Japan: Sit Back, Enjoy The Ride

It looks like all the pieces are in place for a rebound in Japan

Investors who bet on Japan in 2006 may feel down on their luck. After the benchmark Nikkei 225 index surged to a 15-year high in April, the market sputtered. Between May and November, the Nikkei lost nearly 6%, vs. a gain of 10% for the Standard & Poor's 500-stock index, sending foreigners to the exits. Net purchases of Japanese stocks by international investors totaled around $35 billion in the first 11 months of 2006, compared with $85 billion during the same period in 2005.

The "Buy Japan" camp, though, is staying put. The main reason: Stocks haven't been this cheap in decades, at least when compared with U.S. shares. Sure, Japanese issues are trading at about 17 times forecast 2007 earnings, vs. an average of 15 for S&P 500 shares. But when the Nikkei peaked in 1989, they averaged more than 58 times earnings, excluding financial stocks, vs. a multiple of about 13 for the S&P. The figures look even better when you consider that Japan's interest rates are the lowest of any industrialized country--and low rates tend to push price-to-earnings ratios higher. Since the Bank of Japan is wary of choking off growth by ramping up rates too quickly, there's little chance of p-e's taking a dive anytime soon.

The relative strength of Japan's economy helps, too. With banks no longer groaning under huge debt and deflation a thing of the past, the market appears poised for a comeback in 2007. Nomura Securities Co. predicts a 10% rise in the Topix index by yearend. "The market has been so bad there's potential" for a turnaround, says M. Campbell Gunn, a fund manager at T. Rowe Price Group Inc. (TROW ) in Tokyo. Another draw: Japanese companies are getting more generous with dividends, notes Kathy Matsui, chief equity strategist for Goldman Sachs & Co. Japan (GS ). Payouts are now running at 23% of earnings, up from less than 19% in May.

What sectors should you load up on? Tech equipment and transport, says Shinichi Ichikawa, an analyst at Credit Suisse First Boston (CSR ). His picks include Toyota Motor Corp. (TM ), which forecasts a nearly 20% jump in operating profit in the year through March, 2007, and is likely to overtake General Motors Corp. (gm ) as the world's No. 1 carmaker soon. Toyota's ascendancy has been a boon for suppliers such as Denso Corp., where Ichikawa sees double-digit profit growth as the company steps up sales of car navigation gear and hybrid engine parts.

YOU CAN ALSO FIND GEMS among Japan's precision tech specialists. Look for companies with niche technologies used in flat-screen TVs, iPods, and digital videorecorders, recommends Ryoji Musha, Deutsche Securities' (DB ) chief investment officer in Tokyo. One is Nidec Corp. (NJ ), which has 71% of the global market for tiny motors that power hard drives used in DVRs and portable music players. Musha also likes Toray Industries Inc., a carbon fiber specialist and key supplier to jetmakers Boeing Co. (BA ) and Airbus.

While many investment pros are bullish on Japan right now, a few skeptics worry about the impact of a U.S. slowdown. True, Americans buying Toyota sedans, Canon (CAJ ) cameras, Panasonic TVs, and the like have helped to bankroll Japan's recovery. But with the economy back on its feet, Japanese stocks just might rebound regardless of what happens across the Pacific.

By Kenji Hall

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