Nikkei Shows No Signs of Slowing -- 3 ADRs to Watch

I have to admit Japanese stocks are performing much better and in a more stable manner than I had imagined. I clearly cashed out my iShares Japan call options too soon!

The Nikkei 225 Stock Average gained 0.67% to 16,637.78, TOPIX gained 0.54% to 1,636.72, and JASDAQ lost 0.89% to 86.45. Smaller cap stocks are still lagging, and despite the new State Street ETF (ticker: JSC) composed of the smallest 350 (of 1,000) Japanese small caps, it's still difficult to play this segment. There is little interest in JSC at present -- it has a wide bid/ask and often trades at a premium to NAV.

Today, I want to look at three stocks that have both near-term and long-term potential:

First, let's look at Nomura Holdings (NMR), which I traded out of recently (bad timing?), but may re-establish a position. Nomura is a good play on Japan for the following reasons: (1) recent development that Japan's favorable tax status for dividends and cap gains set to expire beginning in 2008 may be extended through March 2009, (2) Nomura's recent purchase of Instinet, making it more attractive to hedge funds and providing it an advantage over other traders, (3) robust M&A activity, (4) introduction of triangular-mergers next May, meaning foreign firms with subsidiaries in Japan can use shares to enter mergers, an excellent chance for Nomura with its globally recognized name, and (5) sustained gains in Japanese stocks will bring more private money into the market meaning more trading and asset management fees.

Second, Nissan (NSANY) is interesting because, among other things discussed below, its ordinary shares (Tokyo: 7201) trade at 10.8x trailing earnings, 1.7x book, and have a trailing yield of 2.12%, compared with its largest domestic (and global) rival Toyota (TM) (Tokyo: 7203), which trades at 17.1x earnings, 2.1x book, and has a yield of 1.24%. There's no doubt Toyota, which is trading at an all-time high, can go higher. But one issue is how much of Toyota's growth is priced in, versus its potential upside, and how negatively investors will react if Toyota reports lower numbers or has more recalls.

Nissan on the other hand, has been mostly about disappointments in '06 (see latest earnings summary, which actually was a positive surprise helped by the weak yen), reporting consistently lower sales as it hasn't had a line up of new cars. That's all changing now and into '07. And there's the recent news of Nissan getting its act together in the hybrid segment. Don't forget its alliance with France's Renault, which provides it with competitive advantages in Europe and BRIC markets. Also, its long/short margin interest ratio at 0.68 improved drastically last week, with over 1m shares added on long margin, as short positions fell by 770k.

Lastly, let's revisit (see here for related discussion, scroll down) Internet Initiative Japan (IIJI). This is a neat IT, small cap play that is basically under the radar in Japan, but well-positioned for the expansion of network/data connectivity and security, ready to benefit from IT upgrades across Japan. After trading lower on Friday and yesterday in a classic "buy on the rumor," and "sell on the news," its ordinary shares (Tokyo MOTHERS: 3774) managed to add nearly 2.5% today closing at ¥423,000 ($9.04 ADR equiv. at ¥117/$1).

I think with its transfer to the TOPIX, which is supposed to transpire Thursday, it will receive much improved coverage, and hopefully (eventually) splits its shares. In the meantime, management has said it won't be issuing new shares, so with only 204k shares outstanding it's expected there will be strong demand as index funds begin purchasing. The Nikkei Kinyu Newspaper reported there's a big possibility of IIJ initiating a dividend at the end of this fiscal (next March). It also said IIJ's president is targeting 15% annual revenue growth.

iShares MSCI Japan Index ETF (EWJ) 1-year chart:

Disclosure: I own shares of Internet Initiative Japan.