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Never Mind the Nikkei

Joe Joseph, a fund manager at Putnam Investments, has invested a big chunk of the International Capital Opportunities Fund (PNVAX) in Japanese companies. The reason: He sees opportunities in companies that have turned their fortunes around.

For now, the macro case doesn't look that compelling. Japan's sizzling expansion and exports have been slowing this year. The country's gross domestic product grew only 0.5% in the first quarter, vs 1.1% during the three months ended in December, the government of Japan's Cabinet Office said Friday. The next trading day (May 22), the Nikkei index fell to two-month lows as the prices of metals and crude oil slumped.

But Joseph isn't fazed. He looks beyond the economic numbers and market swings and sees thousands of companies in Japan whose managers have dramatically improved their businesses. "No matter how you cut it, it doesn't seem like (the good times for small-cap Japanese stocks) are over," Joseph says.

ENERGETIC LEADER. Joseph first noticed Japan's companies beginning to change a few years ago. After Shizuoka-based Yamaha Motor Co. named Toru Hasegawa its president in 2001, Joseph met the new manager at Putnam's offices in Boston. Like many Japanese executives, Hasegawa began in his native tongue and waited for his translator to speak for him in English.

Within about 10 minutes, Hasegawa became visibly impatient. He finally broke into capable English and energetically explained his message. He was not an engineer, like most of the Japanese motorcycle company's previous leaders, and he did not plan to make the most technologically advanced products irrespective of cost or consumer appeal. He didn't want to lose money from turf battles with his Tokyo rival Honda Motor Co. (HMC). Instead, he said he was going to focus on the company's profits.

"This was a huge shift" from Japan's traditional ways, Joseph recalled. He and his investment team bought a stake in Yamaha, even as other analysts shook their heads at the company's heavy debts and swore it would never change.

BIG EXPOSURE.Yamaha isn't the only Japanese company to impress the Putnam team in recent years. About a third of the $1.66 billion International Capital Opportunities fund is invested in Japanese stocks with market capitalization under $4 billion. That makes it more exposed to Japan than the typical foreign fund.

Japan makes up around 26% of the MSCI EAFE Index, an international equity performance benchmark. In 1999, Putnam's fund had only about 8% in Japan.

The fund "has more invested in Japan now than most foreign funds do, but that's not necessarily something to be concerned about," says Gregg Wolper of investment research firm Morningstar. "It depends on which companies it owns."

PROFIT FOCUS.Japanese companies in general were bogged down with debt and high spending throughout the 1990s. After the country's financial crisis in 1997 and 1998, companies had more trouble persuading banks to bail them out with loans.

Instead, they had to turn to investors like Putnam's team and please them with market-friendly steps such as focusing on profit. Wall Street applauded, and Japanese stock prices soared (See BW Online, 3/29/06, "Joy Ride for Japanese Stocks"). "Things got so bad that companies were forced by economic realities to make good decisions," says Karan Sodhi, senior vice-president and portfolio manager at Putnam.

Putnam's bet on Japan, along with a healthy performance in small-cap stocks during recent years, helped the International Capital Opportunities Fund improve its poor performance in previous years. Though the fund has been treading water recently, it's up 14.87% so far this year through May 18, according to Morningstar.

OUTPERFORMER.The fund outperformed 82% of its peers in that time. Over the past three years, the fund beat 60% of its peers with 33.1% total return. That's a decent showing, considering Putnam Investments has suffered from high employee turnover and a bad reputation following the market-timing scandal in 2003. (Morningstar rates the fund two stars out of five.)

One stock Joseph likes is Brother Industries, which Joseph started buying in late 2001. Brother Industries' president, Seiichi Hirata says on the company's Web site that its No. 1 goal is "to become a leading global company with high profitability."

Brother has been slashing staff in recent years and breaking with Japanese tradition to move work to cheaper locations overseas. For example, it said in February that it was opening a printing equipment manufacturing subsidiary in Shenzhen, China.

MARKET-FRIENDLY.Another top holding is Osaka-based Tanabe Seiyaku. Among other things, Joseph likes the company's stable pharmaceuticals business. Tanabe started selling Remicade as a treatment for Crohn's Disease in Japan four years ago. In July, 2003, Remicade was approved to treat rheumatoid arthritis.

The company's other drugs on the market include gastric ulcer and gastritis treatment Gastrom. The drugmaker has taken market-friendly steps in recent months, such as buying back shares and increasing its dividend. About 1% of the fund is invested in Tanabe Seiyaku since the managers first bought the stock about a year ago.

Putnam's managers also continue holding companies that will benefit from the yen's recent's strength against the dollar, such as the Tokyo coffee chain DoutorCoffee. The greenback was trading at around 111.45 yen on May 22, according to Bloomberg, down from 117.88 in January.

READY TO MOVE. While this poses a threat to Japanese exporters that spend in yen and earn dollars, DoutorCoffee has mostly dollar expenses. The coffee beans it buys to roast and sell wholesale are denominated in dollars, so it saves money as the greenback weakens. Joseph started buying Doutor shares in fall 2005 and now holds around $6 million-worth in the fund.

While Joseph and his team still have confidence in many Japanese companies, they're also ready to shed a stock when they don't see any more value. Yamaha Motor's share price had risen to around $28.64 on May 22 from under $6 in early 2002, according to Bloomberg.

Putnam's managers dumped their stake in Yamaha Motor about six months ago. In January, the company made Takashi Kajikawa president instead of Hasegawa, who became a chairman. Says Joseph, pointing out that Kajikawa has an engineering background: "We worried they might be going back to the old way of doing things."

Correction: An earlier version of this story said the fund's return of 14.87% was over a 12-month period. This is its year-to-date return.

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