Thursday, May 11, 2006

The Case For Japanese Equities
Genuine Recovery Finally

Readers of my blog will know that I have been quite bullish on Japanese equities, and its performance have not been too bad over the last 2 years. Is there room for further upside or is this a bear trap? Having worked for one of the biggest broker in the world in Tokyo in the early part of my career has allowed me to watch the Nikkei index rise from 16,000 to above 30,000. Luckily I decided to switch markets after 30,000 and did not have to weather the fall to down below 10,000. The fall wasn't that excessive, its the length of time it took to correct. The bloody thing was like a tai-chi master constipated, it took well over 12 years to do that slow dance of death. The reluctance to write off bad debts and cross-holdings problems caused much inactivity. Till they cannot stand it anymore, and even allowed foreign companies to come in to help. A large part of the recovery is due to Mr. Lion Head Koizumi. Politics used to be collective and even the Prime Minister was largely carrying out party's policies but Koizumi was an individual bent on bending the rules and rubbing people the wrong way to get things done. His ability to push through legislation to privatise postal savings system is a highlight.

If your economy dips low enough, naturally it can only go up. The essence of a genuine recovery is to look at the guiding elements in the recovery. The sharp improvement in net exports over the last 3 years is largely due to the drop in Japan's real exchange rate and China's voracious demand for Japanese technology. From Jan 2000 till Dec 2005, Japan's real exchange rate has lost about 30% in value. Over the same period, exports to China accounted for 30% of the total increase in total exports. The recovery in Japan is not led by private consumption this time around. Real activity growth came from net exports growth, corporate investments (foreign and domestic) and government consumption.

The next phase is activating the huge private savings (about 30% of GDP) and the rising corporate savings rate (despite jumps in corporate investments). These two factors provide the potential to sustain the momentum for the Japanese economic recovery. We are talking of a huge economy recovering after the most horrendous deflation for over 10 years. The asset bubbles (especially in land and equity prices) caused huge sums to be evaporated from the financial system. In a recent study by Nomura, the loss suffered by Japanese economy is almost 2.7x the 1989 GDP - in terms of GDP ratio, the loss was even bigger than the loss due to the great depression in the US in the 1930s.

The improvements are not altogether spectacular. It is hard to change business and cultural ethos overnight. Cleaning up of balance sheets, focusing on R&D and return on capital, improving transparency, etc... all takes time. Indications of a genuine recover include banks' lending - they have been slashing and reducing exposure for the longest but have started lending again over the last 2 years. As the equity markets perk up, the overall mood for bank lending has also improved. Much activity can be seen in institutional property investing in Japan by local institutions and particularly foreign institutions - a sure sign of liquidity moving in the system, and the reactivation of the wealth creation cycle. Jobs market have tightened considerably with companies mostly increasing their hiring of fresh graduates last year and this year.

The heightened consumer confidence has even alerted Bank of Japan to start raising interest rates. The deemed liquidity in the system is more than sufficient and the rates rising is not an alarming signal but a sign that domestic consumption patterns are improving markedly. Growth in domestic consumption will not be overly aggressive because of declining birth rates and higher ratio of retirees. Hence annual growth of about 2% over the next 3-4 years is attainable and impressive at the same time.

When the very big sogo-soshas are recording billion dollar profits, that is a sure sign that the worst is over. These sogo-soshas (e.g. Mitsubishi Corp) have their fingers in every pie of the economy, and they were among the hardest hit group during the recession. To be able to restructure such a mammoth sized company based largely on Japan's economy is a clear indication of genuine improvements in almost every sector of the economy and more.

Another sign of the times was the recent winter bonuses which rose to a record high in December last year. This coincided with consumer confidence indicator at a 15 year high. As the recovery is not matched by huge jumps in CPIs, the quality of the growth is all the more credible.

Corporate restructuring will continue and the influx of foreign private equity has revitalised management behaviour and valuation, and reinforced the benefits of restructuring well. All added up is a phase of reflation for Japan, and the good thing is that it is doing it slowly (although the real estate side has sizzled up pretty swiftly over the last 12 months). Many Japanese companies have had to broaden their revenue streams to international markets over the last 10 years even more, and this will only reduce corporate vulnerability to being overly dependent on its domestic economy. To many of them, a revitalised domestic economy back in Japan only adds icing to the cake - I particularly like Toshiba and the top 5 big banks as exemplary exposures to have.

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