Getting Set For Japan's Rebound
This has been a cruel year for Asian stock markets. In the past few weeks, the Tokyo Stock Exchange has plunged back into the deep malaise that has characterized much of its nearly eight-year-long slump. And exchanges across much of the rest of Asia have suddenly found themselves reeling as a series of currency crises sweep the region. Even Hong Kong's stellar Hang Seng Index has stumbled. In this Special Report, BUSINESS WEEK's Asian correspondents take a look at the markets and come up with a surprising conclusion. While things seem dark now, the future may not be as bad as the doomsayers proclaim. This story details how government plans to deregulate vast sections of the Japanese economy could give many companies' earnings a surprisingly robust boost. An accompanying story shows that even with its travails, East Asia remains one of the world's fastest-growing regions.
It's as if the Tokyo stock market is stuck in a parallel universe. While many bourses around the globe have doubled or tripled this decade, Tokyo has been a virtual black hole by comparison. Since its peak in late 1989, the total capitalization of the Tokyo Stock Exchange has fallen from $5 trillion to $3 trillion--even after a 36% rise in the value of the yen against the dollar. The total value of stocks on the New York Stock Exchange, meanwhile, has reached $9 trillion, almost double the gross domestic product of Japan.
Any way you cut it, the 1990s have been a nightmarish ride for the world's second-biggest equity market. A fragile banking industry burdened with $236 billion in bad loans and an economy that's been growing in fits and starts since 1992 have triggered one rout after another. Now, a string of gloomy indicators, including weak consumer and capital spending, falling industrial production, and the sixth straight month of weak readings on the index of leading economic indicators, suggest that Japan is decelerating once more. The economy will be lucky to grow 2% in the fiscal year ending next March. Throw in a widening racketeering payoff scandal that has implicated Dai-Ichi Kangyo Bank, Nomura Securities, Yamaichi Securities, and others (BW--July 21), and it's no wonder investors are skittish.
The weeks of disheartening news have easily wiped out the Nikkei stock average's earlier gains this year and depressed it to 18,740, down 9% since June (chart). And the government shows no signs of being willing to mount the "price-keeping operations" that have used public money to buoy the market in the past. So when will the Tokyo market snap out of its funk? Probably not this year. Yet that doesn't mean that global investors should shun Japan. Indeed, a rising number aren't. Despite hard times, foreigners have been moving in and now account for a record 10% of the market. That's because many pros see Japan's economy as on the cusp of a transformation that could snap the Nikkei back to 21,000 by mid-1998.
IN LOCKSTEP. To the bulls, Japanese Prime Minister Ryutaro Hashimoto's plans to overhaul Japan's protected and overregulated domestic economy spell opportunity. A shakeup would create new winners and losers as wealth is transferred from one sector of the economy to another, business costs are lowered, and new markets blossom. If Japan can push deregulation and get back on a growth path, its stock may end up emulating the U.S. recovery from the bear market of the '70s, observes Kazuhisa Okamoto, CEO of Barclays Global Investors Group in Tokyo. In America back then, everything from energy to finance was regulated. But as industry after industry was streamlined and deregulated, the seeds of the 15-year bull market in America were sown.
This prospect is tantalizing enough to spawn a reevaluation of Japan. In the 1980s, when a robust economy and easy money drove the market skyward, stocks within industries tended to move in lockstep. It rarely mattered which companies you bought as long as you got the sector right. But that doesn't hold today. Pros now try to lock onto companies likely to outpace the market by dint of their global competitiveness, unique technology, innovation, or adaptability. "It's a stockpickers' paradise right now in Japan," says Paul J. Fraker, a Japan specialist at Brown Brothers Harriman & Co. in New York.
Consider the lucky souls who late last year looked beyond a Nikkei sell-off and foresaw a rebound among blue-chip Japanese multinationals. Many investors made a killing as Canon, Honda Motor, Sony, Toyota Motor, and other big exporters stormed back to health on the back of the yen's decline since mid-1995. Many of these blue chips remain in favor (table). But multinationals are not the only game worth watching. As Hashimoto's efforts to free up the economy get under way, such coddled industries as finance, transportation, and retailing should also produce pleasant surprises. With Japanese indices still heavily weighed down by ailing banks, such "new economy" issues may stand out even as the broad market appears to be treading water.
The makeover of Corporate Japan won't happen overnight, however. Strategists and money managers expect to see a choppy ride in the months ahead. Continued strength in the dollar could hit investors with currency losses--and drive them toward mutual funds that hedge their foreign-exchange exposure. The Japanese economy may also produce some more unpleasant moments. Hashimoto has given up on the huge public-spending programs that were supposed to buoy the economy starting in 1992 but have instead produced budget deficits of Italian proportions. Last spring, he slammed on the brakes, raising the national sales tax from 3% to 5%, eliminating income tax breaks, and cutting spending. The moves are hitting profits, which are expected to advance 6% in the year ending next March, against last year's 17%.
Given the dim outlook, investors are betting that Hashimoto has little choice but to try once again to get the economy moving. One way will be to continue pushing exports, even if that sparks new trade frictions with the U.S. But a more powerful force could be the loosening of the government's very visible hand. The Organization for Economic Cooperation & Development estimates that deregulating utilities, airlines, trucking, telecommunications, and retail distribution alone could boost GDP growth by 6% over 10 years.
Hashimoto is advocating deregulation because Japan must obtain higher returns from its $10 trillion in household savings to finance the care of a rapidly aging population. His biggest move so far has been to speed up the timetable for the "Big Bang" shakeup of Tokyo's capital markets by 2001. Big Bang will ease restrictions on overseas bank accounts, lower barriers separating banks and brokers, slash stock trading commissions and insurance premiums, and open more of the financial marketplace to foreign money managers.
The outcome is expected to be the emergence of a more Western-style financial system. In it, fund managers and other investors will demand far higher returns and accountability from corporations. Japan "is in the early stages of structural revolution that will result in higher returns on equity and a more shareholder-friendly environment," figures Michael Metz, chief investment strategist at Wall Street's Oppenheimer & Co.
Signs of this revolution are appearing with increasing frequency. Toyota Motor Corp. and heavy equipment maker Komatsu Ltd., for example, have begun using excess cash to repurchase stock now that the government has lifted tax burdens that prevented buybacks. Mitsubishi Corp. and Mitsui & Co. are expected to follow suit next year. A corporate governance movement is also emerging. To rid itself of yes-men and build a more American-style board of directors, Sony Corp. is downsizing from 38 to 10 directors. New rules have prompted Toyota, chip-equipment maker Advantest, and Orix, a big leasing company, to issue stock options for the first time in order to encourage their managers to improve earnings.
Companies have begun giving more information to investors. In the past, they rarely broke out sales or profits by divisions. Companies and banks also booked equity holdings at acquisition costs rather than prevailing market prices, a practice that often inflated the strength of their balance sheets. That's now set to change under new accounting rules expected to be in place by 2001. But some companies are already improving their reporting. In July, audio and video manufacturer Pioneer Electronic Corp. overhauled its organization and accounting into three segments: home products, car-navigation gear, and business systems. As a result, investors for the first time will be able to gauge earnings coming out of each unit.
Japan has also experienced a sea change in stock valuation. With the market down, average price-earnings ratios now are running in the high 30s. While this is nearly double the estimated 1997 p-e of 20 for the Standard & Poor's 500 index, it is still half of what it was at the Tokyo market's peak. Measured by price to cash flow, however, Japanese stocks look even better. Trading at an average multiple of 10, notes HSBC James Capel strategist Jason James, they "have started to come in line with foreign markets." What's more, market liquidity is improving as a growing number of banks and corporations sell blocks of each others' shares they have held to cement business ties.
In picking stocks for Japan's new economy, many money managers start with globally diversified multinationals. Many are among the world's most efficient companies. For example, Toyota's stock has cooled off in recent weeks from its record highs because of weak auto sales at home. Still, it continues to be a ferocious competitor. It has cut costs by $800 million a year, is expanding capacity in North America, Europe, and Southeast Asia, and wants to double its profitability by early in the next century. Electronics stocks are also hot. Strong earnings have kept Stephen Silverman, manager of the Merrill Lynch Pacific Fund, true to Canon despite a 30% rise in the price of its American depositary receipts this year. But many others are fans of Sony, whose ADRs remain in high demand even though their price is up 46% in 1997 on booming sales of digital video cameras and PlayStation video games.
BILLION DOLLAR BABIES. What's encouraging some pros even more is the turnaround at Sony Pictures Studios under the leadership of new chief John Calley, who took over last November. A string of strong titles including My Best Friend's Wedding, Men in Black, and Air Force One should produce $1 billion in box office sales by Labor Day. Morgan Stanley, Dean Witter, Discover & Co. analyst Takatoshi Yamamoto estimates that Sony's earnings per share will jump 32% in the fiscal year ended Mar. 31--and another 10% in fiscal 1998--and thinks the company has a good shot at beating the forecasts. Yet Sony still trades at a price-earnings ratio of 29.
A handful of high-tech players with a proven technology edge and strong pricing power are also drawing global interest. One to watch is Tokyo Electron, a leading manufacturer of steppers--devices that help make semiconductors. Tokyo Electron is expected to benefit as chip producers shift product to next-generation, 64-megabit memories. Another company is Kyocera, the world's largest maker of ceramic packaging material that encases semiconductors. It is enjoying strong profit growth from brisk personal computer sales globally.
There's more to Japan than auto and electronics exporters, however. And that's where deregulation comes in. One big beneficiary should be Japan's consumer finance companies. With Tokyo money-center lenders still working off their bad debts, many of these finance companies have targeted small companies that the big banks won't handle. Take Shohkoh Fund & Co., a Tokyo-based finance company that trades over the counter. It has been building its loan portfolio at double-digit rates yet has managed to keep nonperforming loans to a minimum through careful screening. It also charges nearly 30% on loans--a neat trick, since Japan's discount rate is only 0.5%. It's no wonder that its share price, and those of rivals Nichiei Co. and Shinki Co., have climbed an average of 39% in the past year. However, their price-earnings ratios remain at 30 or less.
Another favorite is Orix Corp., an auto and office-equipment leasing company that's getting into financial services. Brown Brothers' Fraker thinks the company is a miniature version of GE Capital Corp. and believes Orix will be one of the biggest beneficiaries of financial deregulation. Orix' pretax earnings are expected to rise 10% in the year ending next March, to $344 million. But J. Brian Waterhouse, an analyst with HSBC James Capel, recommends Long-Term Credit Bank of Japan Ltd. It recently formed an alliance with Swiss Bank Corp. that will shore up the capital base of the Japanese lender by $1.5 billion just in time for the Big Bang.
Retailing stocks are also winning a widening following. The Ministry of International Trade & Industry is considering a proposal to change rules that protect mom-and-pop retailers from malls and chain outlets. The betting is that the government will eventually ease the regulations, opening the way for big foreign and domestic retailers to open American-style superstores across Japan. Not waiting for MITI to move, UBS Securities analyst Kenneth Egusa is urging his customers to snap up Isetan Co., an upscale retailer that already boasts the industry's highest operating profits per square foot. With a p-e of 46, Isetan isn't cheap. But if the Japanese ever get serious about allowing retail expansion, Egusa argues, the company seems poised to cash in on sales to affluent suburban families.
RARE DOGFIGHT. Transportation is another industry heading for a shakeout--and new winners. Japan Airlines Co., for instance, is struggling with bloated costs, price competition on international routes, and new domestic rivals. Among them is Skymark Airline Co., a domestic carrier to be launched by discount travel agency H.I.S. Co. Skymark would be the first new airline since the 1950s and is promising to cut fares in half to compete with JAL and other carriers on its high-volume Tokyo-Sapporo route. As a result, H.I.S., which is traded on the over-the-counter market, has become a stock to watch. In addition to its airline hopes, the company's core business selling package tours and discounted airline tickets is expected to grow 20% annually this year and next.
While there are still plenty of pockets of misery in the Japanese stock market, a changing economy is beckoning. With so much bad news in the air, it takes guts to gamble on Japan right now. For those with a long-range perspective, however, there still are plenty of pearls to be found down deep in Tokyo's stormy market.