Can Japan’s prime minister reform the country’s moribund economy?

Japan’s stocks are hot again

(Tomohiro Ohsum/Bloomberg/Getty)

(Tomohiro Ohsum/Bloomberg/Getty)

Consider the plight of the Japan-focused equity fund manager. For more than two decades, Charles Edwardes-Ker, a vice-president and portfolio manager with TD Asset Management, has been looking for good Japanese stocks to buy. He’s found some well-run companies over that time, but he just can’t win. The Nikkei is down 62% from its bloated 1989 peak. If you had invested $10,000 in the TD Japanese Growth Fund in January of 2001, the year Edwardes-Ker began managing it, you’d be down about $1,500 today.

This year, however, is turning out to be one of the fund’s best years ever, and Edwardes-Ker thinks 2014 could be even better. In fact, some observers believe the Asian giant—the world’s third-largest economy—is finally awakening from its long slumber and confronting its deep structural problems.

Many credit Prime Minister Shinzo Abe, who was elected to the top post last spring with a radical economic agenda. Abe immediately brought in a fiscal stimulus program meant to kick-start the economy. It’s similar to the U.S. government’s quantitative easing, but rather than trying to buy government bonds to push interest rates lower—rates are already at zero—the goal is to push the yen down and combat chronic deflation. It’s already working. The yen has fallen about 11% against the U.S. dollar this year, and that’s been great for exports, while inflation is the highest it’s been in five years.

japan-chartAs a result, the Nikkei is up 34% year-to-date and a $10,000 investment in Edwardes-Ker’s fund in January would be worth close to $13,000 today. Whether that strong performance continues depends on the fate of Abe’s reform efforts. He’d like to increase military spending, sign free trade deals with other Asian countries, make it easier for companies to hire and fire workers, change immigration laws, get more women in the labour force and much more. It’s not clear yet which he’s going to tackle first, but if he’s successful, Japan could look drastically different than it does today.

If even some of that platform gets enacted, the market will improve longer-term, says Eileen Dibb, a Fidelity Investments portfolio manager. Meanwhile, there is still some short-term upside thanks to low valuations. The market is currently trading at 1.2 times book value, and consensus estimates peg the return on equity at around 9%, she says. Historically, the country’s price-to-book ratio has been higher. “These valuations are certainly not expensive and should grow if the economy, as it appears to be doing, picks up,” she says.

Japan’s renaissance is not just political. The corporate sector, which until recently paid little heed to profits or shareholders, is also getting its act together. After Japan’s real estate and stock market bubble burst in 1991, companies had no incentive to grow. Interest rates fell dramatically—the central bank rate has been essentially at zero since 1996—so it cost nothing to borrow money. As a result Japan was littered with “zombie companies,” operations that are near insolvency, yet continue to survive. These often volatile operations can wreak havoc on stock markets.

While there’s still a lot of work to be done, the corporate sector is improving, says Dibb. Businesses are finally cutting costs and restructuring. The 2011 tsunami spurred some of this change, as the harder-hit companies had to slash costs to survive. More foreigners are also investing in the market, bringing a more demanding shareholder focus, says Edwardes-Ker. He points out that foreign ownership of the market has gone from 3% in the 1960s to 30% today.

Consumers are also helping change attitudes. When a country faces years of deflation, there’s no reason for anyone to buy anything, says Mark Grammer, the co-lead of Mackenzie Investments’ growth team. If an item may be cheaper next year, why buy it now? That attitude is changing as inflation resurfaces, he says. It’s easier for companies to make money in an inflationary environment. Not only are people spending money, but corporations can raise prices too.

Canadians should consider this market for three reasons, says Edwardes-Ker. It’s cheap, it’s more diversified than our domestic market and Japan is still a world leader in a number of sectors, such as cars and machinery. However, people should approach the country with caution. If Abe’s policies don’t pan out, then the market could return to its stodgy ways. Japan also faces a severe demographic problem. The population’s median age is 45.8 years, the highest in the world, meaning the labour force is shrinking and social costs are rising.

With this uncertainty, Grammer suggests buying companies that will benefit most from these reforms rather than an index-tracking mutual fund or exchange-traded fund. He’s keen on export-oriented companies, such as Toyota, which should continue to benefit from a low yen. He also likes some domestic operations, like Starbucks Japan and online retailer Rakuten, which should benefit from consumer spending growth. Simon Edelsten, a portfolio manager with Artemis Investment Management, says that construction and infrastructure-related companies could also see gains thanks to the Tokyo Olympics in 2020.

In a country where creating shareholder value hasn’t been top of mind, buying a company with a strong management team is crucial, says Grammer. Company executives need to have a good understanding of their business and demonstrate a clear path to growth. He wants to see earnings expand by double digits, which shouldn’t be a stretch in the year ahead. Tony Roberts, a fund manager with Invesco Perpetual, says average earnings-per-share growth in the country will be about 60%, versus a global average of 10%.

Also look at price-to-book and price-to-earnings ratios. While stocks have gotten more expensive since the start of the year, about 60% of the market is still trading below book value, says Edwardes-Ker. “There’s so much value there,” he says.

Japan hasn’t been a hot spot for Canadian investors, but it might be time to add the country to your arsenal of investments. “We’ll see over the next four or five months if Abe can seize the moment and push through deregulation,” says Edwardes-Key. “The market will love it if he can.”

The CB Hotlist

Abenomics should give these stocks a lift:

ORIX Corp. (TSE: 8591)

P/E: 16.1 | 1-year total return (C$): 76.1% | 1-year EPS growth: 13.9%

This financial services firm will reap the rewards of reinflation and an economic recovery.

Hitachi Metals Ltd. (TSE: 5486)

P/E: 35.6 | 1-year total return (C$): 51.8% | 1-year EPS growth: 136.7%

Rising car sales are boosting this global steel and metals maker’s sales.

Bridgestone Corp. (TSE: 5108)

P/E: 12.3 | 1-year total return (C$): 55.3% | 1-year EPS growth: 51.4%

About 40% of this tire maker’s sales are in the U.S. It’s expanding in Asia too.

Rakuten Inc. (JASDAQ: 4755)

P/E: 65.9 | 1-year total return (C$): 51.5% | 1-year EPS growth: 213%

This e-commerce retailer will see pickup from consumer spending growth and the shift to online.

Toyota (NYSE: TM)

P/E: 32.8 | 1-year total return (C$): 76.4% | 1-year EPS growth: 102.7%

The world’s largest car manufacturer is benefiting big from a weak yen.