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Where to now for Japan? By Fiona Hamilton
Japan is a distant and inscrutable country and, although its economy is the second largest in the world, it has struggled to recover from a catastrophic nineties. Its main TOPIX 100 index has made scant progress over the last 10 Its smaller company sector has been much stronger than the TOPIX over the last decade, gaining around 130% - which puts it in-line with the FT World Index for Asia Pacific ex Japan - but it tends to be very volatile. Over the last 18 months it has been exceptionally weak, so it could be due a rewarding bounce. Political and economic backdrop Japan's economic and political background do little to kindle enthusiasm. GDP growth has been slow compared to most other major regions, and snail-like compared to its regional neighbours. It has had a long struggle against deflation, and this together with an ageing population has made it hard to stimulate consumer spending, which accounts for over half the economy. Its exports have traditionally depended on a buoyant US economy, so they're vulnerable to the fall out from the subprime crisis. To cap it all, Prime Minister Abe resigned in September after barely a year in the job, to be succeeded by an older man. On a more positive note, exports to other parts of Asia and to the big BRIC economies - Brazil, Russia, India and China - have been booming, with China replacing America as Japan's largest trading partner. Years of recession and deflation have forced corporate Japan to put its house in order, with the result that even modest economic growth can result in double digit earnings growth. Capital investment has picked up well, and there are signs that a tighter labour market is feeding through to wages and consumer spending, and Prime Minister Fukuda is more interested in financial matters than his predecessor. Finally, the TOPIX 100 is now on a price/earnings (PE) ratio of around 16, which is not cheap relative to other regions, but is good value for Japan. Tony Dolphin, director of strategy at Henderson Global Investors, says that if the world economy continues to grow at a healthy pace, Japan is one of the few areas where inflation should not be a worry. It is a prime beneficiary of growth in China, and the weak yen has given it such a competitive edge in exports to other areas that it should not matter too much if its currency starts to pick up a little. He also hopes consumer spending will strengthen now that the effects of recent stealth taxes are wearing off. "Japan's domestic economy is so weak, that if the world economy tanks it will suffer," he warns. "But it is one of those markets which runs very fast when it runs, and if we are right to be positive about the general outlook, then Japan should do very well." An optimistic outlook The Allianz RCM Japan fund has topped the sector since Kazuyuki Terao look charge in September 2004, so it is encouraging that he is optimistic about the outlook. "The economy has been in a soft patch, but I believe there will be a recovery later this year driven by exports to the BRIC countries and an upturn in the IT sector," says Terao. Terao is Japanese-born, educated and based, and believes this is a big advantage. His fund concentrates on around 66 larger companies and has done well from backing exporters to other parts of Asia in sectors such as shipping, machinery and steel. However he has been raising exposure to "low valuation, domestic related stocks which appear oversold." Terao's largest holding is Toyota Motors, which also tops the list at the Fidelity Japan fund. This is managed by Robert Rowland, supported by a large locally-based team. Rowland took charge of the fund in 2003, and his returns have picked up since he moved to a more concentrated portfolio. He says Japan is reaping the rewards of economic reforms following a decade of deflation and recession. Like Terao he looks for growth at a reasonable price, and the average PE ratio on his portfolio is around 15.5. Baillie Gifford has one of the largest Japanese equity teams outside Tokyo, and its longer term results indicate that being Edinburgh-based is not a disadvantage. Baillie Gifford Japan is one of the largest mainstream Japanese specialists, with one of the best five year records, and its Japanese smaller company fund is also sizable and relatively successful. Baillie Gifford turned slightly cautious following Mr Abe''s resignation, but has since recovered its nerve. It believes many Japanese smaller companies have fallen to particularly appealing valuations, given that their largely domestic focus should shield them from any slow down in the global economy, and that they have been delivering impressive profit growth and rising dividends.
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