yields. History tells us that this is not a signal to ignore.

Japan's cheap small caps

In most countries large caps and small caps trader more or less in line in terms of valuations. Not so in Japan. There, small companies are very cheap indeed.


What went wrong with the great boom?

From the end of World War II to the beginning of the 1990s, Japan saw one of the greatest economic booms ever. A heady cocktail of low manufacturing costs, a highly motivated labour force, high personal savings rates which created capital for investment and generously low export tariffs enabled it to grow at a hectic speed, flooding the world (particularly America) with cheap goods. As a result, Japan's trade surplus reached $50bn, 3.7% of GDP, by 1985 and the country was soon being held up as an economic miracle.

But one of the things facilitating this was the yen, which, despite rising howls of protest from US manufacturers, was kept cheaper than market forces might have dictated. Eventually, US politicians dragged Japan anxious to avoid punitive tariffs to the negotiating table at the Plaza Hotel in New York in 1985 to sign an agreement that would see the yen doubling in value in two years.

In a bid to restrain the rise, the Japanese government then dropped interest rates and let the money supply to expand at an annual clip of 10.5% from 1986 to 1990. The resulting cheap money flooded the economy, driving a big boom in investment, much of the cash being wasted by public bodies and private firms on useless infrastructure and daft projects. Shares and property prices also rocketed: the Nikkei tripled in three years and at one point Tokyo's land was "worth" more than California.

In May 1989, in a bid to regain some control, the government reversed its policy. The property and share-price booms collapsed and Japan's banks were left with huge amounts of unrecoverable debt. Some went bust. All stopped lending. Consumers stopped spending and many Japanese firms relocated overseas to cut costs, boosting domestic unemployment. The 40 year boom was over.

Japanese funds to buy for the bad times

So if the Japanese market has finally bottomed, what should you buy? You could go for some of the big firms exposed to Asian growth. Back in 2005 one of the key reasons bulls (us included) gave for buying Japanese shares was that they were one of the best ways out there to get safe and cheap exposure to China and the other fast-growing economies of Asia.

That's still true. Barrons suggests getting in via big companies such as Sumitomo (8053), Mitsui (8031) or Itochu (8001), which trades on a p/e of only ten times, despite earnings growing at 20% plus.

Other companies that should do well out of Japan's geographical closeness to Asia's markets are Isuzu Motors, Suzuki, and Komatsu (which makes construction equipment). All are heavily geared to demand from developing countries.

However, although these are surely all good long-term holds and they are certainly cheap, while the jury is still out on decoupling (the idea that the Asian economies can continue to grow at speed even as the US consumer collapses under the weight of record debt and housing bust), I think it might be worth gearing your investments towards small caps. These are even cheaper than the rest of the market the Mothers index of very small firms trades on an average price to growth ratio of around one.

Again, being cheap doesn't mean they will rise. As Jonathan Allum points out, small caps often end up "offensively underpriced" when sentiment is against them. Yet if you want a cheap way to get exposure to Japanese growth, this is the way to go.

One fund to look at might be the JOCHM Japan Fund, run by Scott McGlashan, who has been working in this market for more than 31 years. It aims to invest in under-researched firms easier in Japan than elsewhere, given that analyst coverage has shrunk steadily over the last 15 years and to have a mid-cap bias.

On the investment-trust side, you might look at the JP Morgan Fleming Japan Smaller Companies Fund (JPS), down just over 20% over the last year, but up 48% over the last five years, or the Fidelity Japanese Values (JFV) fund, which also invests in mainly mid- and small-sized firms it's down 18% over the last year, but up 60% over the last five. Both funds trade at hefty discounts of 11% to their net asset values. Finally, for those looking for cheap, simple exposure to the market, there is the Lyxor ETF Japan (LTPX), which tracks Japan's Topix index.

Investing in Japanese property

For years now property across the Western world has been seen as a one-way bet. No more. A quick look at the US, or even around our own cities, makes it clear that the property bubble is deflating, and fast.

So what is an investor addicted to property to do? Head to Tokyo. Here both residential and commercial property are rising. Look first at commercial property in Tokyo. The yield on this is around 4% (and rents are rising at 5%-10% a year as new supply drops off and vacancy rates fall see chart above). Yet you can borrow money to buy it at more like 1.7%.

Look to the residential market and the "positive carry" the difference between what money costs to borrow and what you can make on it looks even bigger. Yields on flats and houses in Tokyo are more like 4.75%, despite prices rising sharply.

We can't necessarily expect prices to keep moving up fast until wages rise further (the fact that no one can afford the average house on the average wage isn't perceived as a problem at the end of a bubble as in the UK earlier this year but tends to be on the way out of a recession). But they aren't likely to fall and yields are good.

"Property in Japan will easily buck the down turn in Western property markets. So how do you buy into this one?" James Ferguson, an economist at Pali International and editor of Model Investor, suggests the Real Estate Investment Trust NCI (3229). It owns offices and high-end retail properties in central urban locations some in areas where "property prices on the ground are rising at 25%-40%" and the shares yield 5.7%.

Says James, "I can't resist a way to play the best-looking real-estate market in the world while being paid up to three times the local rate of interest to do it!" In the UK you can get similar exposure to Japanese property via the Aim listed Prospect Epicure J-Reit Value Fund (PEJR).

Merryn Somerset Webb

Merryn Somerset Webb started her career in Tokyo at public broadcaster NHK before becoming a Japanese equity broker at what was then Warburgs. She went on to work at SBC and UBS without moving from her desk in Kamiyacho (it was the age of mergers).

After five years in Japan she returned to work in the UK at Paribas. This soon became BNP Paribas. Again, no desk move was required. On leaving the City, Merryn helped The Week magazine with its City pages before becoming the launch editor of MoneyWeek in 2000 and taking on columns first in the Sunday Times and then in 2009 in the Financial Times

Twenty years on, MoneyWeek is the best-selling financial magazine in the UK. Merryn was its Editor in Chief until 2022. She is now a senior columnist at Bloomberg and host of the Merryn Talks Money podcast -  but still writes for Moneyweek monthly. 

Merryn is also is a non executive director of two investment trusts – BlackRock Throgmorton, and the Murray Income Investment Trust.