Joy Ride for Japanese Stocks

Japanese stocks soared some 44% last year, but this year share prices have only managed a paltry 2.6% return. That's well below the average for other major markets so far this year. On top of that, Japanese stocks look pricey at this stage, what with the benchmark Nikkei 225 index trading at a price-to-earnings ratio of 18.8 based on prospective earnings, vs. 14.9 for the S&P 500.

So is the Nikkei rally basically a spent force? Anything but: The Japanese stock market rally still has legs for the following trio of reasons:

• The end of the "lost decade" and the resumption of a normal business cycle, which should allow companies to continue to grow

• A change in the relationship between companies and the capital markets that has forced companies to reorient themselves toward higher profitability

• An increasing appetite for risk among Japanese investors, who will at some point realize that they are too far underweight their home stock market

BEYOND THE BUBBLE.

  One of the main causes of the slump in the Japanese economy during the 1990s was the so-called "Three Excesses." That is to say, the crushing burden of excess debt, investment, and employees that companies carried over from the late-1980s bubble era. Those excesses constrained growth, because companies used their profits to repay debt instead of investing or hiring. As a result, the economy couldn't gain momentum.

But with debt finally back to pre-bubble levels and no perceived excess in production capacity or employment levels, companies can take a more forward-looking, strategic approach on what to do with their profits. Should they build a new factory? Hire more people, or give their current employees a raise? Or perhaps increase dividends or buy back stock? Higher levels of investment, employment, wages or dividends would increase aggregate demand.

Thus the economy should enter into a virtuous circle in which higher profits support increased economic activity, which in turn increases profits further. Powered by this engine of self-sustaining growth, future periods of expansion should be longer than in the recent past, recessions shorter and shallower, and profit growth sustained.

FOCUS ON PROFITS.

  This prospect makes Japan a fundamentally more attractive target for investment. It is also one of the main factors that powered the rally in Japanese shares last year. We expect the economy to grow some 2.8% this year and 2.3% next year, not quite the U.S. pace but exceeding Europe's. With that tail wind, recurring profits should grow another 8.7% in the current fiscal year ending in March and 6.9% next fiscal year. They rose an astounding 20.0% last year.

What enabled companies to break out of the low-growth trap of the 1990s was a new focus on profitability. Following the Japanese financial crisis of 1997 and 1998, companies realized that they could not rely on banks for financing anymore and would have to appeal to the markets instead. That meant having to convince investors of their financial health and their future earnings power, rather than simply being big.

At the same time, the Japanese government brought domestic accounting regulations more in line with international standards, which made corporate accounts more transparent. The need to appeal to (demanding) foreign shareholders to absorb the unwinding of cross-shareholdings further spurred on this trend. In short, the change in the relationship between companies and the capital markets forced companies to change their priority from market share to profitability.

THE RALLY CONTINUES.

  As a result, profits have hit record levels in an unusually wide span of sectors, from cars and chemicals to wholesalers and retailers. Given that this new relationship between companies and the capital markets will continue and that companies are still holding down their fixed costs even as activity rises, we expect a good deal of the benefit from higher economic activity to flow down to the bottom line.

This factor, while priced in to some degree, has much further to go, in our view. Margins are still well below those in other countries, turnover is at historically low levels, and the years of paying back loans have left firms with record-low leverage. We expect all three of these factors to rise as the economy expands and deflation gives way to modest inflation.

Return on equity has already risen strongly from the 1990s average of 4.19% to 7.44% in 2005. That is the highest level since the 7.59% level hit during the peak of the bubble era in 1989. It suggests there is a fundamental underpinning for the stock market's recovery. We think ROE levels will increase to 9.40% in the fiscal year 2006 and further to 10.95% in fiscal year 2007. And that will power the next leg of the rally.

What could really make things interesting is the return of Japanese investors into the stock market. Ever since the market bottomed out in April, 2003 it has been foreign buying that has pushed share prices higher. Japanese individuals and institutional investors have both been net sellers.

The reason is simple. When Japan was suffering from deflation, to own real assets such as factories or equities basically meant losing money. Investors naturally became risk averse -- they were more concerned with return of principal than return on principal. Better just to lend the money to the government or put it into government-guaranteed savings, even if these investments paid next to nothing.

MORE BUYERS.

  However, there are signs that this attitude is changing. The expected rate of return on real estate investments has been falling. Bank lending has finally started to pick up, meaning that companies are starting to borrow and invest. M&A activity is surging. As confidence returns, investors are starting to move further out the efficient investment frontier, taking more risk in hopes of getting more return.

Eventually they will realize that they are seriously underweight their own equity market and will need to start buying. But with both foreigners and Japanese buying, who will they buy from? With more buyers than sellers, the price goes up. That will be the long-term driver of a re-rating of the Japanese market.

In short, the Japanese economy is finally coming out of the "lost decade" and resuming a normal business cycle. Companies can now shift their focus away from reducing debt and towards ensuring future profits and returning funds to shareholders. These changes are consistent with the recent trend towards a corporate governance system that places greater importance on shareholders.

They set the stage for a self-sustaining virtuous circle of economic growth and a continued rise in profits. A stronger economy should boost the risk tolerance of Japanese investors and encourage them to rebuild their equity holdings, which have fallen to unusually low levels. This is why the rally in Japanese equities has much further to run.