After Tough 2007, Japan Stocks
May Be the New Year's Bargains
By ANDREW MORSE
December 31, 2007
TOKYO -- Investors in Japanese stocks just suffered through their worst year since 2002. But there's hope that the new year may treat them better.
Historically cheap stock prices could overcome worries about the strength of the yen and weak corporate governance in the world's second-largest economy -- both long-running concerns.
The Nikkei Stock Average of 225 companies fell 11.1% in 2007 to 15307.78, its first losing year in the last five. (The last trading day was Friday.) The Topix index, which is usually used by strategists because of its breadth, did even worse, dropping 12.2% to 1475.68, also its first loss since 2002. Both indexes fared far worse than other Asian markets, which generally posted double-digit gains.
Even so, it will take sizable gains in the new year to pretty up the longer-term picture. The Nikkei is down 60.7% from its record close, set Dec. 29, 1989, while many Asia markets set dozens of record closes this year.
The drop in 2007 is in part because of a surge in the yen, which erodes the value of earnings from foreign markets when calculated in the country's currency. It also comes after a series of company actions and court decisions that suggest Japan isn't ready for more aggressive shareholder capitalism, like that practiced in the U.S. and U.K.
But the slump in share prices has made Japanese stocks look cheap compared with those in other countries. Big blue-chip companies -- like car maker Honda Motor, copy-and-camera maker Canon -- are trading near their lows for the year even though many are expected to post record profits. Strategists say that will draw value-hunting investors, many of whom have shunned the country's stock market, although they will be selective in which companies they buy.
"Everybody is underweight Japan," says Shoji Hirakawa, a strategist at the Tokyo office of Swiss banking group UBS, referring to the fact that global investors hold fewer Japanese stocks in their portfolios relative to the percentage of the world's markets that is Japanese. Mr. Hirakawa says foreign investors will likely prowl Japan for bargains in 2008.
UBS recently recommended that investors raise their exposure to Japan to the same as its global percentage. Mr. Hirakawa forecasts the Topix index will rise to 1900 by the middle of 2008, which suggests a 29% leap.
Already, some foreign investors appear to have taken notice. The Qatar Investment Authority, a $60 billion sovereign-wealth fund, is looking to buy Japanese shares as part of its portfolio. So is the China Investment Corp. which manages $200 billion.
Behind the optimism is the fact that Japanese shares are cheap by a host of widely used metrics. The Topix trades at a price/earnings ratio -- a measure of how expensive a stock is that compares a company's stock price to its earnings per share -- of about 16 times. That is lower than the global average of 16.7 times and much lower than the nearly 20 times for markets in the rest of Asia.
Japan is even cheaper when viewed by its price/book value ratio. This ratio compares the value of a company to the value of its assets, like bank deposits, buildings and land and machinery. On average, Japanese stocks trade at a price/book value ratio of a little over 1.5 times, compared with a global average of about 2.4 times. U.S. stocks trade at a little over 2.5 times, while the markets in other Asian countries trade at over three times.
UBS's Mr. Hirakawa reckons about 40% of the companies that comprise the Topix trade for a price/book value ratio of less than one. That means those companies' stock-market values are less than the value of their assets.
To be sure, it's an open question as to how quickly -- or even if -- investors recognize the relative cheapness of Japan. Peter Tasker, a strategist at the Tokyo office of Dresdner Kleinwort, says that Japanese companies are at their cheapest level in 25 years if measured by their earnings. But in a recent report, he conceded that "it takes time for low valuations to attract capital."
Mr. Tasker doesn't have a published target for the Topix.
Critics say that Japanese companies are risky because the yen still hasn't stabilized against the dollar. They say the Japanese currency might rise further if the U.S. economy weakens and the U.S. central bank cuts interest rates. That would hurt the competitiveness of Japan's exporters by making their products more expensive on overseas markets.
Concerns about the health of Japan's economy, which is still mired in slow growth, could also cap stock prices. Earlier in December, a widely watched Bank of Japan survey showed business sentiment in the country had slipped to its lowest level in more than two years. In addition to the yen, high oil and raw-material costs weighed on sentiment.
Worst of all, critics complain Japanese management teams don't run companies for their shareholders, but rather for employees and business associates. Shareholders who have tried to persuade companies to take their interests into account have been brushed aside and more companies have adopted poison pills -- plans that protect management by diluting some shareholders. Over the summer, Japan's Supreme Court ruled that a small condiment maker, Bull-Dog Sauce, could use such a plan to ward off a hedge fund that wanted to buy it.
"The lack of attention paid to shareholders is evident," says Marc Goldstein, a corporate governance specialist at consultancy RiskMetrics Group. "It is why Japan has been among the worst-performing stock markets in the world."
Still, evidence is starting to emerge that companies are taking better care of their shareholders. Many firms have begun using some of their profits to buy back shares, which pushes up stock prices, all other factors being equal. Earlier this year, Canon, steelmaker JFE Holdings and trading house Mitsubishi announced they would buy back shares with a total value of more than 250 billion yen ($2.2 billion).
Dividends are also rising. The 1,742 companies listed on the Tokyo Stock Exchange's first section paid 2.4 trillion yen in dividends in the first fiscal half, which ended Sept. 30. That's a 25.1% increase from the same period a year earlier, according to Mr. Hirakawa of UBS. He thinks the figure will rise to a 5.5 trillion yen for the full fiscal year, which ends March 31.
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