Japan Investing Remains an Enigma

By Murray Coleman

Despite ongoing political turmoil, the Japanese Nikkei average is rallying, surging nearly 20% since mid-March.

The blue chip exchange has now moved into positive ground for the year. By contrast, most other major developed stock markets around the world remain firmly in the red.

"Japan isn't a top-down story anymore. But it's still the home of many of the world's most competitive global companies," said Darrel Whitten, a former Lehman Brothers research director who now runs Japaninvestor.com.

Improving corporate governance and booming trade has helped boost cash reserves at many Japanese goliaths. Analysts believe that they'll get plenty of opportunities to deploy that war chest in coming years as neighbors such as China, Russia and South Korea continue to grow.

"In world trade, Japan's strategic location can't be ignored," said Tom Hepner, an advisor and portfolio manager at Ruggie Wealth Management in Lake County, Fla. "Its wealth of intellectual capital, well-educated workforce and technologically advanced manufacturing sector puts Japan in a strong position across Asia."

But any payoff from that wealth is likely to be a slow, drawn-out process. The promise of a prolonged resurgence in Japanese equities has come and gone many times before in the past decade. And with GDP growth predications for the next several years hovering around 2% a year, there's concern that if the global economy continues to weaken, Japan will slip into a recession.

"The sentiment is that Japanese stocks have bottomed, but on the upside it's still going to be a bit touch-and-go for awhile," said Whitten, the Tokyo-based analyst. "Institutional investors are concerned that Japan might turn out to be another value trap."

Exporting Is King

Exports remain the backbone of the Japanese economy. While that's a strength in good times, it leaves the country vulnerable when other global leaders slow. "If the U.S. moves into a lengthy recession, it's going to be more difficult for Japan to avoid the same fate than a lot of other major developed economies," said David Cohen, director of Asian forecasting at Action Economics.

Elections later this year could help Japan muddle through any immediate downturn. For now, the country's political system seems paralyzed to enact any major economic reforms. That's key since a stringent immigration policy and aging workforce need stimulus to keep competing at high levels in global markets.

The situation is so bad that politicians can't even decide on whom to appoint as governor of the country's central bank. "It's like President Bush having trouble finding consensus to appoint Ben Bernanke," said Tu Packard, senior economist at Moody's Economy.com. "This is a tremendously embarrassing situation reflecting how much in shambles Japanese politics is right now."

A few rays of hope remain on the horizon, however. Construction activity and bank lending have shown some signs of expansion lately. If fixed-income markets improve, that could provide a big boost to Japan's domestic fortunes. And even though the yen has strengthened against the U.S. dollar, it remains competitive with the euro and major Asian currencies. In fact, the country's interest rates have actually been going up - another positive trend that inflation is present and deflation remains a past nemesis.

"We're fairly optimistic about Japan—if they can get over their political paralysis, the country has strong infrastructure and a very good workforce. This is still a world-class economy with a lot going for it," said Packard.

Is There Value?

U.S. investors have several different ways to play Japan using exchange-traded funds.

The WisdomTree DEFA ETF (NYSE: DWM), for instance, uses corporate dividend yields to rank stocks. Japan gets about a 9% weighting. That's less than half its weight in the market-cap-weighted iShares MSCI EAFE Index (NYSE: EFA).

"Japan as a whole has relatively low dividend yields compared to the rest of the world. That said, as Japan grows and companies pay more dividends, they'll get larger weights in the index," said Jeremy Schwartz, WisdomTree's deputy research director.

The PowerShares FTSE RAFI Developed Markets ex-U.S. ETF (AMEX:PDN), meanwhile, takes into account dividends as well as a company's total book value, cash flow and sales, to weight its holdings. It gives Japan almost the same weight as EFA does.

Jason Hsu, Research Affiliate's research director, says he's finding a lot of underlying strength in the country's firms. "You want to get substantial exposure to Japan, regardless of whether you think it's undervalued or overvalued. It's just too important to the global economy," he added. "We'd only venture away from the market when data strongly suggests mispricing over a longer-term period."

Steven Schoenfeld argues that long-term focused U.S. investors shouldn't adjust allocations to Japan based on macro-economic forecasts.

"In this global economy, it's wrong to consider an investment in Japan as simply a play on that country's GDP rate. No matter what its overall growth may or may not be, Japanese companies are producing earnings and creating a significant presence in world markets," said the chief investment officer for global quantitative management at Northern Trust.

And he says that overweighting Japan in a portfolio isn't as big of an issue as shifting allocations in the opposite direction. "I'm not beating my hand on the table arguing that investors need to put more into Japan," Schoenfeld said. "What I'm warning is that people need to be very careful if they choose to underweight it relative to the market."