Value Appearing in Japanese Stocks

By David Hodgson

The US ‘sub prime’ event raises risks and uncertainties: foreclosures and forced selling of homes leading to lower prices, problems migrating between sub prime and prime, widening spreads on mortgage-backed securities, mark-tomarket problems in related credit derivatives and tightening bank lending standards. All of this may have knockon effects on the real economy, such as the pace of annualized US auto sales. US auto sales were 16.3million in March 2007, down from 16.6million a year previously. However, for the Japanese carmakers, the effect on volume is partly offset by relentless market share gains. In March 2007, Japanese and Korean carmakers won 41.9% of new car sales in the US. Furthermore, if the real economy starts to deteriorate, the US Federal Reserve Bank will presumably cut interest rates and it would turn out to be nothing more than a ‘growth scare.’

While events in the US can be interpreted as scary and other things being equal, the TOPIX Index seems capable of re-breaking through the 1750 resistance level, driven by the strengthening fundamentals, improving macroeconomics and company profits. On the macroeconomics, exports remain strong recently (+9% to China, +7% to the US and +17% to Europe). The latest Land Price Survey was positive with nationwide prices up around 3% on a weighted basis and up to 40% in parts of central Tokyo. Consumption seems likely to pick up in 2007 on the ‘Phillips Curve’ (inflation against unemployment) effects, as the tighter labour market leads to higher wage growth. Capital investment (CPI) remains strong and is broadening into non-manufacturing investment. The current pace of capital investment is adding 2% per annum to Japan’s capital stock yet the Capacity Utilisation Index (capex) is at a post bubble high at 109.3 –so a strong capex is likely to continue. Also, the CPI is likely to receive a kicker as rents, which are 19% of the CPI, start to rise. The latest Bank of Japan ‘Tankan’ survey of business confidence seems consistent with GDP growth of around 2.5%. Although the headline measure of confidence fell slightly from 25 to 23, it was coming off a two-year high. The employment conditions index tightened further and capex plans are the highest on record for a March Tankan.

On company profits, Nomura Securities (a leading Japanese stockbroker) recently revised up their forecast for pre-tax profits growth for fiscal year 2007 to +12.8%, while the Nikkei newspaper forecasts a similar increase of 12%. However, with the fiscal year 2006 results season, a short term risk factor is the annual ‘kabuki theatre’ ritual in which companies ‘low ball’ their guidance for the new fiscal year with ‘very conservative’ forecasts, which, at first sight disappoint investors, only for companies to revise up their forecasts during the course of the year. The key point is that, during the deflation period, with flat top line growth, companies restored profitability by rationalising and cutting costs. Now that companies typically have around 7% sales growth, further growth in profits will come from operational gearing and productivity gains.

On the valuation of the Japan stock market, Japan trades at a discount to the US and European equity markets on the EV/EBITDA share valuation ratio. Japan also trades on a much lower Price/Book Value multiple for an improving Return on Equity. Japan’s Equity Risk Premium is relatively high. While Japan’s Price/Earnings ratio is higher, this is justified by the lower level of Japanese inflation and interest rates. Japan appears under-valued on Equity-Bond Yield ratios.

In the background, there are other positive forces for improving return on equity, dividends and capital efficiency, notably M&A. With the large reduction in friendly cross-shareholdings in recent years, we are now starting to see more M&A in Japan, including some examples of hostile takeover bids. In 2006, the value of M&A deals in Japan rose 27% to US$127billion. However, the density of M&A in Japan, measured as a percentage of total stock market capitalization, remains low with potential for further increases at 2.3% of market cap in 2006 compared with 7.2% in the US and 7.6% in Europe. Furthermore, the Japan Pension Fund Association recently proposed that, if companies have a return on equity of less than 8% for three straight years, they will oppose re-appointing directors (another force to improve capital efficiency).

On investment themes, sectors and stocks, a portfolio of Japanese shares ought to do relatively well in the mid to long-term, constructed with a diversified range of themes. For example, Real Estate stocks such as Daibiru 8606 ought to benefit from improving land prices and rents. Housing and Housing Materials stocks should benefit from the large ‘pent up’ demand for home re-modelling in Japan. Private Railways such as Keio Corp 9008 and Odakyu 9007 can be seen as real estate proxies. If capital investment remains strong, related stocks such as Okamura 7994, Kurita Water 6370, Hisaka Works 6247 and Itochu Techno Solutions 4739 look well-placed.

Another theme is consumption trends with attention to Japan’s demographics. In surveys of how Japan’s retiring ‘baby boomer’ generation will spend their money, travel ranks highly, so stocks such as HIS 9603 and Japan Airport Terminal 9706 seem to have a favourable outlook. With 20% of Japanese now aged 65 or older according to the 2005 census, demand for pharmaceuticals seems set to grow, benefiting stocks such as Tanabe Seiyaku 4508, Toho Pharmaceutical 8129, Towa Pharmaceutical 4553, Kyowa Hakko Kogyo 4151 and Mochida Pharmaceutical 4534.

And then there are environment-related issues. The Japanese auto industry leads the world in hybrid and more fuelefficient cars. Isuzu Motors for instance is a leader in diesel engine technology –if the US adopted diesel on the scale that Europe has, it would no longer need to be a net importer of oil. Toho Titanium 5727 is a leading producer of materials for lighter, more fuel-efficient airplanes. Sharp 6753 is the world’s leading producer of solar panels, which reduce carbon emissions. Nippon Soda 4041 has a chemical process for disposal of toxic PCBs. Other themes are growth in the global market for car satellite navigation (Alpine Electronics 6816, Zenrin 9474); growth in international trade, particularly with Asia, benefiting shipping, port services and warehousing companies such as Nippon Yusen 9101, Kamigumi 9364 and Hitachi Transport System 9086; and growth in China demand benefiting companies such as Uni-Charm 8113 and Toto 5332.

The views expressed are the personal views of the writer. Shares can fall as well as increase in value and the investor’s capital may be at risk.